SEM 2 Flashcards
Call Option definition
Gives the holder the right but not the obligation to buy an asset at the exercise/strike price
option premium definition
Purchase price of the options
difference between, in/at/out of the money
in the money: Stock price > k
out of the money: Stock price < k
at the money: Stock price = k
Consider a stock priced at £195 and a put costing £5
suppose the stock is priced at £188 at expiration
what is the holding period return
value at expiration = 195-188 = 7
investor profit = 7-5 = 2
holding period return= 2/5 = 40%
Use of Derivative markets
Allows market participants to trade/reallocate different types of risk in the economy
You have 100 shares of MSFT stock at £46
You buy a put option with k=45 on 100 shares
MSFT tanks to £35
what is the effect of the put
Without insurance you lose £1100
by exercisng the put option you sell shares for £4500 only a loss of £100
explain the law of one price
- In an efficient market, identical securities ( same PV of cash flows) must sell for the same price, no matter how they are generated
how does introducing debt into capital structure effect EPS
Magnifies the result compared to the unlevered position
M and M model assumptions
Capital markets are perfect and friction free
- companies and indivudals can borrow at the same rate ( unrealistic)
- no taxes, transaction costs, issuance costs ( very unrealistic)
- there are no costs associated with liquidation (lawyer costs)
- companies have a fixed investment policy: investment decisions are not affected by financing decisions
Define: Financial distress
When a firm has difficulty meetings its debt obligations
Define: Default
When a firm fails to make the required interest or principal payments on debt
Define: Bankruptcy
If asset value < liabilities
2 types of Bankruptcy costs
Direct costs: Fees to accountants, lawyers ect average cost of 3-4% of pre-bankruptcy MV
Indirect costs: lost sales, damage to reputation and management time spent attempting to avert bankruptcy, estimated potential cost of 10-20% of firm value
Pecking order theory assumptions
- Sticky dividend policy
- A preference for internal funds
- An aversion to issuing equity
note: POT does not lead to optimal capital structure, rather capital structure is reflection of the firms need for external finance
What is the asset substitution problem (agency cost of debt)
- shareholders in company with outstanding debt own call option on assets of the company
- managers have incentive to accept negative NPV projects with large risks if firm is close to bankruptcy
- call option value increases with increasing volatility
- transfer of wealth from bondholders to shareholders
When does agency cost of equity arise
when there is a conflict of interest between managers and shareholders
Explain the underinvestment problem
Equity holders choose not to invest in positive NPV project becuase the firm is in financial distress and the value of undertaking this investment opportunity will accrue to the bondholders rather than themselves
- existing shareholders will not contribute as the first gains from the project accrue to the debt holders
- New shareholders will not buy equity at existing prices but will require a substantial discount. existing shareholders will reject this as their interests are diluted
detail the free cash flow problem ( agency cost of equity)
if FCF is not paid out to investors, managers more likely to abuse the funds for their own benefit; e.g corporate jet, negative NPV projects for growth
solution; increase leverage, higher dividends, align goals of management and shareholders through compensation
Define: payout policy
the way a firm chooses between the alternative ways to distribute FCF to equity holders
2 types of dividend
cash, paid quarterly or yearly
stock, less common and resemble stock splits
what is a share repurchase and how is it done
when the firm uses cash to buy shares of its own outstanding stock
Open market repurchase makes up 95% of share repurchases
Tender offer: a public announcement of an offer to buy back a specified amount of outstanding securities at a prespecified 10-20% premium
Dutch auction: firms lists different prices it is prepared to buy shares and shareholders in turn indicate how many shares they will sell at each price
targeted repurchase: firm purchases directly from a specific shareholder at a discounted or premium price ( potentially to avoid takeover)
Greenmail: when a firm wants to avoid threat of takeover
Describe the signalling power of dividends
- investors may associate dividend increases with higher future earnings, positive signalling
- share repurchase may be used by firms to send positive signals to the market since firms are likely to buy back its own stock when it is undervalued
empirical finding are consistent with above
how do different groups believe dividend payout affects firm value
the conservative - increase in dividend payout increases firm value
the neutral - dividend policy doesn’t affect firm value
the radical- an increase in dividend payout reduces firm value
what is the perfect market view of change in dividend policy
a firms value is relatively insensitive to its choice of dividend policy when its capital structure is held constant
any change in Dividend payment will lead to an equal and opposite change in the amount of funds raised from new shares
What is the profitability index rule
it recommends an investment whenever the profitability index exceeds some predetermined number
P = NPV/ initial investment
when there is an option to delay, invest only when the index is >1
What is the hurdle rate rule
Raises the discount rate by using a higher discount rate than the cost of capital to compute the NPV to give a margin for error
Hurdle rate = cost of capital x annuity rate/ risk free rate
Advantages of going public for a firm
Raising Capital: Funding growth initiatives and expansion plans, R&D, paying off debt
Greater liquidity - easier for initial investors to buy/sell
less informational asymmetry
Increased Visibility and Credibility
Potential for Higher Valuation
disadvantages of going public for a firm
less monitoring = less control as ownership could be dispersed
costly and time consuming to disclose information, to meet listing requirements
Types of Initial Public Offering (IPO)
primary offering - new shares listed, all capital raised goes to the firm
secondary offering - individual investors selling shares
4 sources of funding for a firm
Angel investors - individual investors offering capital for a significant portion of equity
Private Equity firms - Limited partnerships , raising money to invest in private firms (often appoint managers to monitor the capital they have invested)
Institutional investors - they invest in private firms
Corporate investors - corporations invest in other firms for the returns and/or to achieve strategic objectives
Mechanics of an IPO
Find an Underwriter
Provide info to the Authorities (legality)
value the firm
build a book
price the deal and manage risks
Public debt: 4 types of corporate debt
notes - unsecured short term debt
debentures - unsecured long term debt
mortgage bonds - secured by real property
assets backed bonds - secured by any kind of asset
Public debt: 4 types of bond market
Domestic bonds - issued an traded locally; open to foreign investors
Foreign bonds - issued by a foreign firm in the local market; purchased by local investors
Euro bonds - international bonds not in local currency
Global bonds - a combination of domestic, foreign and eurobonds
Junk bonds
high probability of default therefore high yields
2 types of private debt
Term loans - A loan that lasts a specific term and is funded by either one bank or a group of banks.
Private placements - A bond issue sold directly to a small group of investors. It is less costly to issue since it is not registered.
indirect quotation
the exchange rate is given in number of units of the foreign currency per unit of the home currency
What is the interest rate parity
As a result of market forces, the forward
rate differs from the spot rate by an
amount that sufficiently offsets the interest
rate differential between two currencies
Then, covered interest arbitrage is no
longer feasible
state the international fisher effect
Suggests that currencies with higher
interest rates will depreciate because the
higher nominal interest rates reflect higher
expected inflation
Hence, investors hoping to capitalize on a
higher foreign interest rate should earn a
return no higher than what they would
have earned domestically
What is the cash and carry strategy
A strategy used to lock in the future cost of an asset by buying the asset for cash today and “carrying” it until a future date.
The cash-and-carry strategy also enables a firm to eliminate exchange rate risk
Advantages of forward contracts
– A forward contract is simpler, requiring one transaction rather than three.
– Many firms are not able to borrow easily in different currencies and may pay a higher interest rate if their credit quality is poor
Types of merger
horizontal - same industry
vertical - acquiring buyer or seller (google/andriod)
congolmerate - unrelated industries
What is the acquisition premium
Paid by an acquirer in a takeover, it is the percentage difference between the acquisition price and the pre-merger price of a target firm
7 reasons to acquire
Large synergies
Economies of scale/scope
vertical integration (streamline)
expertise
diversification/ risk reduction
Earnings growth
managerial motives
Define Business risk
Business risk is the risk inherent in a company’s operations and will depend largely on the industries in which the company operates
Define Financial risk
Financial risk is the additional risk to which shareholders are exposed due to a company’s use of debt finance.
Define Defualt risk
Default risk is the risk that a borrower may fail to make the repayments that are due to lenders.
Both financial risk and default risk are associated with debt finance but the two risks can be distinguished. In particular, any borrowing by a company will cause financial risk, even if the risk that the borrower may default is zero
Problems due to financial distress
Overinvestment (asset substitution): investing in negative NPV projects; underinvestment: not
investing in positive NPV projects; cashing out: paying out dividends instead of investing in
positive NPV projects; employee job security: highly leveraged firms run the risk of bankruptcy
and so cannot write long-term employment contracts and offer job security
Explain why bond issuers might voluntarily choose to put restrictive covenants into a new
bond issue
Bond issuers benefit from placing restricting covenants because by doing so they can obtain a
lower interest rate
