What is the difference between preferred stock and common stock?
Preferred stock is slightly higher priority than common stock. Preferred stock has a promised fixed dividend and can usually be valued as a perpetuity. It is sort of like a perpetual bond. Common stock has no promised dividend and all dividends owed to pr
How can a company be worth anything if it has never had any profits?
The stock market doesn't look backward, it looks into future. Value of stock contains not just current profits, but also potential for future profits and growth. Stocks can be worth a lot because their business is expected to grow a lot in the future, so
Common stock is called the "residual" claim. Explain why it is called that and what the advantages and disadvantages to having a residual claim are
Common stock called residual claim because its only claim is on what's "left over" after govt taxes and bondholders have been paid. If you think the claimants on the firm's cash flows lining up to collect their portion, stockholders would be at the end of
A friend comes to you and says, "Microsoft is worth $115 billion and General Motors is worth $42.4 billion. Yet, Microsoft only earns $2.25 billion per year while GM earns $4.73 billion per year. How can a company that earns about half as much of GM be wo
A company's value can come from 2 sources:
Current earnings & Growth
If the stock mkt is willing to value Microsoft highly despite low current earnings, it must be that market participants expect strong growth in future, much higher than growth expected f
What are the two measures of risk we talked about in class? What is the difference between the two?
Variance (sq. root, standard deviation) - measures total risk (systematic plus unsystematic - all things that contribute to movements in price of stock)
Beta - measures only systematic risk (or undiversifiable risk)
Systematic risk is the risk that we are
Why does risk matter in valuing projects, stocks, or any cash flows?
Risk matters because people are risk averse, so they will only bear greater risk if you offer them a greater expected reward. The less certain you are about cash flows, the higher you must expect them to be in order for the project to be acceptable
What is stock?
share of common stock, or equity, represents ownership claim on firm that has no maturity and no promised payments
What is preferred stock?
A share of preferred stock has no maturity, but receives pre-specified regular dividend
What happens when new information becomes available?
Public, easy to interpret info - price moves immediately
Private or hard to interpret info - price may move slowly (means mkt is not strong-form efficient)
What does this mean for investors?
Trying to pick stocks is uphill battle, diversify and minimize t
Definition of risk
Risk is related to probability and magnitude of obtaining outcomes that are other than their expected value. It measures variability of possible results
Why does risk matter?
It is generally assumed that people do not like risk (they are risk averse). They will require a reward commensurate with the risk they take.
What matters with risk?
Expected return
Dispersion of possible returns
Standard deviation
Measures dispersion around mean
Variance
Average squared difference
When a company generates cash flow, it can either reinvest it or pay it out to stockholders. Under what conditions would reinvesting make sense?
You can earn greater than your o/c of capital, positive NPV projects
-Important factors = income (dividends and expected growth
Efficient market hypothesis
idea that competition among investors works to eliminate all positive NPV trading opportunities, implies that securities will be fairly priced based on their future cash flows, given all info available to investors
Evidence based on market reaction to var
Strong-form market efficient
All info, private and public, is priced
Semi-strong form market efficient
All public info is priced (can't profit on)
Market Risk Premium
Premium required for extra risk
Risk Premium = Stock Returns - Return on Treasury bonds
7% = 12% - 5%
Portfolio
Collection of assets such as stocks, bond, real estate, etc
-Return of portfolio of assets is on avg return of all the assets, weighted by relative amount invested in each
However, risk of portfolio of assets is different from average risk of all assets i
Diversification
Reduces risk of assets when held in portfolios
Riskiness of portfolio
Depends not only on riskiness of each asset in portfolio, but also on relation (correlation) between returns from 2 assets
Correlation
Measure degree to which when one asset goes up the other asset also goes up (-1, 1)
Investors care about:
Rate of return - expected or average return
Risk - dispersion of return, measured by variance or st. dev.
What does an individual asset contribute to portfolio expected return and risk?
Expected return: asset's own expected return multiplied by its importance (weight) in portfolio
Risk: asset's own variability, but more importantly, asset's covariability (correlation) with other assets in portfolio
Non-diversifiable portion
Risk of the asset that the investor bears when holding the asset in portfolio (part we care about because we end up bearing it)
=Asset's standard deviation of return x asset's correlation with portfolio return
Diversifiable portion
Asset's standard deviation of return x (1 - asset's correlation with portfolio)
Is risk of portfolio same as average risk of securities?
No, this ignores how they interact (correlation/diversification)
What does this stuff imply about choosing portfolio?
If you select stocks that are not perfectly positively related, you can reduce risk of portfolio.
Don't put all your eggs in one basket.
Be concerned about correlation between stocks in portfolio because that will determine how much diversification you ge
What is the difference between a bond, common stock and preferred stock?
Bond - provides promised payment and usually has maturity date.
Common stock - represents ownership claim on firm with no promises payments and has no maturity
Preferred stock - represents ownership claim on firm WITH promised payments and has no maturity
What are the different ways of valuing a stock?
Valuing stock as the present value of its expected future dividends
Valuing stock as present value of either company's total payout or its free cash flows
Valuing stock by using common multiples of comparable firms
What are the three forms of market efficiency?
Weak form - the history of past prices is in prices
Semi-strong form - all public info in prices
Strong form - all info is in prices
What is the equity risk premium?
The equity return minus the treasury bond return
Explain the mean-standard deviation rule
Assume that returns can be explained by mean and standard deviation and that individuals prefer more return to less return and less risk to more risk. It follows that investment A is preferred to investment B in the following cases:
Expected return of A i
Explain the Modigliani and Miller (M&M) proposition about capital structure. Make sure you explain why it is useful.
M&M says that absent taxes, transaction/info costs and changes to investment policy, a firm's capital structure does not affect its value.
Basic idea is that capital structure changes deal with how firm is financed (how it will divide-up value it creates)
3 Nobel winning prizes
1. Portfolio theory / portfolio optimization / diversification (Markowitz)
2. CAPM (Sharpe)
3. M&M Theorem (Modigliani and Miller)
Why do we focus on data - why is it important?
Focus on beta because we learned the market only rewards exposure to systematic risk. That means prices in market are set to reflect relation between systematic risk and expected return. Therefore, we need a way to measure just systematic risk (as opposed
The pre-tax WACC is also the company's expected return on assets. The WACC is a weighted average of the company's cost of equity and cost of debt capital. Does that mean that the company's expected return on assets is determined by its cost of equity and
No, the risk of company's assets (line of business, what it does) determines expected return on its assets, which is then divided between debt and equity based on their relative exposures to this underlying risk. It is the asset risk that fundamentally dr
Explain why we only care about systematic risk.
Unsystematic risk is diversified away in a portfolio. The only risk we end up bearing is the systematic risk, which cannot be diversified away. Thus, we focus on systematic risk.
The two main methods of valuing common stocks are discounted cash flow (or discounted dividends) and the method of multiples. Compare and contrast them.
Discounted cash flow is the most correct theoretically, but it requires forecasts of many hard to predict variables. In discounted cash flows, you start with the fact that the value of the company's stock is simply the present value of all residual cash f
Let's say I have an investment rule where I buy stock in every firm that is a target of a takeover. If I claim that I can consistently earn abnormal returns doing this, is that claim consistent with market efficiency? Explain.
No, this claim is not consistent with semi-strong form efficiency (although it is not evidence against weak-form efficiency because it requires knowledge of a particular event). This rule is based on buying stocks after a public information event. I have
You notice that another stock has a standard deviation of 30%, just like SBUX. However, that stock has an equity beta of 0.8. Is this possible? Explain.
Sure. The standard deviation measures the total equity risk, while the stock's beta measures only the systematic risk of the equity. Further, they are not on the same scale. While SBUX and the other stock have the same total risk, that total risk has diff
What does the beta of a stock measure?
Beta measures systematic risk. Technically, it is the slope coefficient from a regression of the stock's returns on the market's returns, so it measures how much the stock tends to move for a 1% move in the market.
How does holding stocks in a portfolio reduce your exposure to unsystematic risk?
Holding a large portfolio of stocks with less than perfect correlation produces a diversification effect. This effect is due to the fact that unsystematic events do not strike all companies at the same time, so when some of your stocks have negative unsys
Write down the formula for portfolio variance and explain in words what each term does.
Formula says the risk of portfolio is made up of weighted risks of assets in portfolio (first 2 terms) plus an adjustment for how those assets move together (the last term). The first two terms are necessary because portfolio risk must be affected by risk
Explain what the difference is between systematic and unsystematic risk and give me one example of each.
Systematic - risk related to economy/market-wide events like interest rates, recessions & wars. These types of events affect all stocks & cannot be diversified away.
Unsystematic - related to events that don't affect all companies. Examples include plant
If a change in a firm's mix of debt and equity changes any one of three things, the firm's total value will change. What are these three things?
Taxes
Transaction Costs
Investment Policy
Why can the WACC differ from the cost of equity?
When the firm is financed by debt, then the WACC differs from the cost of equity.
When discounting projects in the firm, when is the WACC the appropriate discount rate to use?
The WACC is appropriate to use when the risk of the project is similar to the risk of the firm, such as scale expansion of the firm.
3. Will the expected return on equity be higher or lower for an all equity firm? Why?
The expected return on equity is lower for an all equity firm. With debt financing, the risk of the equity claim increases, leading to higher expected return on equity. The risk of the equity claim increases since equity holders are the residual claimant.
Characteristic line
Shows relation between security's returns and market's return.
Slope of characteristic line is called beta.
Beta measures stock's systematic risk
Beta
measures systematic risk
AKA non-diversifiable risk
LOWER IS BETTER (0 = risk-free, market = 1)
Security Market Line (SML)
equation of CAPM
Provides level of expected return for various values of B (beta)
E[r] = rf + B(rm - rf)
Beta vs. Standard Deviation
Standard deviation = total risk
Beta = systematic risk
Can you use the WAC as a discount rate for any project in the firm?
No, different projects/investments have different risks, so apply different discount rate appropriate for risk of the project.
WACC is correct for scale expansion (more of same, like SBUX opening another SBUX)
What is capital structure?
How the firm is finance:
% Equity, % Debt, % Preferred Stock
Risk of project is not necessarily equal to risk of stock. Why?
Because debt holders are paid before equity holders, if you have lots of debt in firm's capital structure equity holders bear additional risk
Where does risk come from?
B(equity) = B(assets) + B(assets)*(D/E)
^Risk of E = ^Risk of Bus + ^Financial risk that comes from being last in line to get paid (amplifying term)
Bondholder Shareholder Conflict
Dividend payout problem
Asset substitution
Claim dilution
Dividend Payout Problem
If shareholders pay themselves dividend, the claims of bondholders become less secure (due to lower asset coverage).
Liquidating dividend is extreme case
-Covenants setting max dividends
Asset substitution
Value of equity is enhanced, and that of debt reduced, by variance increasing projects. There is danger that shareholders will increase riskiness of firm at expense of bondholders.
-Covenants restricting shifts in asset composition/sales.
Claim dilution
After issuing bonds, the shareholders can issue new bonds of equal/greater seniority thereby diluting claims of original bondholders
-Covenants to restrict that new debt must be behind you in line.
Investor Biases
Overconfidence and excessive trading
Hanging on to losers
Limited attention and mood
Your company is considering adding more debt to its capital structure. It is your job to figure out how this might impact the value of the company. What information do you need to know to determine its impact?
Think about M&M theorem:
-You would care about how the change will affect your company's taxes (through interest deductibility),
any transaction costs that will be incurred, and
whether the capital structure change will somehow change your investment poli
If financing policy affects firm value, it does so through at least one of three channels. List them
Taxes
Transaction Costs
Investment policy
If a company increases its total value by creating an interest tax shield, who benefits? Equity holders or bondholders? Why?
The equity holders benefit. The tax shield means that ATCF's will be higher. Since the equity holders are residual claimants, they care about the ATCF's. The bondholders are no better or worse off because their payment is fixed.
How does the financing decision (equity vs. debt) for a project affect NPV?
By creating a tax shield, choosing debt could increase the project NPV.
If you said financing doesn't matter, you got some points. If you just stated the M&M list, you got half credit. If you specifically mentioned tax shields as part of the list or in th
What's the difference between closed-end and open-end mutual funds?
Open-end funds are sold by the fund company. Closed-end funds are traded on exchanges