What are the three types of financial management decisions and what questions are they designed to answer?
Capital budgeting
What long-term investments or projects should the business take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of the firm?
What are the three major forms of business organization?
Sole Proprietorship
Partnership (General, Limited)
Corporation (C-Corp, S-Corp, Limited Liability Company)
What is the goal of financial management?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company's stock?
What are agency problems and why do they exist within a corporation?
Agency relationship
Principal hires an agent to represent his/her interests
Stockholders (principals) hire managers (agents) to run the company
Agency problem
Conflict of interest between principal and agent
Management goals and agency costs
What is the difference between a primary market and a secondary market?
Dealer vs. auction markets
Listed vs. over-the-counter securities
NYSE
NASDAQ
How do you find the value of a bond, and why do bond prices change?
Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate
If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond
What is a bond indenture, and what are some of the important features?
Contract between the company and the bondholders that includes:
-The basic terms of the bonds
-The total amount of bonds issued
-A description of property used as security, if applicable
-Sinking fund provisions
-Call provisions
-Details of protective cov
What are bond ratings, and why are they important?
capacity to pay
How does inflation affect interest rates?
nominal rate= real rate+expected inflation rate
What is the term structure of interest rates?
the relationship b/w time to maturity and yields, all else equal. (normal or inverted: sloping and LT vs ST)
yield=real rate+inflation premium+interest rate risk premium
What factors determine the required return on bonds?
coupon rate depends on risk (anything affects the risk of cash flows to the bondholders):
default risk premium, taxability premuim(municiple), liquidity premium (frequent trading?)
cash flows from stock, pricing of stocks
1.dividends
2.sell the stock to market or company
PV of expected cash flows
What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%.
The firm will increase the dividend by a constant percent every period
The price is computed using the growing perpetuity model
Supernormal growth
Dividend growth is not consistent initially, but settles down to constant growth eventually
The price is com
stock price sensitivity to R or g
g rate up, P up
R rate up, P down
What are some of the major characteristics of common stock?
-Voting Rights
-Proxy voting
-Classes of stock
-Other Rights
1.Share proportionally in declared dividends
2.Share proportionally in remaining assets during liquidation
3.Preemptive right - first shot at new stock issue to maintain proportional ownership i
What are some of the major characteristics of preferred stock?
Dividends
-Stated dividend that must be paid before dividends can be paid to common stockholders
-Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely
-Most preferred dividends are cumulative - any missed preferr
expected return and standard deviation for an individual asset? For a portfolio?
An asset's risk and return are important in how they affect the risk and return of the portfolio
The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets
What is the difference between systematic and unsystematic risk?
systematic:
-Risk factors that affect a large number of assets
-Also known as non-diversifiable risk or market risk
-Includes such things as changes in GDP, inflation, interest rates, etc.
Unsystematic:
-Risk factors that affect a limited number of assets
What type of risk is relevant for determining the expected return?
There is a reward for bearing risk
There is not a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on that asset's systematic risk since unsystematic risk can be diversified away
What is the reward-to-risk ratio in equilibrium?
risk premium/beta of asset
asset RtoR=mkt RtoR at eq, it is at SML, slope is (E(RM)-Rf)/betaM<-always 1
so, slope of SML is market risk premium
What are the two approaches for computing the cost of equity?
Dividend Growth Model
SML or CAPM
How do you compute the cost of debt and the after-tax cost of debt?
cost of debt is the YTM, but not coupon rate
p.s. cost of preferred stock is a perpetuity
How do you compute the capital structure weights required for the WACC?
w=?/V (use mkt value or book value)
WACC=weRe+wdRd(1-Tc)
!!! cost of debt is tax deductable
What is the WACC?
-is a discount rate, diff risk diff rate
-use the individual costs of capital that we have computed to get our "average" cost of capital for the firm.
-This "average" is the required return on the firm's assets, based on the market's perception of the ris
What happens if we use the WACC for the discount rate for all projects?
...
What are two methods that can be used to compute the appropriate discount rate when WACC isn't appropriate?
pure play approach: use average beta in CAPM
subjective approach: adjust WACC according to risk level
How should we factor flotation costs into our analysis?
1.compute the weighted average flotation cost
2.find NPV (including flotation cost is including the cost of issuing, may lead to negative NPV)
Explain the effect of leverage on EPS and ROE
-When we increase the amount of debt financing, we increase the fixed interest expense
- good or bad years
-Leverage amplifies the variation in both EPS and ROE
What is the break-even EBIT, and how do we compute it?
Find EBIT where EPS is the same under both the current and proposed capital structures
-that is EBIT/shares value=(EBIT-bond value)/shares value
How do we determine the optimal capital structure?
to maximize the cash inflow, max stockholder wealth, or min the WACC
because according to capital structure theory, firm value is determined by the change in risk of cash flow, and change in cash flows
What is the optimal capital structure in the three cases that were discussed in this chapter?
Case I - no taxes or bankruptcy costs
No optimal capital structure
Case II - corporate taxes but no bankruptcy costs
-Optimal capital structure is almost 100% debt
-Each additional dollar of debt increases the cash flow of the firm
Case III - corporate ta
What is the difference between liquidation and reorganization?
Reasons: business failure, legal bankruptcy, technical insolvency, accounting insolvency
Liquidation: Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule
Reorganization: Restructure the corporation wi
What are the different types of dividends, and how is a dividend paid?
regular, extra, special, liquidating
declaration date, ex-dividend date, date of record, date of payment
!!!dividend matter, but not dividend policy
What is the clientele effect, and how does it affect dividend policy relevance?
Asymmetric information - managers have more information about the health of the company than investors
investors have preferences in dividend payouts
What is the information content of dividend changes?
Dividend increases
-Management believes it can be sustained
-Expectation of higher future dividends, increasing present value
-Signal of a healthy, growing firm
Dividend decreases
-Management believes it can no longer sustain the current level of dividend
What are stock dividends, and how do they differ from cash dividends?
-Pay additional shares of stock instead of cash
-Increases the number of outstanding shares
How are share repurchases an alternative to dividends, and why might investors prefer them?
-Company buys back its own shares of stock
-Similar to a cash dividend in that it returns cash from the firm to the stockholders
-Stock repurchases send a positive signal that management believes the current price is low
-The stock price often increases w
expected vs unexpected
Over time, the average of the unexpected component is zero
Announcements and news contain both an expected component and a surprise component
It is the surprise component that affects a stock's price and therefore its return
efficient markets
Efficient markets are a result of investors trading on the unexpected portion of announcements
The easier it is to trade on surprises, the more efficient markets should be
Efficient markets involve random price changes because we cannot predict surprises
systematic risk measurement
beta coefficient: asset systematic risk vs market systematic risk (greater >1 is bad)
risk premium=expected return-risk-free rate
beta up, risk premium up
What is the expected return on the asset?
pure time value of money: Rf
reward for bearing sys risk: E(Rm)-Rf
amount of sys risk: Beta
CAPM
defines the relationship between risk and return
if we know Beta of asset(sys risk of asset), we ca use CAPM to determine its expected return
cost of capital
also the risk of the asset in investor's view
required return=appropriate discount rate=risk of CF
risk=buz risk+fin risk
DGM A&D
Advantage - easy to understand and use
Disadvantages
-Only applicable to companies currently paying dividends
-Not applicable if dividends aren't growing at a reasonably constant rate
-Extremely sensitive to the estimated growth rate - an increase in g of
SML or CAPM A&D
Advantages
-Explicitly adjusts for systematic risk
-Applicable to all companies, as long as we can estimate beta
Disadvantages
-Have to estimate the expected market risk premium, which does vary over time
-Have to estimate beta, which also varies over tim
Value of the firm
V=mkt claims(share & bond)+nonmkt claims(bankruptcy & tax)
overall value of the firm X by captial structure
division of value will (TAX,D/E ratio)
pecking-order theory & Tradeoff theory
POT: internal > debt > equity
TOT: with target D/E ratio, profitable firm use debt
Business and Financial Risk
Re=Rf+Be(Rm-Rf)
Be=Ba(1+D/E)
where Ba is business risk (sys risk)
D/E is financial risk (level of leverage)