SEM 2 Flashcards

1
Q

Call Option definition

A

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

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2
Q

option premium definition

A

Purchase price of the options

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3
Q

difference between, in/at/out of the money

A

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

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4
Q

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

A

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

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5
Q

Use of Derivative markets

A

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

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6
Q

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

A

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

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7
Q

explain the law of one price

A
  • In an efficient market, identical securities ( same PV of cash flows) must sell for the same price, no matter how they are generated
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8
Q

how does introducing debt into capital structure effect EPS

A

Magnifies the result compared to the unlevered position

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9
Q

M and M model assumptions

A

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

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10
Q

Define: Financial distress

A

When a firm has difficulty meetings its debt obligations

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11
Q

Define: Default

A

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

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12
Q

Define: Bankruptcy

A

If asset value < liabilities

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13
Q

2 types of Bankruptcy costs

A

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

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14
Q

Pecking order theory assumptions

A
  • 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
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15
Q

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

A
  • 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
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16
Q

When does agency cost of equity arise

A

when there is a conflict of interest between managers and shareholders

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17
Q

Explain the underinvestment problem

A

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

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18
Q

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

A

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

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19
Q

Define: payout policy

A

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

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20
Q

2 types of dividend

A

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

21
Q

what is a share repurchase and how is it done

A

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

22
Q

Describe the signalling power of dividends

A
  • 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
23
Q

how do different groups believe dividend payout affects firm value

A

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

24
Q

what is the perfect market view of change in dividend policy

A

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

25
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
26
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
27
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
28
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
29
Types of Initial Public Offering (IPO)
primary offering - new shares listed, all capital raised goes to the firm secondary offering - individual investors selling shares
30
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
31
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
32
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
33
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
34
Junk bonds
high probability of default therefore high yields
35
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.
36
indirect quotation
the exchange rate is given in number of units of the foreign currency per unit of the home currency
37
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
38
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
39
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
40
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
41
Types of merger
horizontal - same industry vertical - acquiring buyer or seller (google/andriod) congolmerate - unrelated industries
42
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
43
7 reasons to acquire
Large synergies Economies of scale/scope vertical integration (streamline) expertise diversification/ risk reduction Earnings growth managerial motives
44
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
45
Define Financial risk
Financial risk is the additional risk to which shareholders are exposed due to a company’s use of debt finance.
46
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
47
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
48
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
49