Week 2 Flashcards
(113 cards)
1
Q
What is MM Proposition I (no taxes)?
A
- Value of the levered firm = value of the unlevered firm
- Through homemade leverage individuals can undo the effects of leverage
2
Q
In creating homemade leverage, how can you unlever and how do you lever?
A
- To unlever a position, sell shares and lend the proceeds
- To lever a position, buy shared with borrowed money
3
Q
What is MM Proposition II (no taxes)
A
Expected return on equity is positively related to leverage becuase risk to equityholders increases with leverage
4
Q
Why is the value of levered firm higher than the value of the unlevered firm?
A
The levered firm will pay less taxes then the all-equity firm because the levered firm has to pay interest to debtholders which is tax deductible
5
Q
Why do bankruptcy costs lower firm value
A
The possibility of bankruptcy has a negative effect on firm value tue to the costs associated with bankruptcy that will lower the value of the firm. Shareholders will bear theses additional costs
6
Q
What three selfish strategies increase agency costs?
A
- Incentive to take large risks
- Incentive towards underinvestment
- Milking the property
7
Q
What is the selfish investment strategy: Incentive to take large risks?
A
Firms will pursue high-risk projects to maximize shareholder value when in financial distress. This behaviour expropriates value for bondholders
8
Q
What is the selfish investment strategy: incentive towards underinvestment?
A
Unlevered firms will always invest in projects if NPV >0, nut levered firm may deviate because shareholder will bear most, if not all of the costs, while bondholders will capture most of the value.
9
Q
What is selfish investment strategy: Milking the property?
A
Paying out additional dividends to leave less in the firm for bondholders. This is in favour of shareholders.
10
Q
What are protective covenants?
A
These are agreements between share- and bondholders to reduce interest rates. The should reduce bankruptcy costs and thus increase firm value. They are the lowest-cost solution to shareholder-bondholder conflict. They can be both negative and positve of nature
11
Q
What are positive protective covenants?
A
These types of agreements specify an action the company agrees to take / condition to abide by
12
Q
What are negative protective covenants?
A
These types of covenants limit the actions a company may take
13
Q
What four sources does CF go to?
A
- Payment to shareholders
- Payment to bondholders
- Government
- Layers etc.
14
Q
What is the difference between marketable and non-marketable claims?
A
Marketable claims can be bought and sold in financial markets
Non-marketable claims cannot
15
Q
What is the Free Cash Flow hypothesis?
A
Increase in dividends benefits shareholders by limiting the ability of managers to pursue wasteful activities. Principal and interest (debt) have even greater effect on this.
16
Q
What is the market timing theory?
A
This theory states that equity will be issued when the market price is high compared to book value and debt is issues when market price is low relative to book value
17
Q
Name three emperical regularities in regards to capital structure?
A
- Most corporations have low debt-asset ratios
- A number of firms use no debt
- Many corporations employ target debt-equity ratio
18
Q
Name five important considerations for determining a target D/E ratio?
A
- Taxes (tax shield improves profitability
- Types of assets; large portion in tangible assets reduces financial distress costs
- Uncertainty of operating income: higher uncertainty increases financial distress –> less debt
- Peerfirms influence capital structure; peer effects. Mostly small firms following larger firms
- Capital structures are unstable over time; they cahnge based on variety of factors, expect for low leverage firms
19
Q
What does the tradeoff theory state?
A
Tradeoff theory descirbes how a firm shold optimize its capital structure in a world with taxes and bankruptcy. It states firms constantly balance their costs and benefits of debt in pursuit of the optimal D/E ratio
20
Q
Name three benefits of debt
A
- Tax liability reduction
- Reduction wasteful discretionary spending
- Banks monitor managers more efficiently
21
Q
What are the drawbacks of debt?
A
- Costs of financial distress
- Agency costs of underinvestment, incentive to focus on risky projects
- Personal tax costs (Ti > Tc)
22
Q
What are the different types of bankruptcy costs?
A
These bankruptcy costs are always paid before bondholders are paid. Two different types: direct and indirect.
Direct costs: legal and administrative costs, PV of delays in payouts. Small portion of total costs
Indirect costs:
1. Loss in revenue due to customer reluctancy
2. Suppliers want instant cash, which requires higher NWC.
3. Difficulty in raising capital –> forego fine investment opportunities
23
Q
What is the agency cost of debt?
A
Increasing shareholder wealth at the expense of bondholders.
24
Q
What is the agency costs of equity?
A
Decreasing shareholder wealth in advantage of bondholders
25
Name the four essential points of the tradeoff theory?
1. Use of debt is beneficial as firm value will increase with leverage
2. The value of the firm will decrease past an optimal point of debt due to costs of debt
3. Optimal leverage is firm-specific, determined by indirect and direct costs
4. Costs of debt can be reduced through protective convenants, which lead to default if violated.
26
What does the pecking order theory state?
This theory tries to explain capital structure choices made by firms. It's a behavioral theory that poses the question whether firms should issue debt or equity first?
27
Which hierarchy should firms use to fund investments according to the pecking order theory?
1. Use FCF first. Using retained earnings is an independent decision
2. Issue debt: First offer cllateralised securities. Firm signals that it believes in a project and that it doesn't perceive a large increase in bankruptcy costs
3. Issue equity: only issue shares if the firm exhausts debt capacity
28
Explain why equity should be the last resort for firms to fund their investments
1. Asymmetric information; managers have access to different information than investors. Markets are thus semi-efficient (inside information has value). Part of communication betwene managers and investors is conducted through signalling. Increasing leverage is a credible signal since company is willing to provide some collateral. Issuing equity is not a credible signal and is associated with the adverse selection process.
29
What is adverse selection?
Bad quality category drives out good quality category
30
What are the implications of the pecking order theory?
1. There is no target amount of leverage
2. Profitable firms use less debt
3. Firms like financials flexibility
4. Observed leverage is shaped by investment opportunities
31
Why would investors prefer the use of isolationist valuation?
Because they assume the markets make mistakes and they prefer to calculate value on their own
32
Why would investors prefer the use of relative valuation?
Investors assume markets make mistakes on individual cases but are correct on average
33
Name three assumptions of the WACC method?
1. Assumes a constant D-E ratio
2. Assumes constant perpetual tax rate
3. Changes in D/E ratio changes risks associated with CF and will impact return expected
34
When is the WACC method an appropriate method?
1. Analyzing a snapshot
2. Constant D/E ratio thorughout multiple periods
3. Firms in a steady state (constant leverage ratio / costly capital structure)
35
What is the problem of the WACC method?
Doesn't really show where the value is coming form (the project or the capital structure)
36
What are the four types of financing side effects?
1. Tax shield of debt
2. Cost of issuing new securities (bankers, lawyers etc.)
3. Cost of financial distress: possibility of financial distress imposes costs
4. Subsidies to debt financing: yield on gvmt debt can be substantially below the yield of taxable debt. Adds value
37
What is the general rule of valuation method selection?
1. Use WACC or FTE if firm's target D/E ratio applies to project over its life.
2. Use APV if the project's level of debt is known over the life of a project.
Exemptions:
In PE transactions, the debt level is reduced based on predetermined schedule --> Use APV. Also, for lease-vs-buy decisions and situations involving tax subsidies and flotation costs
38
What are the challenges in creating positive social value and environmental value?
1. Incorporating SV & EV goals in objectives and strategy
2. Move from static to dynamic perspectives
39
What are the four different value models?
1. Shareholder model maximizes shareholder value. Maximal value = Financial value
2. Refined shareholder model: maximize V = Financial Value + b*SV+c*EV, where b and c are the weights of the social value and environmental value between 0 and 1
3. Stakeholder model: maximizes stakeholder value. Max Value = Financial Value + b*SV, with b being a weight between 0 and 1
4. Integrated model maximizes value for current and future stakeholders. Max value = Financial Value + SV +EV
40
Give two reasons companies should follow integrated value?
1. Ethical case: corporate responsibilty (license to operate)
2. Business case: long-term value creation
41
What is a license to operate?
This is based on consumer trust in you brand and reputation. When you 'lose your license to operate', consumers don't want to you from your company anymore
42
What are the driving forces behind the internalization of SV & EV?
1. License to operate
2. Regulation and taxation
3. Technological advancement
4. Customer preferences
5. Employee preferences
43
What are the four quadrants of the Value Creation Matrix?
1. Overexploitation: FV creative, but SV and EV destructive
2. Win-win: FV, EV, SV creative
3. Charity: FV destroying, SV and EV creative
4. Collapse: FV, EV, SV destructive
44
What are the two types of transitions in the Value creation Matrix?
1. Successful transition: from quadrant 1 (Overexploitation) to Q2 (Win-win)
2. Unsuccessful transition: from Q1 (Overexploitation) to Q4 (Collapse)
45
What is Integrated Value?
Integrated Value should be calculated as FV + b*SV +c*EV where the weights of b&c are up to the board.
Focus and balancing should depend on strategy and areas of value destruction
46
How do you value social and environmental value?
1. Determine material S&E issues
2. Quantify S&E issues in their own units
3. Put monetary value on those S&E units (Q*Shadow Price)
The value flow = Q * Shadow Price
47
What is the shadow price?
This price reflects the true scarcity of resources to stay within the planetary boundaries.
48
What are the 'true' shadow prices based on?
1. Rights human, labour and environmental cost to restore original situation
2. Well-being: employee, consumer and community well-being
49
Name two important considerations to take into account when calculating IV?
1. Discount CF of financial value and the Value flows of the SV& EV
2. Consider what is attributable to the company and how much to the rest of the supply chain?
Scope 3 emissions are only 50% attributable to the company.
50
How do you calculate the Integrated leverage?
I debt / I assets
51
In what two ways can paying out dividends increase value?
When firms don't have enough positive NPV projects to invest in, they might be better off paying dividends because:
1. Investors can generate a larger return by investing the received dividends elsewhere
2. Managers may destroy value by increasing discretionary spending (money that can be spent without shareholder permission)
51
What factors influence the consideration of how much and how to pay out dividend?
1. Shareholder preference and characteristics
2. Whether increase in income of the form is permanent or temporary.
If permanent: pay out dividend, if temporary: initiate share buyback
52
What is MM Proposition III?
In perfect capital markets, whilst keeping the investment policy of the firm fixed, the firm's choice of dividend policy is irrelevant and doesn't affect the initial share price
53
How can dividend be viewed in isolation according to MM?
1. Dividend = residual of investment policy of the firm
2. To extent investment policy is unchanged, a firm cannot increase firm value by increasing dividends
54
What is the Extension of the MM Proposition III?
If investment policy remains unchanged:
1. Magnitude of payout doesn't impact value
2. Form of payout doesn't impact value
55
What is the declaration date?
Date on which the board of directors declares a payment of dividend
56
What is the cum-dividend date?
The last day on which the buyer of a stock is entitled to a dividend
57
What is the ex-dividend date?
The first day upon which the seller of a stock is entitled to a dividend
58
What happens on the ex-dividend date in a world with perfect capital markets?
The share price will drop with the amount of cash dividend on the ex-dividend date
59
What are the pros of dividends?
1. Dividend appeals to investors who desire a stable CF but don't want transaction costs incurred from creating homemade dividends
2. Investors with low-self control can meet current consumptions needs while leaving the principal untouched
3. Managers can prioritize shareholder interests over the interests of bondholders
4. Reduces cash for wasteful discretionary spending
5. Signalling optimism concerning the future CF, which leads to expectations of future increases in dividends.
60
What are the cons of dividends?
1. Taxed as ordinary income
2. Reduces internal sources of financing
3. Dividends are hard to cunt once started without negatively affecting stock price
61
What are the three ways of share repurchases?
1. Open market purchases
2. Tender offer
3. Targeted repurchase
62
What are homemade dividends?
Either by reinvesting excess dividends at t=0 or selling off shares, individual investors can achieve any net cash payout desired along the diagonal line
63
What is a targeted repurchase of shares?
Buying back shares from specific shareholders. Can lower transaction costs and prevent hostile takeovers
64
What are open market repurchases of shares?
Purchasing a firm's own equity in the market while not revealing they are in fact the firm
65
What are tender offer repurchases?
The firm announces it is willing to buy a specified number of shares at a predetermined price.
66
Name five real world considerations of Dividends vs Share buybacks?
1. Flexibility: hard to reduce dividends. Therefore, temporary CF increases should be used for buybacks, permanent increases for Dividend increase
2. Executive compensation: repurchases usually increase share prices, excecs get higher return on stock options
3. Offset to dilution: share options increase shares outstanding, buybacks mitigate it. Only valid if options have been exercised before
4. Undervaluation: managers believe repurchases is best investment and their stock is depressed. Immediate market reaction after announcement usually quite favorable
5. Taxes: buybacks have tax advantages over dividends (capital gains tax vs personal tax)
67
Name two reasons why, despite tax advantages of Buybacks, managers still prefer dividends?
1. Fear buybacks lead to illegal manipulation
2. Tax authorities can penalize firms for only repurchasing to avoid taxes levied on dividends
Both fears have not materialized despite increase in repurchases
68
Name three real-world factors favoring a high-dividend policy
1. Desire for currnet income (avoid transaction costs of homemade dividends)
2. Behavioural finance: might help people struggling with self-control to never dip into principal
3. Agency costs: managers acting in shareholder interests may wish to transfer wealth from bondholders to shareholders.
69
What is the information content effect?
Rise in share price follows a dividend signal if dividends cause shareholders to increase expectations of future earnings and CF
70
What is the catering theory of dividends?
MAnagers will respond to time variation in investor demand for dividends by modifying the company's dividend policy
71
What is the clientele effect?
Shareholders can be divided into groups based on their tax bracket and dividend preference.
Once payouts of corporations conform to the desire of shareholders, no single firm can affect its market value by switching dividend strategies. Firms can boost share price only when an unsatisfied clientele exists
72
Name three important rules for dividend payout policy?
1. Intrinsic value of firm is reduced when positive NPV projects are foregone to pay a dividend
2. Firms should avoid issuing shares to pay dividends in a world with personal taxes
3. Share repurchases represent a sensible alternative to dividends
73
Why would firms initiate a stock split?
Stock splits are usually done to enter a more liquid trading range (e.g. to be able to be afforded by more, smaller investors)
74
What are counterarguments for stock splits?
1. Stocks with very high prices do not appear to have liquidity problems as financial institutions handle significant part of the trading volume
2. Following a 2-for-1 stock split, liquidity has to more then double to become more liquid, doesn't seem to be the case
75
How do you calculate CF and what does an increase in Dividend mean for the CF components?
Cash Flow = CapEx + Dividends
An increase in Dividends means a lower CapEx, which will eventually lower CF
76
What are five reasons for a reverse stock split?
1. Transaction costs may be less
2. Liquidity and marketability is improved when share prices are raised to a popular trading range
3. Increases, respectability as shares with prices below a certain level are underestimated or disregarded
These are not really compelling. What is important:
1. Risk of delisting if share price falls below certain level
2. Buy out of shareholders that end up with less than a certain number of shares
77
In what type of situations is dividend signalling crucial?
In periods when there is information asymmetry.
Market infers rise in earnings and CF from dividend increase, leading to a higher share price
78
What are the three buckets of the clientele effect?
1. Individuals with high tax brackets (preference for low/no dividends)
2. Individuals in low tax brackets (prefer some dividiend if current income is desired)
3. Institutions with special tax rules (prefer high dividend if current income is desired)
79
How can options be used to reduce the risk of the principal-agent problem?
1. Incentivizing them with stock options that will increase in value as the value of the company increases.
80
What four types of options exist?
1. Long call (buy right to buy)
2. Short call (sell right to buy)
3. Long put (buy the right to sell)
4. Short put (sell the right to sell)
81
What three factors influence the price of the option premium?
1. Time until expiration date (increases risk)
2. Exercise price
3. Volatility level in stock
82
What is an option?
An option is a contract giving the owner the right ot buy (call) or sell (put) an asset at a fixed price an or before a given date.
83
What is an expiration date for options?
Maturity date of the option. After this date, the option is dead
84
What is the difference between American or European options
American options may be exercised at any time up to the expiration date, whereas European options may only be exercised on the expiration date
85
When is a call option in the money, and when out of the money?
In the money when: Share price is higher than the exercise price
Out of the money when share price is lower than the exercise price
86
When are put options in the money and out of the money?
1. In the money when share price is lower than the exercise price
2. Out of the money when share price is higher than the exercise price
87
What is the formula for the put-call parity?
Price of underlying + price of put option = Price of a call + PV of exercise price
87
What five factors influence the call option price?
1. Time period
2. Strike price
3. Share price volatility
4. Value of underlying
5. Interest rate
88
What are the upper and lower bound of American option prices?
Upper bound is the share price
Lower bound is the share price - exercise price
89
What does delta mean in option pricing?
Delta measures the extent to which a rise in the price of the underlying causes an increase in the option price.
E.g., a Delta of 0.8 means that for every €1 that the price of the underlying increases, the price of the call option will increase by €0.80
89
How do each of the five factors influencing american option values impact the prices of call and put options?
Increases in:
1. Value of underlying asset: Call option price increases, put option price decreases
2. Exercise price: Call option price decreases, put option price increases
3. Share price volatility: Call and put option prices will both increase
4. Interest rate: Call option price will increase, put option price will decrease
5. Time to expiration date: call option and put option prices will both increase
90
What does gamma mean in regards to options?
Gamma measure the rate of change of delta with respect to change in the value of the underlying share price
E.g., if the underlying has a delta of 0.8 and gamma of 0.05:
For every €1 increase in price underlying, the delta will increase with 0.05 to 0.85
91
Name three important characteristics of gamma?
1. Very small when the option is deep out of the money or in the money
2. Gamma is the highest when options are in the money
3. Gamma is positive when holding options and negative when writing options.
92
What is vega in options mean?
Vega measures the rate of change in the value of options with respect to implied volatility. This is always positive and higher when volatility increases
92
What does theta measure with regards to options?
measures the rate of change in value of an option with respect to the change in time to maturity. This is always negative, as the closer you are to the expiration date, the lower the risk of unforeseen events that will impact the price of the underlying will be
93
Who benefits from a typical loan guarantee?
1. If existing risky bonds are guaranteed, all gains go to bondholders. There is no obligation to sharehoders in case of bankruptcy
2. If new debt is issued and guaranteed: low interest rate because of competitive markets. Shareholder will then gain the most.
3. Employees of financially distressed firms. Also employees of suppliers
94
What is the cash cycle?
Operating cycle - Accounts payable period
94
What two dimensions are always included in short-term finance policies?
1. Size of the firm's investment in current assets
2. Financing of current assets
95
What are flexible and restrictive policies in relation to the size of the firm's investment in current assets?
1. Flexible policy will have a high current assets / sales ratio
2. Restrictive policy will have a low curret assets / sales ratio
96
What is a flexible and restrictive policy in regards to the financing of current assets?
1. Flexible policy has a low current liabilities / non-current liabilities ratio
2. Restrictive policy has a high current liabilities / non-current liabilities
97
Name three characteristics of a restrictive short-term financial policy?
1. Low cash balances and no marketable securities
2. Small investments in inventory
3. Allowing no credit sales and accounts receivables
97
Name three characteristics of a flexible short-term financial policy?
1. Large balances of cash and marketable securities
2. Making large investments in inventory
3. Liberal credit terms, high level of account receivables
98
What are carrying costs?
Costs that rise with the level of investment in current assets.
Costs that fall with the level of investment in current assets are called shortage costs
99
What two types of costs do carrying costs consist of?
1. Opportunity costs (rate of return on current assets is relatively low)
2. Costs of maintaining economic value (warehousing etc.)
100
What two types of costs do shortage costs consist of?
1. Trading / order costs: costs of placing order for more cash (brokerage costst) or more inventory (production, set-up costs)
2. Costs related to safety reserves (lost sales, customer goodwill, disruption of production schedules etc.)
101
What should you do when carrying costs are low or shortage costs are high? And what when it is the other way around?
With low carrying costs or high shortage costs --> Invest in more current assets (flexible policy)
With high carrying costs or low shortage costs --> Invest in less current assets (restrictive policy)
102
What three factors influence financing of current assets?
1. Secular growth trend
2. Seasonal variation around trend
3. Unpredictable day-to-day and month-to-month fluctuations
103
What considerations need to be taken into account when creating a short-term financial policy?
1. Cash reserves
2. Maturity hedging
3. Term structure
104
What is maturity hedging?
Firms want to invest in current assets with short-term borrowings and non-current assets with long-term borrowings to reduce risk
105
What are the four different types of cash outflows?
1. Payment of accounts payables
2. Wages, taxes, and other expenses
3. Capital expenditures
4. Long-term financing
106
What is an unsecured loan and what types are there?
An unsecured loan is usually a line of credit from the bank
Non-committed loans are informal arrangements, whereas committed loans are formal, legal arrangements
107
What are the three types of secured inventory loans?
1. Blanket inventory line: lien against all borrower's inventory
2. Trust receipt: borrower holds inventory in trust for the lender
3. Field warehouse financing: third party supervises situation
