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Lecture 18 Onward
80
Finance
Undergraduate 3
12/10/2012

Additional Finance Flashcards

 


 

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Term
Total Percentage Return (L18)
Definition

Total percentage return = dividend yield + capital gains yield

 

Dividend yield = income/beginning price

 

Capital gains yield = (ending price - beg. price)/beg. price

Term
Risk premium of an asset (L18)
Definition

Risk premium = Asset return - rF

 

r= rate of return on T-bills

Term
Statistical measures of volatility of returns (L18)
Definition

Variance: expected squared deviation from expected return

 

Standard deviation: square root of variance

Term
Normal Distribution Rule (L18)
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

Term
Efficient Capital Markets (L18)
Definition

Efficiency in processing new, material information

 

Weak-form efficient: historically available

Semi-strong form efficient: publicly available

Strong form efficient: privately available

Term
Weak Form Efficient (L18)
Definition
One cannot make money cashing in on historically available information
Term
Semi-Strong Form Efficient (L18)
Definition
One cannot make money cashing on on publicly available information
Term
Strong Form Efficient (L18)
Definition
One cannot make money cashing in on privately available information
Term
Efficient Market Hypothesis (L18)
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

Term
General concept of required rate of return (L1920)
Definition
required rate of return = compensation for time value of money + compensation for risk
Term
Measures of risk in financial assets (L1920)
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

Term
Sources of risk surpirses (2 of them) (L1920)
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

Term
Expected return on a risky asset depends only on systematic risk (L1920)
Definition

The unsystematic risk can be diversified away at no cost

 

BETA coefficient: sensitivity of a security's return to the market return

Term
Beta Coefficient (L1920)
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

Term
Reward-to-risk ratio (L1920)
Definition

[E(R) - rF] / (B - 0)

 

Term
Security Market Line (L1920)
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

Term
Capital Asset Pricing Model (CAPM) (L1920)
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

Term
Cost of Capital (L21)
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

Term
Cost of Equity (L21)
Definition

Required return by equity investors given the risk of CFs

 

2 methods:

- Dividend growth model

- SML-CAPM approach

Term
DGM Approach for R(L21)
Definition

R= 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

Term
SML Approach for R(L21)
Definition
R= rF + B[E(R) - rF]
Term
Cost of Debt (RD) (L21)
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

Term
Weighted Average Cost of Capital (L21)
Definition

V = market value of firm = Debt + Equity + Preferred

 

Use weights and add up costs of equity, debt, and preferred

Term
Economic Value Added (L22)
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

Term
WACC for Divisions (L22)
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

Term
Beta of leveraged vs. unleveraged firm (L22)
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

Term
Ways to Raise Capital (L23)
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

Term
Venture Capital (L23)
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

Term
Steps to selling public securities (L23)
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

Term
Issue methods for equity (L23)
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

Term
Underwriters (L23)
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

Term
Firm Commitment Underwriting (L23)
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

Term
Best Efforts Underwriting (L23)
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

Term
Aftermarket (L23)
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

Term
Green Shoe Option and Lockup (L23)
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

Term
Underpricing (L23)
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

Term
Seasoned Equity Offerings (SEO) (L23)
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

Term
Issuance Costs (L23)
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

Term
Rights Offerings (L23)
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

Term
PIPEs (L23)
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

Term
Private Debt (L23)
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

Term
Public (Corporate) Debt (L23)
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

Term
Optimal Capital Structure (L24)
Definition

Simultaneously maximizes value of firm and market value of common stock while minimizing WACC

 

Minimizing WACC:

- Decreasing WACC increases NPVs, thus increases VF

Term
Financial Leverage (L24)
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

Term
Break-Even EBIT (L24)
Definition

EBIT where EPS is same under current and proposed capital structures

 

Net Income = EBIT - Interest Expenses

EPS = NI / Shares Outstanding

 

EPScurrent = EPSproposed

Term
Homemade Leverage (L24)
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

 

Term
Franco Modigliani and Merton Miller (L24)
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

Term
M&M Proposition I (L24)
Definition

- Value of firm is not affected by changes in capital structure

 

- Cash flows of firm do not change, so value doesn't change

 

Term
M&M Proposition II (L24)
Definition
WACC of firm is not affected by capital structure
Term
Corporate Taxes (L25)
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

Term
Does leverage improve NPV? (L25)
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

Term
Factors that limit amount debt companies use (L25)
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

Term
Bankruptcy (L25)
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

Term
Chapter 7 Bankruptcy (L25)
Definition

Liquidation: termination of firm as a going concern

 

Trustees take over assets, sells them, and distributes proceeds according to absolute priority rule (APR)

Term
Chapter 11 Bankruptcy (L25)
Definition

Financial restructuring of a failing firm to attempt to continue operations as going concern

 

- Restructure firm w/ provision to repay creditors

Term
Bankruptcy and Leverage (L25)
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

Term
Dividend Terminology (L26)
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
Term
Stock Dividends and Splits (L26)
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

Term
Stock Repurchase (L26)
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

 

-

Term
Dividends and Signals (L26)
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

Term
Does dividend policy matter? (L26)
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

Term
Lower payouts might be desirable because... (L26)
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

Term
High payouts might be good because... (L26)
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

Term
Some Sensible Dividend Policy Moves (L26)
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

Term
Overconfidence (L27)
Definition

Assuming forecasts are more precise than they actually are

 

Example: 80% of drivers consider themselves above average

Term
Overoptimism (L27)
Definition

Overestimate likelihood of good outcome; different from overconfidence in that someone could be overconfident of a negative outcome

 

Overestimating expected returns

Term
Confirmation Bias (L27)
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

Term
Home Bias (L27)
Definition
People prefer familiar things, so they are less inclined to diversify
Term
Framing Effects (L27)
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

Term
Prospect Theory (L27)
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

Term
Heuristics (Errors in Judgment) (L27)
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

Term
Belief Biases (L27)
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

Term
Selling Behavior (L27)
Definition

Disposition effect: sell winning stocks much more often than losing

 

- Selling good stocks is costly, and holding bad ones is costly

Term
Buying Behavior (L27) Neurofinance
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

Term
Behavior and Market Efficiency (L27)
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

Term
Bubbles and Crashes (L27)
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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