SEM 2

Question 1

Call Option definition

Answer 1

Gives the holder the right but not the obligation to buy an asset at the exercise/strike price

Question 2

option premium definition

Answer 2

Purchase price of the options

Question 3

difference between, in/at/out of the money

Answer 3

in the money: Stock price > k
out of the money: Stock price < k
at the money: Stock price = k

Question 4

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

Answer 4

value at expiration = 195-188 = 7
investor profit = 7-5 = 2
holding period return= 2/5 = 40%

Question 5

Use of Derivative markets

Answer 5

Allows market participants to trade/reallocate different types of risk in the economy

Question 6

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

Answer 6

Without insurance you lose £1100
by exercisng the put option you sell shares for £4500 only a loss of £100

Question 7

explain the law of one price

Answer 7

• In an efficient market, identical securities ( same PV of cash flows) must sell for the same price, no matter how they are generated

Question 8

how does introducing debt into capital structure effect EPS

Answer 8

Magnifies the result compared to the unlevered position

Question 9

M and M model assumptions

Answer 9

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

Question 10

Define: Financial distress

Answer 10

When a firm has difficulty meetings its debt obligations

Question 11

Define: Default

Answer 11

When a firm fails to make the required interest or principal payments on debt

Question 12

Define: Bankruptcy

Answer 12

If asset value < liabilities

Question 13

2 types of Bankruptcy costs

Answer 13

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

Question 14

Pecking order theory assumptions

Answer 14

• 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

Question 15

What is the asset substitution problem (agency cost of debt)

Answer 15

• 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

Question 16

When does agency cost of equity arise

Answer 16

when there is a conflict of interest between managers and shareholders

Question 17

Explain the underinvestment problem

Answer 17

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

Question 18

detail the free cash flow problem ( agency cost of equity)

Answer 18

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

Question 19

Define: payout policy

Answer 19

the way a firm chooses between the alternative ways to distribute FCF to equity holders

Question 20

2 types of dividend

Answer 20

cash, paid quarterly or yearly
stock, less common and resemble stock splits

Question 21

what is a share repurchase and how is it done

Answer 21

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

Question 22

Describe the signalling power of dividends

Answer 22

• 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

Question 23

how do different groups believe dividend payout affects firm value

Answer 23

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

Question 24

what is the perfect market view of change in dividend policy

Answer 24

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

Question 25

What is the profitability index rule

Answer 25

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

Question 26

What is the hurdle rate rule

Answer 26

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

Question 27

Advantages of going public for a firm

Answer 27

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

Question 28

disadvantages of going public for a firm

Answer 28

less monitoring = less control as ownership could be dispersed
costly and time consuming to disclose information, to meet listing requirements

Question 29

Types of Initial Public Offering (IPO)

Answer 29

primary offering - new shares listed, all capital raised goes to the firm
secondary offering - individual investors selling shares

Question 30

4 sources of funding for a firm

Answer 30

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

Question 31

Mechanics of an IPO

Answer 31

Find an Underwriter
Provide info to the Authorities (legality)
value the firm
build a book
price the deal and manage risks

Question 32

Public debt: 4 types of corporate debt

Answer 32

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

Question 33

Public debt: 4 types of bond market

Answer 33

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

Question 34

Junk bonds

Answer 34

high probability of default therefore high yields

Question 35

2 types of private debt

Answer 35

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.

Question 36

indirect quotation

Answer 36

the exchange rate is given in number of units of the foreign currency per unit of the home currency

Question 37

What is the interest rate parity

Answer 37

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

Question 38

state the international fisher effect

Answer 38

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

Question 39

What is the cash and carry strategy

Answer 39

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

Question 40

Advantages of forward contracts

Answer 40

– 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

Question 41

Types of merger

Answer 41

horizontal - same industry
vertical - acquiring buyer or seller (google/andriod)
congolmerate - unrelated industries

Question 42

What is the acquisition premium

Answer 42

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

Question 43

7 reasons to acquire

Answer 43

Large synergies
Economies of scale/scope
vertical integration (streamline)
expertise
diversification/ risk reduction
Earnings growth
managerial motives

Question 44

Define Business risk

Answer 44

Business risk is the risk inherent in a company’s operations and will depend largely on the industries in which the company operates

Question 45

Define Financial risk

Answer 45

Financial risk is the additional risk to which shareholders are exposed due to a company’s use of debt finance.

Question 46

Define Defualt risk

Answer 46

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

Question 47

Problems due to financial distress

Answer 47

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

Question 48

Explain why bond issuers might voluntarily choose to put restrictive covenants into a new
bond issue

Answer 48

Bond issuers benefit from placing restricting covenants because by doing so they can obtain a
lower interest rate