Term
| What is a firm's intrinsic value? Its current stock price? Is the stock's “true” long-run value more closely related to its intrinsic value or to its current price? |
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Definition
| A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock’s “true” long-run value is more closely related to its intrinsic value rather than its current price. |
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Term
| When is a stock said to be in equilibrium? At any given time, would you guess that most stocks are in equilibrium as you defined it? Explain. |
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Definition
| Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued. |
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Term
| Suppose three honest individuals gave you their estimates of Stock X's intrinsic value. One person is your current roommate, the second person is a professional security analyst with an excellent reputation on Wall Street, and the third person is Company X's CFO. If the three estimates differed, in which one would you have the most confidence? Why? |
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Definition
| If the three intrinsic value estimates for Stock X were different, you would have the most confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm’s managers have the best information about the company’s future prospects, so managers’ estimates of intrinsic value are generally better than the estimates of outside investors. |
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Term
| Is it better for a firm's actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain. |
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Definition
| If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general would probably expect the firm’s market price to be under the intrinsic value—realizing that if management is doing its job that current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the market price be high—since it is the current price that he will receive when exercising his stock options. In addition, he will be retiring after exercising those options, so there will be no repercussions to him (with respect to his job) if the market price drops—unless he did something illegal during his tenure as CEO. |
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Term
| If a company's board of directors wants management to maximize shareholder wealth, should the CEO's compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measure? Why? |
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Definition
| The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock’s market price—b ut the price used should be an average over time rather than on a specific date. |
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Term
| What are the four forms of business organization? What are the advantages and disadvantages of each? |
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Definition
The four forms of business organization are sole proprietorships, partnerships, corporations, and limited liability corporations and partnerships. The advantages of the first two include the ease and low cost of formation. The advantages of corporations include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. Limited liability companies and partnerships have limited liability like corporations.
The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) setting up a corporation and filing required state and federal reports, which are complex and time-consuming. Among the disadvantages of limited liability corporations and partnerships are difficulty in raising capital and the complexity of setting them up. |
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Term
| Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm's stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years but another action keeps the stock at $20 for several years but then increases it to $40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies. |
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Definition
| Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models. |
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Term
| What are some actions that stockholders can take to ensure that management's and stockholders' interests are aligned? |
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Definition
| Useful motivational tools that will aid in aligning stockholders’ and management’s interests include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who don’t perform well, and (3) the threat of takeover. |
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Term
| What is an opportunity cost? |
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Definition
| The opportunity cost is the rate of interest one could earn on an alternative investment with a risk equal to the risk of the investment in question |
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Term
| Explain whether the following statement is true or false: $100 a year for 10 years is an annuity; but $100 in Year 1, $200 in Year 2, and $400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity. |
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Definition
| True. The second series is an uneven cash flow stream, but it contains an annuity of $400 for 8 years. The series could also be thought of as a $100 annuity for 10 years plus an additional payment of $100 in Year 2, plus additional payments of $300 in Years 3 through 10. |
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Term
| If a firm's earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain. (Hint: If you aren't sure, plug in some numbers and check it out.) |
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Definition
| True, because of compounding effects—growth on growth. The following example demonstrates the point |
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Term
| Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain. |
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Definition
| For the same stated rate, daily compounding is best. You would earn more “interest on interest.” |
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Term
| To find the present value of an uneven series of cash flows, you must find the PVs of the individual cash flows and then sum them. Annuity procedures can never be of use, even when some of the cash flows constitute an annuity because the entire series is not an annuity. True or false? Explain. |
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Definition
| False. One can find the present value of an embedded annuity and add this PV to the PVs of the other individual cash flows to determine the present value of the cash flow stream |
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Term
| The present value of a perpetuity is equal to the payment on the annuity, PMT, divided by the interest rate, I: PV = PMT/I. What is the future value of a perpetuity of PMT dollars per year? (Hint: The answer is infinity, but explain why.) |
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Definition
| The concept of a perpetuity implies that payments will be received forever.FV (Perpetuity) = PV (Perpetuity)(1 + I)∞ = ∞. |
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Term
| Suppose interest rates on residential mortgages of equal risk are 5.5% in California and 7.0% in New York. Could this differential persist? What forces might tend to equalize rates? Would differentials in borrowing costs for businesses of equal risk located in California and New York be more or less likely to exist than differentials in residential mortgage rates? Would differentials in the cost of money for New York and California firms be more likely to exist if the firms being compared were very large or if they were very small? What are the implications of all of this with respect to nationwide branching? |
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Definition
| Regional mortgage rate differentials do exist, depending on supply/demand conditions in the different regions. However, relatively high rates in one region would attract capital from other regions, and the end result would be a differential that was just sufficient to cover the costs of effecting the transfer (perhaps ½ of one percentage point). Differentials are more likely in the residential mortgage market than the business loan market, and not at all likely for the large, nationwide firms, which will do their borrowing in the lowest-cost money centers thereby quickly equalizing rates for large corporate loans. Interest rates are more competitive, making it easier for small borrowers, and borrowers in rural areas, to obtain lower cost loans. |
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Term
| Which fluctuate more—long-term or short-term interest rates? Why? |
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Definition
| Short-term interest rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term interest rates reflect the average expected inflation rate over the next 20 to 30 years, and this average does not change as radically as year-to-year expectations. |
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Term
| Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why? |
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Definition
| Interest rates will fall as the recession takes hold because (1) business borrowings will decrease and (2) the Fed will increase the money supply to stimulate the economy. Thus, it would be better to borrow short-term now, and then to convert to long-term when rates have reached a cyclical low. Note, though, that this answer requires interest rate forecasting, which is extremely difficult to do with better than 50% accuracy. |
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Term
Suppose the population of Area Y is relatively young and the population of Area O is relatively old but everything else about the two areas is the same.
Would interest rates likely be the same or different in the two areas? Explain.Would a trend toward nationwide branching by banks and the development of nationwide diversified financial corporations affect your answer to Part a? Explain. |
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Definition
a. If transfers between the two markets are costly, interest rates would be different in the two areas. Area Y, with the relatively young population, would have less in savings accumulation and stronger loan demand. Area O, with the relatively old population, would have more savings accumulation and weaker loan demand as the members of the older population have already purchased their houses and are less consumption oriented. Thus, supply/demand equilibrium would be at a higher rate of interest in Area Y.
b. Yes. Nationwide branching, and so forth, would reduce the cost of financial transfers between the areas. Thus, funds would flow from Area O with excess relative supply to Area Y with excess relative demand. This flow would increase the interest rate in Area O and decrease the interest rate in Y until the rates were roughly equal, the difference being the transfer cost. |
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Term
| A significant increase in productivity would raise the rate of return on producers’ investment, thus causing the investment curve (see Figure 6-1 in the textbook) to shift to the right. This would increase the amount of savings and investment in the economy, thus causing all interest rates to rise. |
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Definition
| Suppose a new process was developed that could be used to make oil out of seawater. The equipment required is quite expensive; but it would, in time, lead to low prices for gasoline, electricity, and other types of energy. What effect would this have on interest rates? |
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Term
| Suppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest rates in Europe. What effect would this have on the price of an average company's common stock? |
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Definition
| Treasury bonds, along with all other bonds, are available to investors as an alternative investment to common stocks. |
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Term
| What does it mean when it is said that the United States is running a trade deficit? What impact will a trade deficit have on interest rates? |
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Definition
| A trade deficit occurs when the U.S. buys more than it sells. In other words, a trade deficit occurs when the U.S. imports more than it exports. When trade deficits occur, they must be financed, and the main source of financing is debt. Therefore, the larger the U.S. trade deficit, the more the U.S. must borrow, and as the U.S. increases its borrowing, this drives up interest rates. |
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Term
You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums:
Inflation premium = 3.25%Liquidity premium = 0.6%Maturity risk premium = 1.8%Default risk premium = 2.15%
On the basis of these data, what is the real risk-free rate of return? |
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Definition
T-bill rate = r* + IP
5.5% = r* + 3.25%
r* = 2.25%. |
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