Picasso - Finance Flashcards
Explain the time value of money.
Bird in the hand is worth two in the bush
Value of a dollar tomorrow is worth less than today.
- Opportunity cost of investing in treasuries, bonds, stocks, etc.
- Risk = measured by the discount rate
- Inflation
Why is inflation important?
- Reduces the purchasing power of your dollar
- Real interest rates –> Bond investor: fixed-rate instruments are hurt not only by the real value of dollars received by the coupon, but the fed may raise interest rates to slow inflation and make your bond less attractive
- Expectations of rising interest rates
- Some inflation is good for the economy: incentivizes people to spend their money today rather than tomorrow
Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?
Return on assets
Let’s assume $5 of earnings.
A: $5/100=5.0%
B: $5/10=50.0%
All else equal, Company B is more efficient at using its assets.
But is this levered return? May be burdened with debt
What is the treasury stock method? Walk through the calculation.
Method of calculating of net dilution from the exercise of options, assuming that any cash proceeds the Company receives are used to repurchase shares in the market
Shares issued - (Proceeds/Share price)=net shares issued
A product’s life cycle is now mature. What happens to the net working capital?
Decrease as business becomes more efficient.
Company may be able to demand tighter receivable terms from customers, optimize inventory holding periods, and stretch payables.
Why is bank debt maturity shorter than subordinated debt maturity?
Temporal seniority
If a subordinated bond matured before a bank loan, it would be “effectively senior” as it would be paid off first before the bank loan assuming the co is a going concern
What is LIBOR? How is it often used?
London Interbank Offered Rate
Rate at which prime financial institutions lend overnight to one another.
Reference / benchmark rate at which many financial institutions lend to one another and at which instruments are priced.
What is a PIK?
Paid in kind interest
Interest accrued on the principal balance that is not paid in cash to the bond honlder.
What is a PIPE?
Private Investment in Public Equity Dave & Busters during Covid Qualified investors When credit markets are tight. No unencumbered assets. Need to raise capital quickly. Fast moving investor willing to put money in equity at a discount to current share price No expensive roadshow
If you put $100 in the bank and got back $2 every year for the next 19 years and then in the 20th year, received $102, what is your IRR?
Same as a bond. 2%
What is a coverage ratio? What is a leverage ratio?
Coverage = EBITDA / Net interest
- How many times do your earnings cover EBITDA? Try to have it above 2x
Leverage = Debt / EBITDA
- At a constant EBITDA, how many years would it take to pay down debt
How do you think about the credit metric: (EBITDA – Capex)/interest expense?
Great for capital intensive companies
Numerator is a more realistic metric of a company’s cash flow and ability to meet its contractual obligations
You have a company with $100 million in sales. Which makes the biggest impact? A) Volume increases by 20 percent B) price increases by 20 percent C) expenses decrease by $15 million.
(B) Price increases by 20%
A) Volume increase would be accompanied by an increase in variable costs
B) Straight to pre-tax income (though may not be sustainable)
C) Sales up $20 while expenses down $15.
If a company’s revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?
Depends on variable / fixed costs. Assuming it has some operating leverage, EBITDA will grow more than 10% because costs will be constant notwithstanding output
Why should the fair market value of a company be the higher of its liquidation value and its going-concern value?
One would think rational managers will liquidate the company if its going-concern value is worth less than what it’d be if it closed doors today (and vice versa)
How will a decrease in financial leverage affect a company’s cost of equity capital, if at all?
Draw optimum capital structure graph.
Cost of debt is cheaper than equity due to its tax shield and relative seniority in the capital structure. As you incur more debt, WACC goes down up into the point that the company starts feeling the debt burden (extra distress > value of tax shield).
Let’s say that I have a bond with a 5 percent coupon. What happens to the market price when the prevailing interest rates rise to 8 percent? How are the coupons affected?
Price of the bond will go down
Coupon unaffected
What’s the difference between IRR, NPV and payback?
IRR: annualized rate of return given a stream of cash flows from an investment that makes NPV = 0
NPV: whether or not a project can add value based on its additional costs; use to compare the size of investments at a given discount rate
Payback: amount of time it takes an investor to recoup costs (no time value of money)
Why would a company repurchase its own stock? What signals (positive and negative) does this send to the market?
- Reduce the denominator of EPS
- Return on buyback > other projects in the market
- Return capital to shareholders at capital gains rate (taxed more favorably)
(+) Signals = mgmt believes in the company, believes stock is undervalued (they know the co. better than anyone else)
(-) Signals = not using cash well. If the share price is too high, can be lighting capital on fire
If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt versus equity)?
Depends on the (i) cost of debt; (ii) covenants on debt; (iii) current capital structure; (iv) current stock price; (v) age of the company, etc etc
Why would a company issue preferred over common stock?
- Should raise from the cheapest source available, but there are other considerations
- Investors want downside protection and annual payments.
- Not dilutive
- Sufficent cash flow to cover payments (can PIK it too)
- Share price low
Why might a company issue debt over equity?
- Cheaper cost of capital
- Unemcumbered assets or stable cash flows
- Tax deductible interest**
- Investors want downside protection and annual payments.
- recapitalization
- Not diluting shareholders
What are some reasons why a company might tap the high-yield market?
- Too risky for investment grade market.
- LBO / M&A
- Recap
- Already levered
What is the relationship between a bond’s price and its yield?
Inversely related
What are the factors that affect option pricing?
Option: right but not obliation to purchase or sell an asset at or before a specified point in the future.
- Price of underlying security
- Time to exercise
- Standard deviation of price of underlying asset
- Risk free rate / dividends impact cost of carry
Explain put-call parity.
Demonstrates the relationship between a put and call with the same strike and expiration
- Shows that the implied volatility of calls and puts are identical
- short a put and long a call
Say you have a normal bond that you buy at par and you get the face amount at maturity. Is that most similar to buying a put, selling a put, buying a call or selling a call?
- Limited upside; 100% downside
- Selling a put
You have a company with $500 million of senior debt and $500 million of junior debt. The senior debt has an interest rate of L+ 500 and, in default, would recover 70 percent; the junior debt would recover 30 percent in default. What should the interest rate be on the junior debt?
Loss on default * Probability of default = incremental interest that needs to be paid
70% loss on a 5% probability (assumption) = 3.5%
L + 850
What if this was an LBO scenario and you had a sponsor putting in 500 million of equity?
What’s the new recovery to juinor holders?
70%500=350. Senior holders would recover 150 of the first 500.
The remaining 350 would go to the junior guys, bringing their recovery to 350+(0.3500)=500
No incremental interest needed
A company has $10 million of cash and $1 million of shares, nothing else. What’s its stock price?
What is cash valued at?
1.0x?
Stock price of $10
What if the company wins $10 million in the lotto?
Cash up $10.
Stock market expectations.
$20?
What if the company uses the lotto money to repurchase shares at $25/share? What’s the share price today if the repurchase is in one month?
$10mm/$25=0.4mm shares
0.6 shares OS
PF share price = 10/.6=16.66
Wtd average share price = 0.425 + 0.616.667 = $20
What kind of stocks would you issue for a startup?
Protect downside while limiting dilition.
- Preferred stock (liquidation preference, convertible into debt, accruing)
- Voting stock
- Convertible debt
When should a company buy back stock?
- ROI on stock buybacks is greater than other investments
- Price low enough (cyclical industry)
- Send signal to market
Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?
Dividends: Yes - ordinary tax rate
- Not tax deductible at corporate level
Preferred Stock: Yes - “return of capital” tax rate - treatment found in prospectus
- Normally NOT tax deductible
When should a company issue stock rather than debt to fund its operations?
- Stock price (Tesla) / You’re Hertz
- Interest rate on debt burdensome (credit risk, credit markets are closed, etc.)
- Credit support lacking (lumpy cash flows or no asset support)
Why would an investor buy preferred stock?
- Protect downside
- Can structure and negotiate with company (coupon, liquidation preference, conversion features)
- Tax rate favorable (qualified dividend?)
- Equity / Debt unattractve
Why would a company distribute its earnings through dividends to common stockholders?
- ROI on dividend versus other capital allocation pathways (M&A, capex, R&D, share buybacks)
- Send signal to market
- Some investors rely on the dividends
You are in the board of directors of a company and own a significant chunk of the company. The CEO, in his annual presentation states that the company’s stock is doing as it has gone up 20% in the last 12 months. Is the company’s stock doing well?
Depends.
- Beta –> what’s the market done?
- Industry / comps?
- Robinhood traders?
When would you write a call option on Disney stock?
“Write” = sell
You may or may not own some Disney stock but don’t think it doesn’t have much room to run over X period. Collect premium and hope it doesn’t rise above strike.
- Hedge?
- Speculation?
