Term
Total Percentage Return (L18) |
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Definition
Total percentage return = dividend yield + capital gains yield
Dividend yield = income/beginning price
Capital gains yield = (ending price - beg. price)/beg. price |
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Term
Risk premium of an asset (L18) |
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Definition
Risk premium = Asset return - rF
rF = rate of return on T-bills |
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Term
Statistical measures of volatility of returns (L18) |
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Definition
Variance: expected squared deviation from expected return
Standard deviation: square root of variance |
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Term
Normal Distribution Rule (L18) |
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Definition
68.27% of observations fall within 1 st. dev. of mean
95.45% of observations fall within 2 st. dev. of mean
99.73% fall within 3 st. dev. of mean |
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Term
Efficient Capital Markets (L18) |
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Definition
Efficiency in processing new, material information
Weak-form efficient: historically available
Semi-strong form efficient: publicly available
Strong form efficient: privately available |
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Term
Weak Form Efficient (L18) |
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Definition
One cannot make money cashing in on historically available information |
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Term
Semi-Strong Form Efficient (L18) |
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Definition
One cannot make money cashing on on publicly available information |
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Term
Strong Form Efficient (L18) |
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Definition
One cannot make money cashing in on privately available information |
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Term
Efficient Market Hypothesis (L18) |
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Definition
Competition makes market efficient; investors try to learn as much as possible and exploit mispricings
Trading shrinks expected profits and drives prices toward "fair" values, so markets gradually become efficient
Equilibrium: enough mispricing for few investors to profit from research and trading; trading does not pay for everybody else |
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Term
General concept of required rate of return (L1920) |
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Definition
required rate of return = compensation for time value of money + compensation for risk |
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Term
Measures of risk in financial assets (L1920) |
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Definition
Stand-alone risk: pertains to the CFs of an asset; variance and standard deviation
Portfolio risk: risk of two (or more) assets put together is different from the risk of each asset considered separately
- Portfolio risk is usually smaller than sum of individual standard deviations due to imperfect correlation among returns |
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Term
Sources of risk surpirses (2 of them) (L1920) |
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Definition
Systematic: affects a larger number of assets (to different extents); aka market risk
Idiosyncratic: affects a single asset (or limited number); unique, asset specific |
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Term
Expected return on a risky asset depends only on systematic risk (L1920) |
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Definition
The unsystematic risk can be diversified away at no cost
BETA coefficient: sensitivity of a security's return to the market return |
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Term
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Definition
Measures amount of systematic risk present in a particular risky asset relative to average risky asset
- Beta = 1: asset has same systematic risk as overall market
- Beta > 1: more risk than market; aggressive
- Beta < 1: less systematic risk; defensive
Lower beta = lower risk = lower expected returns |
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Term
Reward-to-risk ratio (L1920) |
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Definition
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Term
Security Market Line (L1920) |
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Definition
Expected returns and betas of all assets must plot on same straight line
- If only systematic risk affects E(R), then reward-to-risk must be same for all assets; SML is representation of market equilibrium
Slope of SML = E(Rm) - rF = market risk premium |
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Term
Capital Asset Pricing Model (CAPM) (L1920) |
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Definition
E(R) = rF + B[E(R) - rF]
CAPM: equation of SML showing equilibrium relationship between expected return and beta of any security
rF is pure time value of money
Beta is amount of systematic risk
The market risk premium is the reward for bearing risk |
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Term
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Definition
AKA required return and appropriate discount rate (just different POVs)
Opportunity cost of using capital in one way as opposed to another of the same systematic risk
Depends on use of funds, not source |
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Term
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Definition
Required return by equity investors given the risk of CFs
2 methods:
- Dividend growth model
- SML-CAPM approach |
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Term
DGM Approach for RE (L21) |
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Definition
RE = Dt+1/Pt + g
dividend yield + capital gains yield
To estimate g: use analysts' forecasts of future growth rates or use historical average o past growth rates |
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Term
SML Approach for RE (L21) |
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Definition
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Term
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Definition
Best estimated by YTM on existing debt
After-tax cost of debt: RD(1-t)
- Dividends aren't tax deductible, so no tax impact for cost of capital |
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Term
Weighted Average Cost of Capital (L21) |
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Definition
V = market value of firm = Debt + Equity + Preferred
Use weights and add up costs of equity, debt, and preferred |
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Term
Economic Value Added (L22) |
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Definition
EVA = WACC x (Debt+Equity)
You want your EVA to be greater than your CFFA
It's a measure of corporate performance; if EVA<CFFA, the firm is destroying value |
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Term
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Definition
Cost of equity: can't use CAPM or DGM
- Solution is to use CAPM and find beta for project
Finding beta:
1. Pure Play Approach:
- Find companies that specialize in similar project
- Compute beta for company(ies)
- Take an average and use that for calculation
2. Subjective Approach:
- Consider project's risk relative to overall firm
- Use discount rate > WACC if project is riskier than firm |
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Term
Beta of leveraged vs. unleveraged firm (L22) |
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Definition
Leverage affects exposure to systematic risk; CFs from tax shields reduce firm's risk, and borrowing raises volatility of earnings
- Increases equity beta
BL = BU[1+(1-t)(D/E)]
BU= unlevered (zero-debt) firm; BL = levered firm
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Term
Ways to Raise Capital (L23) |
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Definition
Debt and equity financing; depends on different stages of firm's life
-Early-stage financing/venture capital
- IPOs and private equity
-Seasoned equity offerings
- Rights
- Bank loans and LT debt |
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Term
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Definition
Private financing for relatively new businesses in exchange for stock; usually entails some hands-on guidance
Stages:
1. First-stage (seed round): initial steps; little money
2. Second-stage: major investments to make idea operative
3. Mezzanine financing: idea is leaving ground
4. Vulture financing: risky, financially distressed ideas |
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Term
Steps to selling public securities (L23) |
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Definition
1. Obtain permission from board
2. File with SEC
3. SEC examines during 20-day waiting period
- Red herring: preliminary prospectus during waiting
4. Securities can't be sold during waiting
5. Price determined on effective registration date |
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Term
Issue methods for equity (L23) |
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Definition
General cash offer: offered to public on cash basis
- IPO: first equity offer made
- Seasoned equity offering (SEO): new equity issue after company issued IPO
Rights offer: public issue of securities in which equity first offered to existing shareholders |
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Term
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Definition
Investment firms acting as intermediaries between company and investing public
Fuctions:
1. Implement method used to issue securities
2. Price and sell securities
3. Lead underwriter provides price stabilization
Provides due diligence: investigate issuer on behalf of public |
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Term
Firm Commitment Underwriting (L23) |
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Definition
- Issuer sells entire issue to underwriting syndicate
- Syndicate resells issue to public; makes money on spread between price it paid to issuer and price received from investors when stock is sold
- Spread is lower for competitive issues than for negotiated issues
- Most common type of underwriting in US |
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Term
Best Efforts Underwriting (L23) |
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Definition
Underwriter makes "best effort" to sell securities at agreed-upon offering price
- Company bears risk of issue not being sold
- Offer can be pulled if there's not enough interest; firm and underwriter incur substantial flotation costs
- Less common in US |
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Term
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Definition
Trading period after new issue is sold
- Syndicate stabilizes price by purchasing shares when price falls below offer price
- Most IPOs are over-allotted: more shares were sold than actually existed; underwriter has built in short position
- If price falls, then short is covered by buying shares in market to support price
- If price rises, then short is covered by Green Shoe option |
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Term
Green Shoe Option and Lockup (L23) |
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Definition
Green Shoe: allows syndicate to purchase additional 15% of issue from issuer up to 30 days after sale date
- Allows issue to be oversubscribed
- Provides protection to lead underwriter as they peform price stabilization
Lockup agreement: restriction on insiders that prevents them from selling shares of an IPO for specified time period (usually 180 days); price usually drops when expiration is due |
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Term
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Definition
Large increase above offer price during first day of IPO
- Costly, firm's money left on the table
- Speculative IPOs; underprice to attract investors
- WInner's curse: if average investor gets a lot of shares of IPO, it must be because the better-informed investors let him take them
- Must underprice the issue to attract average investor |
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Term
Seasoned Equity Offerings (SEO) (L23) |
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Definition
If issuing equity to fund positive NPV projects, stock price should go up, but it tends to decline because...
1. Signaling and manager information: firm sells stock only when its overvalued
2. Signaling and debt usage: if project has +NPV, then why have new shareholders when you could use debt?
3. Issue costs: issuing securities is expensive |
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Term
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Definition
Gross spread: direct fees paid to underwriter
- Difference between price paid by syndicate and what security sells for on market
Other direct expenses: filing fees, legal fees, taxes
Indirect expenses: opportunity costs
Abnormal returns: price drop on day of issuance
Underpricing: below-market issue price on IPOs
Green shoe option: cost of additional shares the syndicate can buy at offer price after issuance |
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Term
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Definition
Issue of common stock to existing shareholders; buy specified # of shares at set price
Warrants (rights): certificates carrying terms of offering
Value of right: Calculate new price per share, then find difference between original share price and new share price; difference is value of right
A right and subscription price are like 2 different currencies
- Right has value if subscription price < trading price
Share price drops based on number of shares issued; dilutive effect
- Shareholders' wealth unaffected as long as they exercise or sell their rights |
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Term
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Definition
Private Equity: firm sells securities directly to investors
- Rule 144A: issuer sells securities to banks who resell to "qualified institutional buyers"; avoids registration under Exchange Act
Illiquid; investment bankers help negotiate terms of sale but don't underwrite |
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Term
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Definition
Mature firms can obtain LT funding directly from limited number of investors or banks
- More than 50% of all debt is issued privately
Basic types:
1. Term loans: direct business loans; maturity ranges from 1-5 years; repayable during life of loan
2. Private placements: longer maturity than term loans |
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Term
Public (Corporate) Debt (L23) |
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Definition
LT bonds; issuance procedures similar to stocks (SEC)
Public vs. Private Debt:
- Higher costs b/c of SEC registration
- Less restrictive covenants than private placements
- More difficult to renegotiate b/c of # of holders
- Interest rates lower than private debt |
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Term
Optimal Capital Structure (L24) |
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Definition
Simultaneously maximizes value of firm and market value of common stock while minimizing WACC
Minimizing WACC:
- Decreasing WACC increases NPVs, thus increases VF |
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Term
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Definition
Leverage: extent to which a firm relies on debt
- ROE = Net Income / Outstanding Equity
- EPS = NI / Shares Outstanding
Higher debt means greater fixed interest expenses
- Good year: has more left for shareholders
- Bad year: still has to pay fixed interest; less to disburse
Leverage amplifies variation in payoffs for shareholders, hence EPS and ROE |
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Term
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Definition
EBIT where EPS is same under current and proposed capital structures
Net Income = EBIT - Interest Expenses
EPS = NI / Shares Outstanding
EPScurrent = EPSproposed |
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Term
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Definition
Replicate ROE with leverage by making D/E ratio equal to 1 for the investment
- You can unlever the firm and obtain same ROE w/o leverage
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Term
Franco Modigliani and Merton Miller (L24) |
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Definition
- Value of firm is determined by CFs and risk of its assets
- Only changes in these points should affect firm value
- Therefore, capital structure is irrelevant
Two Propositions:
- Proposition I: value of firm not affected by capital structure; CFs of firm do not change, so value doesn't change
- Proposition II: WACC of firm is not affected by capital structure |
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Term
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Definition
- Value of firm is not affected by changes in capital structure
- Cash flows of firm do not change, so value doesn't change
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Term
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Definition
WACC of firm is not affected by capital structure |
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Term
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Definition
When a firm adds debt, it reduces taxes
OCF = EBIT(1-t) +t(interest)
- t(interest) is the interest tax shield
Increase in CFs from shield affects firm value
- These tax savings are the key benefit from borrowing over issuing equity |
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Term
Does leverage improve NPV? (L25) |
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Definition
Under case 2, financing is a 0-NPV proposition unless there are major market imperfections
- A major imperfection is that interest expenses receive different tax treatment than dividends, making NPVleverage > 0
- Therefore, firms should be 100% leveraged, but bankruptcy costs prevent this from being true |
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Term
Factors that limit amount debt companies use (L25) |
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Definition
1. Tax-benefits of debt aren't as big as they seem
- Personal taxes can cancel benefits
2. Equity still has other advantages (value of control)
3. Other potential costs of debt
- Tighter covenants
- Bankruptcy costs |
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Term
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Definition
A firm becomes bankrupt when value of assets equals value of debt
- V = D and E = 0; bondholders gain control of firm
Bankruptcy is a legal, not economic, process
- When firm can't fulfill debt obligations |
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Term
Chapter 7 Bankruptcy (L25) |
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Definition
Liquidation: termination of firm as a going concern
Trustees take over assets, sells them, and distributes proceeds according to absolute priority rule (APR) |
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Term
Chapter 11 Bankruptcy (L25) |
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Definition
Financial restructuring of a failing firm to attempt to continue operations as going concern
- Restructure firm w/ provision to repay creditors |
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Term
Bankruptcy and Leverage (L25) |
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Definition
Trade-off: more debt means greater tax shields that increase value, but it also means greater expected bankruptcy costs
- As D/E increases, probability of bankruptcy increases
- Increased probability increases expected costs
Eventually, added value of tax shield offset by expected bankruptcy costs; V starts to decrease & WACC increases |
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Term
Dividend Terminology (L26) |
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Definition
- Cash dividend: payment directly to stockholders
- Extra cash dividend: "extra" amount may not be repeated in future
- Special cash dividend: extra cash definitely won't be repeated
- Liquidating dividend: some or all of firm sold
- Declaration date: Board declares dividend, and it becomes a liability
- Ex-dividend date: 2 days before date of record; if you buy stock on or after this date, you won't receive dividend
- Stock price drops by about amount of dividend
- Date of record: holders of record are determined
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Term
Stock Dividends and Splits (L26) |
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Definition
- Small: less than 20-25%
- Large: more than 20-25%
Stock splits: essentially same as a dividend but expressed as a ratio
- Stock price reduced when it splits
- Used to return price to more desirable trading range |
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Term
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Definition
Company buys back own shares
- Tender offer: company states a purchase price and desired number of shares to repurchase
- Open market: buys its own C/S on open market
- Similar to cash dividend since it returns cash from firm to stockholders
- Can be desirable due to lower capital gains taxes and option to defer tax into future
- Usually a positive sign; stock price usually increases when repurchases announced
- Tender offers more positive since they state a specific price
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Term
Dividends and Signals (L26) |
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Definition
- Assymetric information: managers have more info about company than investors; hard to separate true dividend policy from information effect
- Increased dividends are a sign of a healthy firm
- Decreased dividends sign of difficulties |
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Term
Does dividend policy matter? (L26) |
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Definition
Maybe yes:
- Value of stock based on PV of expected future dividends
- If changing dividends today influences expected dividends next year, then it matters
Maybe no:
- In theory, if firm reinvests capital now, it will grow and pay higher dividends later (zero-sum) effect |
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Term
Lower payouts might be desirable because... (L26) |
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Definition
Upper income tax brackets: lower dividends reduce current tax liability in favor of higher capital gains with DTL (capital gains taxed at fixed rate)
- Flotation costs: low payouts can decrease capital needed to be raised
- Dividend restrictions: debt contracts might limit % of income that can be paid out |
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Term
High payouts might be good because... (L26) |
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Definition
- Individuals need current income
- Groups that are prohibited from spending principal (trusts and endowments)
- No guarantee that higher future dividends will materialize (uncertainty resolution)
- Dividend exclusion for corporations
- Tax-exempt investors don't worry about tax treatment |
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Term
Some Sensible Dividend Policy Moves (L26) |
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Definition
1. Don't forgo positive NPV projects to pay dividends
2. Avoid issuing stock to pay dividends
3. Consider share repurchase if cahs has few better uses |
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Term
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Definition
Assuming forecasts are more precise than they actually are
Example: 80% of drivers consider themselves above average |
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Term
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Definition
Overestimate likelihood of good outcome; different from overconfidence in that someone could be overconfident of a negative outcome
Overestimating expected returns |
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Term
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Definition
More weight given to info that agrees w/ preexisting opinion; contradictory info is deemed less reliable
Ignore news that is inconsistent w/ previous guess
Similar to self-attribution bias |
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Term
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Definition
People prefer familiar things, so they are less inclined to diversify |
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Term
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Definition
How a question is framed can impact answer given or choice selected
- It can be the same proposition, but how it's phrased can influence whether or not it is accepted |
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Term
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Definition
Outcomes are compared to "reference points"
- Losses hurt more than gains feel good (about 2:1)
- Risk seeking over losses, risk averse over gains
Reference points: cutting dividends, selling stock at loss, etc.
Loss aversion: average stock returns must be very high since people hate losses
Probability weighting: overweight tiny probabilities |
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Term
Heuristics (Errors in Judgment) (L27) |
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Definition
- Rules of thumb, mental shortcuts
- "Affect" heuristic: reiance on instinct or emotions
- Representativeness heuristic: reliance on stereotypes or limited samples to form opinions of entire group
- "Order in chaos": perceived patterns where non exist |
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Term
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Definition
Gambler's Fallacy: departure from norm will be corrected in short-term
- Ex: 5 heads in a row, so a tails is due
- Doesn't acknowledge independence
Hot hand fallacy: a "hot" streak will continue |
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Term
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Definition
Disposition effect: sell winning stocks much more often than losing
- Selling good stocks is costly, and holding bad ones is costly |
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Term
Buying Behavior (L27) Neurofinance |
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Definition
Investors chase returns; buy winning stocks and ones that receive a lot of attention; like to overtrade
- Transaction costs erode returns
People experience highs when selling for a gain |
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Term
Behavior and Market Efficiency (L27) |
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Definition
EMH doesn't require all investors to be rational
Limits to arbitrage:
1. Firm-specific risk: reluctant to take large position in single security
2. Noise trader risk: irrational traders are hard to predict
3. Implementation costs: may outweigh potential arbitrage profits |
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Term
Bubbles and Crashes (L27) |
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Definition
Bubble: market prices exceed rational level
Crash: sudden drop in market values; end of bubble
Sources of bubbles: hot hand fallacy, overoptimism/confidence
Hard to identify bubbles in real time (hindsight bias)
- Investors who get out right before peak are winners |
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