SG Flashcards
Fisher Separation theorem
under certain conditions the shareholders can delegate to the management the task of choosing which projects to udetake, whereas they themselves determine the optimal financial decisions.
hence, the investment and financing choices can be completely disconnected from each other.
2 periods
2 types of investment: physical investment projects (POF) or financial (lend/borrow - CML)
The firm will first invest in all physical investment projects with returns greater than 1+r (until tangency point)
The decision of physical investment will be taken by all firms regardless of the preferences of their owners.
Fisher separation assumptions
perfect capital markets - vital
borrowing and lending occur at the same rate
unrestricted amount of lending and borrowing
no transaction costs associated with the use of the cpital market
However, usually, fo example, borrowing rate is higher than lending. Then, probably, two tangential points, so agents would choose differing physical investment decisions.
NPV
NPV of the project is just the sum of the present values of receipts, less the sum of the Pvs of the payments.
It is the optimal technique for corporate management to use if they wish to maximize expected shareholder wealth.
Performs well under all circumstances and should be employed.
Payback period
payback period -> enough cash in the payback period to repay imitial investment?
Payback is flawed: portion of the CF stream is ignored in project evaluation. Payback ignores the time value of money. Can be eliminated by discounting project CFs that accrue within the payback period.
IRR
IRR is compared to a hurdle rate (required rate of return).
Solution to a polynomial may not be unique
In the evaluation of mutually exclusive projects, use of the IRR rule may lead to choices that do not maximise expected shareholder welath.
The multiples method
Market information can be used to estimate the value.
The method assesses the firm’s value based on the value of a comparable publically traded firm.
MV/Earnings ratio
MV/EBITDA
MV/CF
MV/BV
Should always be used in conjunction with other merhods like NPV.
It incorporates a lot of information in a simple way. It does not require ssumptions on the discount rate and growth rate. The weakness is the assumption that the comparable companies are truly similar to the company one is trying to evaluate. But we also assume market is always correct. This approach would leas to big mistakes if money making opportunities are present.
Conglomerate discount
the estimate of the sum of individual parts is on average 12% greater than the traded value of the conglomerate.
It is possible that the conglomerate is a less efficient form of organisation due to inefficient capital markets.
It is possible that the multiples method used is inappropriate here because signle segment firms are too different from divisions of a conglomerate operating in the same industry.
Diversification
It seems that by forming bundles of assets we can eliminate risk: through holding portfolios of assets, we can reduce the risk associated with our position.
THe correlations between assets are less than perfect. It implies that when returns on the first are above average, those on the second need not be above average. Hence, the returns will tend to cancel each other out, implying that the the cariance for a portfolio will be smaller than the corresponding weighted average of the indiviual asset variances.
The portfolio variance falls as the number of assets increases
The limiting portfolio return is the average covariance between assets returns.
Indifference curves in MV analysis
steep for risk-averse
flat for less risk-averse
two-fund separation
Any risk-averse investor can form their optimal portfolio by combining two mutual funds. The first of these is the tangency portfolio of risky assets, and the second is the risk-free asset. All that the degree of risk-aversion dictates is how much weight is placed on the funds.
Assumptions for CAPM/mean-variance analysis
investors maximise their utility defined over expected return and return variance
unlimited amounts of borrowing and lending at Rf
Homogeneous expectations regarding future asset returns
Asset markets are perfect and frictionless (no taxes, no transaction costs, short selling allowed)
+ Equilibrium in the capital market: demand for risky assets identical to the supply => market portfolio = tangency portfolio
Market portfolio
portfolio comprising all assets where the weights used un the construction of the portfolio are calculated as the market capitalisation of each asset divided by the sum of market capitalisation of each asset divided by the sum of market capitalisations across all assets.
idiosyncratic risk
sigma^2 E
the risk is unrelated to market fluctuations and does not affect expected returns
undiversifiable risk
beta^2 sigma^2 M
cannot be escaped and hence increases equilibrium expected returns
it is driven by variation in the return on the market as a whole
Market efficiency
A market is said to be efficient with respect to some information set W if no agent can make positive economic profit through the use of a trading rule based on W. Economic profit is defined as the level of return after costs are adjusted appropriately for risk.
In other words, if I know some information, then I cannot exploit it and earn a positive net risk-adjusted return, if the market on the asset is efficient.
