teori spørsmål Flashcards
What are some basic Business forms?
Form of Business Three basic forms are sole proprietorship, partnership, and corporations. Some disadvantages of sole proprietorship and partnerships are; unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. Some advantages are: simpler, less regulation, the owners are also the managers, and sometimes personal tax rates are better than corporate tax rates. The primary disadvantage of the corporate form is the double taxation to shareholders on distributed earnings and dividends. Some advantages include limited liability, ease of transfer-ability, ability to raise capital, and unlimited life. When a business is started, most take the form of a sole proprietorship or partnership because of the relative simplicity of starting these forms of business.
Goal of Financial Management
Goal of Financial Management To maximize the current market value (share price) of the equity of the firm(whether its publicly traded or not).
where can Agency problems come from?
Agency problems In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who, in turn, appoint the firm´s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someones else best interests rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.
Not-for-Profit Firm Goals?
Not-for-Profit Firm Goals Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization, i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, the answer is that the appropriate goal is to maximize the value of the equity.. aka få mest mulig for pengene så value ikke som penger men som hva en de tilbyr til samfunnet
What investment rule would you recommend and why?
I would recommend Net Present Value. NPV is recommended because it compares the entire cash flow at a given discount rate and therefore considers the time value of money and associated risk. The discounted future cash flows are then compared to the initial investment, I(o). The method allows for comparison between projects with different risk profiles. If NPV>0 the project should be initiated, if you have sufficient capital, since its returns are greater than the discount rate. NPV may also be used in combination with internal rate of return (IRR), which will provide a comparable interest for the project. Finally, the discount rate relates the relative riskiness directly:
High risk = High discount rate
NPV is easy to use, understand, and communicate.
Explain the Internal Rate of Return (IRR) method and the potential pitfalls associated with it?
IRR provides us with a discount factor where NPV = 0.
Potential pitfalls associated with the method:
1. Timing. With some cash flows the NPV increases as discount rate increases. This is contrary to the normal relationship between the NPV and discount rate. The IRR rule will only give the same answer as the NPV rule whenever the NPV of a project is a smoothly declining function of the discount rate, and for some project cash flows this is not the case.
2. Scaling. IRR sometimes ignore the magnitude of the project when we have mutually exclusive projects, i.e. can only undertake one of the projects.
3. Multiple or no IRRs. Certain cash flows generate NPV = 0 at two different discount rates. It is also possible to have no IRR, but still positive NPV.
4. Cannot differ between lending and borrowing.
What is a Monte Carlo simulation and how can you apply it to an investment analysis? Advantages/disadvantages?
Monte Carlo algorithm:
1. Identify the projects cash flows, formula for project NPV, and its dependent input factors.
2. Estimate probability distributions for the input factors, e.g. product price.
3. Draw from the probability distributions in (2) and calculate NPV.
4. Repeat step (3) several times, e.g. 100 000 times.
5. Calculate expected NPV from (4).
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(1) In a Monte Carlo simulation, a set of input factors are drawn in what can be understood as a complex “what if” analysis
(2) A set of input factors is chosen and each of the input factors is assigned a probability distribution
(3) The input factors are then simulated repeatedly to create a probable outcome for the project’s NPV
(4,5) This creates a probability distribution for the NPV and expected NPV
(6) If the expected NPV>0, the investment can be accepted. However, an investor may assess the relative riskiness, e.g. whether a downside (and upside) of the investment is considerable. Finally, a complex model may be too complex, and we may end up with something “exactly wrong” or GIGO (“Garbage In, Garbage Out”).
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Advantages: Possibility to define advanced/complex NPV-estimation and include correlation.
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Disadvantages: Relies on correct probability distributions in (2). May become too complex. Time consuming.
What is the Capital Asset Pricing Model (CAPM) and why is it important when evaluating a set of investments?
CAPM describes the relationship between risk and the expected return, and explains the risk/return tradeoff
Higher risk = Higher returns
The expected return is given by the equation
(formel 1)
The return for the asset depends on the time value of money (risk free interest rate) and the asset specific risk (beta times market risk premium). The asset specific risk represents how much the investor must be compensated when investing in the asset (compared to a risk free investment and the market premium).
Beta represents the relative riskiness of an asset compared to the market.
(formel 2)
A beta bigger than one represents an asset which is more risky than the market, while a beta smaller than one represents an asset which is less risky than the market. For examples, β = 2 indicates that the asset is twice as risky compared to the market, and consequently the investors require twice the expected return.
CAPM assumes that the investors have the same information and expectations.
Explain real options.
Real options are adjustments that a firm can make after a project is initiated. Such adjustments will provide a positive (or at least zero) addition to the project value, and is therefore important to include in the project evaluation.
(formel)
Examples of options: expand, abandon, delay, sell, and scaling (synergy/cannibalism).
Explain sensitivity analysis and its advantages/disadvantages
Sensitivity analysis compares the outcome of a project by varying the value of one input at a time. For example, a project that is dependent on oil price and construction cost, may choose to do a sensitivity analysis by varying the oil price by +/- 10% and 20%, or vary the construction cost by +/- 10% and 20%, and study how the NPV of the project varies as the input varies.
A major disadvantage is that we only vary one variable at a time, while there is a chance many of the variables may experience changes at the same time due to correlation. Moreover, we do not know what change is more likely, e.g. is a reduction in oil price by 20% equally probable as a 10% increase in construction cost?
Explain “tax shield” in financing, and how this changes the Modigliani and Miller’s theorem I and II.
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Interest Tax Shield: Tax savings resulting from deductibility of interest payments.
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MMI: The market value of a company increases with debt due to the tax shield. I.e. financial managers (stockholders) should increase debt/equity-ratio.
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MMII: Risk and expected return on equity increases in proportion to the debt/equity-ratio, expressed in market values, although the risk is reduced due to tax shield compared to MMII (no taxes).
What is the opportunity cost of capital supposed to represent? Give a concise definition.
The opportunity cost of capital is the expected rate of return investors could earn in financial markets at the same level of risk as the asset to be valued.
How do Net Present Value (NPV) and Internal Rate of Return (IRR) complement each other?
NPV provides an estimate of a project’s profitability assuming a set discount factor.
IRR provides a discount rate where NPV = 0.
Together, NPV and IRR provides valuable information about the project’s profitability and its vulnerability towards its correct discount rate. If the IRR is larger or equal to the project’s discount rate, the project is profitable. The bigger difference between the IRR and the project’s discount rate, the higher is the profitability’s certainty.
Explain how Modigliani and Miller find that a company’s value in a world without taxes is independent of its capital structure (debt and equity). And, why is this not true when they consider a world with taxes? (F2014)
M&M find that a company’s value in a world without taxes is independent of its capital structure by comparing a simple strategy (buy shares in a levered corporation) with a two-part strategy (buy shares in an unlevered firm and borrow on personal account – homemade leverage). They compare the strategies both in terms of net earnings and initial cost. Both the cost and the payoff from the two strategies are the same. Thus, one must conclude that the company is neither helping nor hurting its stockholders by restructuring. In other words, an investor is not receiving anything from corporate leverage that she could not receive on her own.
How does debt affect the company’s value according to Modigliani and Miller’s first theorem with taxes? Derive and explain.
Explain briefly tax shield in financing and how this is important when calculating the Weighted Average Cost of Capital (WACC).
A tax shield is a reduction in corporate taxes due to an increase in the debt/equity-ratio.
(formel)
A tax shield is a reduction in corporate taxes due to an increase in the debt/equity-ratio.
what is MM Proposition I (no taxes)
MM Proposition I (no taxes): The value of the levered firm is the same as the value of the unlevered firm. I.e. no capital structure is any better or worse than any other capital structure for a firm’s stockholders.
what is MM Proposition II (no taxes)
MM Proposition II (no taxes): Increased debt/equity-ratio increases the risk and return for shareholders.
what is MM Proposition I (corporate taxes)
MM Proposition I (corporate taxes): The value of the levered firm is the value of an all-equity firm plus the present value of the tax shield in the case of perpetual cash flows. Because the tax shield increases with the amount of debt, the firm can raise its total cash flow and its value by substituting debt for equity.
what is MM Proposition II (corporate taxes):
MM Proposition II (corporate taxes): Increased debt/equity-ratio increases risk and return for shareholders (at a slower rate than without taxes).
explane Modigliani and Miller theorems?
