Term 2 Flashcards
What does an efficent market do?
Provide correct signals to financial managers
Encourage the purchase of shares
Ensure efficient allocation of resources
What are the three forms of EMH?
Weak - Reflect Past info
Semi-Strong - Reflect Past and publicly available
Strong - Reflect Past, Public and Private
What are the implications of EMH?
As information is freely and immediately available
Prices will adjust instantly
No opportunity for excess returns
Firms cannot fool investors,
Will always receive a fair price for their shares
What is implied if analysts are making money?
If technical analysts make money - weak inefficient
If Fundamental analysts make money - semi-strong inefficient
If insider traders make money - strong inefficent
What are the implications of EMH for financial decision making?
Use passive investment strategy
Do not consider timing for equity release
What are some calendar anomalies?
Calendar Effects
What are the two theories on capital structure?
Traditional: There is an optimal structure
Modigliani and Miller (MM) capital structure is irrelevant
How do you calculate the value of a firm?
V=E+D
Value
Value of Equity
Value of Debt
Sum Earnings/(1+K)^t
How do you calculate Weighted Average Cost of Capital
k=Ke(E/V)+kd(D/V)
What is the traditional view with no taxation
Firms can substitute to from equity to debt, increasing risk but lowering average cost of capital
What is the MM view with no taxation?
Argues the traditional view will fail, as substitution will cause the ROR on equity to rise
What are the assumptions of MM?
Market value is independent of capital structure
The expected ROR on stock increases in proportion to the debt equity ratio
What is the cost of debt capital if taxes are included?
Kd(1-Tc)
What is a tax shield?
TcD
The saving the firm makes by paying tax deductible interest
What level of earnings will shareholders receive in a taxed firm?
(EBIT-KdD)(1-Tc)
What is the value of levered firm?
Vl=Vu+Dtc
Levered
Unlevered
Tax times debt
How can the value of a levered firm be expressed interms of personal tax?
Vl=Vu+(1-(1-Tc)(1-Ts)/(1-Tb))B
Ts is tax on equity income
TB is tax on bond income
Discuss bankruptcy and its costs
A high debt-equity ratio increases the risk of bankruptcy
Direct Costs - Cash outflows
Indirect- Arise before firm fails, consumers stopping buying
What are the implications of the trade off theory?
Firms with:
volatile cash flows
Intangible assets
Long life products
Will have less debt
What are the limitations of trade off theory?
It rules out conservative debt ratios for taxed firms - Opposite empirically
Positive association with profitability and debt
Discuss asymmetric information and signalling?
Managers can use a rise in debt ratios to signal all is well
What is the simple view of a firm?
Assets:
Existing Investments generating cash flows
Future Investments
Liabilities:
Debt
Equity
Discuss the par value of debt?
Par value is issue value
If IR fall, market value > par value
What is the value of a firm?
Where assets = liabilities
What are the three approaches of company valuation?
Accounting Information:
Stock Market Values
Discounted Cash Flows
Discuss accounting information
Financial, P/E and P/B Ratios
This is called relative valuation
What are the advantages and disadvantages of accounting information
Information is easily available and adjustable
Fundamentally backwards looking
Can be manipulated
Discuss Stock market values
Market Cap:
Price*Number of shares
Requires EMH assumption
What are the advantages and disadvantages of Stock Market Valuation
Data is easy to obtain
Allows relative comparisons
Are markets efficient
Quality of information
Discuss discounted cash flows
Most Popular Method
Requires a lot of assumptions and information
How do you perform a discounted cash flow valuation?
Sum(D/1+ket)
What are the two components of systematic risk of equity?
No debt:
Business of operating risk
Re=RF+BRP
Debt:
Financial Risk
Re=RF+BRP+FRP
How do you estimate the cost of equity for WACC?
Ke=Rf+B(ERm-Rf)
What are the problems with estimating the cost of equity?
Different corporations have different levels of systematic risk
Effected by time horizon
Can be problematic if many tranches of debt
What is Gordons Dividend Model?
V=FCF/WACC-g
Free cash flow
G is growth of FCF
How do you exectue the dividend cash flow valuation?
Forecast FCF
Determine the WACC
Estimate Continuing Value
Assess the Value of Equity
Test the Results
How do you calculate FCF?
FCF=EBIT(1-Tc)+Deprecation - Net Investment - Increases in working capital
Net Investment = Capital Expenditures - Depreciation
How do you calculate the WACC with tax?
k=Ke(E/V)+kd(D/V)(1-Tc)
How do you calculate the systematic risk of assets?
BA=(D/D+E)BD+(E/D+E)BE
Systematic risk of assets, BA
Systematic risk of equity, BE
Systematic risk of debt, BD
What factors effect valuation?
Acquisitions
Management buy outs
New Issues
Liquidations
What is the key issue of Dividend Policy?
Pay out and the frequency
Cash or Share Repurcahase
Regular or Sepcial
Needs of Investor
Types of Dividends
Special Dividends - One off
Stock Dividend - More Shares
BuyBacks
What are the two theories on dividiends?
Traditional - More Dividends = Higher Value
MM - Dividend policy irrelevant
What occurs to the dividend policy if the market has imperfections?
Policy becomes relevant to value
What happens if taxation is present?
If personal taxes are incldued, firms should retain all income as CG it taxed at a lower value
Firm value falls if dividends paid
What are the advantages of share repurchase?
Provides investers with more choice
Flexibility to firm
Dividend Tax avoidance
Increase control
Why do firms pay dividends?
Despite all disadvantages:
Clientelle effect
Signalling
Agency Problem
Define Clientelle Effect?
Firms choose dividend polict based on tax rates of investors
How can investors be divided under the clientelle model?
High Tax - Prefer no dividends
Low Tax:
Individual - Low Dividends for Income
Institutional - Prefer Dividends for income
Corporations - High Dividends
What is the issue of the clientelle effect?
There are enough high paying dividend firms to satisfy investors, thus no boost to be gained
What is signalling?
Dividend reflect managers beliefs
Can be reversed, high dividends = Lack of opportunities
Also dividend smoothing
Discuss agency costs?
Dividends can prevent managers from using excess cash inefficently
What is some empricial evidence on dividends?
Dividends are being replaced by BuyBacks
Dividend Smoothing Exists
High Tax Brackets = More Dividends
Define Merger
A transaction where two firms agree to integrate options
Define Acquisition
A stratergy where one firm buys 100% of another firm
Defien takeover
A acquisition where the target firm did not solicit the bid
What are the three types of mergers?
Horizontal
Vertical
Conglomerate
Who are the gainers and looses of mergers?
The target firm gains
The acquirer looses out
Discuss the acquisition premium
Acquirers pay an average premium of 43% over true value
Discuss the Key Steps of a Merger?
Valuation Public Offer Hostile V Friendly Methods of Payment Tax Issues Approval
Discuss Hostile V Friendly?
If proposed to managers and they agree - Friendly
If Resisted, submit tender offer - Hostile
Discuss cash v stock?
Cash is simple
Stock is where firm issues stock to give to shareholders
Exchange ratio is the number of shares recited for each share
Discuss Tax issues?
If paid in cash, instant tax liability
If in shares, defered
Who must the deal be approved by?
Both sets of managers
UK Regulator
What are the reasons for Mergers?
Economies of Scale, Scope and VI
Efficiency Gains
Diversifcation
problems with Mergers?
EPS and Tax motives do not work
Multiple different perspectives to be considers
To what parties are mergers beneficial?
Not always underperforming companies Better for society Acquirer bad Target Good Employees Lose Directors loose Finanical Institutions win
How do you analyse a merger using short term event studies?
Calculate abnormal returns within the time window for each day through:
Ra=R-E(R)
Calculate Statistical Significance
Why do the targets earn higher returns?
Acquirers bids to higher price
Loss of Control
Loss of Potential Gains
Competition
What is the hubris hypothesis?
The winning firm will over bid,
Market is efficent, but bidders make mistakes
What are the Antitakeover Defences?
Poison Pill White Knight Defence Shark Repellents Greenmail Supermajority Amendments Golden Parachutes
What is a posion pill?
Target shareholders given right to sell at discounted prices
What is a white knight defence?
Managment calls upon a friendly investor to intervene
What is a shark repellents
Amendments to corporate charter to make it more difficult
What is a greenmail
Buying off the shares
What is a supermajority amendments
Making it require a large approval to go ahead
What are golden parachutes
Illegal large termination bonuses for execuitves
