Finance--Final Study Guide Chapter 10 -Dollar Returns: if you buy any asset, your gain or loss from that investment is called your return on investment and usually has 2 components--1) you may receive cash directly while you own investment (income component) 2) value of your asset you purchase will often change--capital gain or loss -Total Dollar Return= Div. Inc. + Capital Gain (Loss) -Percentage Returns: How much do we get for each dollar we invest? DIVIDEND YIELD= D/P where D is the dividend paid on the stock during year and P is stock price at beginning of year; Second component is CAPITAL GAIN YIELD= (P1-P0)/ P0 which is the change in price during year divided by beginning price; putting it together we get X in dividends and X in capital gains yield and our final % return is both added together -Average Returns: See Notes and PAGE 297--T-Bills, Gov. Bonds, Corp. Bonds, Lg./Sm. Stocks -Risk Premiums: excess return req'd from an investment in a risky asset over that req'd from a risk-free investment--T-Bills are RISK-FREE b/c gov. can always raise taxes to pay bills -Frequency Distributions and Variability: we need a measure of how volatile a return is, two common measures of volatility are: -Variance: avg. squared difference between actual and average return--bigger the number, more actual returns differ from average returns and more spread out returns will be -Standard Deviation: positive square root of variance -Normal Distribution: symmetric, bell-shaped curve that is completely defined by its variance and standard dev. SEE FIGURE 10-10 PG 307 -Geometric Average Return: average compound return earned per year over a multiyear period GAR= [(1+R1) x (1+ R2) x ... (1+R100)]1/T 1 where R is return; will always be equal to or less than arithmetic average -Average Arithmetic Return: return earned in an avg. year over a multiyear period; simply just adding all returns up and dividing by number of years -Geometric VS. Average: to forecast up to a decade use AAR, if a few decades split difference between AAR and GAR, if long forecasts using many decades use GAR -Efficient Capital Market: market in which security prices reflect available info--basically saying there is no reason to believe price is too high or too low -Efficient Market Hypothesis (EMH): hypothesis that actual capital markets, such as the NYSE, are efficient; New info rapidly incorporated into price; Hard to beat markets by selection and timing; buy and hold strategy may be best Chapter 11 -Expected Return: return on a risky investment expected in the future; If you have Stock X for a number of years, you'll earn 30% half the time and 10% the other half, therefore expected return is 20%--E(R)= .5 x 30% + .5 x 10%=20%; Risk Premium= Expected Return- Risk-free rate -Portfolio: group of assets such as stocks and bonds held by an investor -Portfolio Weight: % of a portfolio's total value in a particular asset; if we have $50 in one asset and $150 in another, then our total portfolio weight is $200, the % of our portfolio in our first asset is $50/200=25% and in the next is $150/200=75%; the expected return on a portfolio is a combo on the expected returns of the assets in that portfolio -Expected and Unexpected Returns: 1) the expected return from the stock is the part of the return that shareholders in the market predict or expect 2) second part of return is unexpected or risky part-- government figures, results from latest arms control talks, news that sales are higher than expected, sudden unexpected drop in interest rates; Total Return= Expected Return + Unexpected Return OR R= E(R) + U -Systematic Risk: risk that influences a large number of assets, also called market risk -Unsystematic Risk: risk that affects at most a small number of assets; these risks are unique to individual companies or assets; unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk -Principle of Diversification: spreading an investment across a number of assets will eliminate some, but not all risk -Systematic Risk Principle: expected return on a risky asset depends ONLY on that asset's systematic risk; no matter how much total risk an asset has, the systematic risk is relevant in determining expected return (and risk premium) on that asset -Beta Coefficient: amount of systematic risk present in a particular risky asset relative to that in an average risky asset; by definition, an average asset has a beta of 1.0 relative to itself--as asset with a beta of .50, therefore, has half as much systematic risk as an average asset, of 2.0 has twice as much -Portfolio Betas: if we had a large number of assets in a portfolio, we would multiply each asset's beta by its portfolio weight and then add up results to get portfolio's beta -Beta and the Risk Premium: SEE PG 344 -Risk-to-Reward Ratio: slope= E(Rx) Rf/ Betax ; in a well-functioning market, the ratio is the same for every asset -Security Market Line (SML): positively sloped straight line displaying the relationship between expected return and beta -<a href="/keyword/market-risk-premium/" >market risk premium</a> : slope of the SML, the difference between the expected return on a market portfolio and the risk-free rate -Capital Asset Pricing Model (CAPM): equation of the SML showing the relationship between expected return and beta; depends on 3 things: 1) pure time value of money-as measured by risk-free rate, this is reward for waiting for your money, without taking any risk 2) reward for bearing systematic risk-measured by <a href="/keyword/market-risk-premium/" >market risk premium</a> , the component is the reward for bearing an avg. amount of systematic risk in addition to waiting 3) amount of systematic risk-as measured by beta -Cost of Capital: minimum required return on a new investment; what the firm must earn on its capital investment project just to break even Chapter 12 *The cost of capital depends primarily on the use of the funds, not the source--cost of capital associated with an investment depends on the risk of the investment -Cost of Equity: the return that equity investors require on their investment in the firm; to determine use 1) dividend growth model approach 2) SML approach -Dividend Growth Model Approach: Re= D1/P0 +g where Re is return of equity, D1 is next period's projected dividend, P0 is price per share of stock, and g is assumption that firm's dividend will grow at constant rate; to calculate expected dividend form coming year use D1= D0 X (1+g) where D0 is dividend just paid -Estimating g: 1) use historical growth rates or 2) use analysts' forecasts of future growth rates -Advantages: Simplicity, easy to understand and use -Disadvantages: 1) only applicable to companies that pay dividends 2) the key underlying assumption is that they grow at a constant growth rate (not always case) 3) estimated cost of equity is very sensitive to estimated growth rate 4) does not explicitly consider risk -SML Approach: expected return on a risky investment depends on three things: 1) risk-free rate Rf 2) <a href="/keyword/market-risk-premium/" >market risk premium</a> E(RM)- Rf 3) systematic risk of asset relative to average, or Beta -RE= Rf + BE X (RM Rf) -To use we need a risk free-rate, an estimate of <a href="/keyword/market-risk-premium/" >market risk premium</a> , and an estimate of relative Beta -Advantages: 1) explicitly adjusts for risk 2) applicable to companies other than those with steady dividend growth -Disadvantages: 1) SML requires 2 things be estimated, economic factors change quickly and past migt not be best guide for future -Cost of Debt: return that lenders require on the firm's debt, can be observed either directly or indirectly, b/c cost of debt is simply interest rates the firm must pay on new borrowing, or we can observe those in financial markets; yet, the coupon rate of firm's outstanding debt is irrelevant, that just tells us what the cost of debt was when the bonds were issued, not today! -Cost of Preferred Stock: (RP); RP= D/P0 where D is the fixed dividend and P0 is current price of stock -Weighted Average Cost of Capital (WACC): the weighted average of the cost of equity and the after-tax cost of debt--basically the overall return the firm must earn on its existing assets to maintain the value of stock -Capital Structure Weights: D for market value of firm's debt, E for market value of firm's equity, V for combined market value of debt and equity: V=E+D, if we divide both sides by V, we can calculate % of total capital represented by debt and equity: 100%= E/V+D/V and are called CAPITAL STRUCUTRE WIEGHTS -Taxes: in general, the after-tax interest rate is simply equal to pretax rate multiplied by 1 minus the tax rate: RD X (1-TC) where TC is corporate tax rate -WACC= (E/V) X RE + (D/V) X RD X (1-TC) -SML and the WACC: FIGURE 12.1 PG 383--very useful -Pure Play Approach: Use of a WACC that is unique to a particular project, based on companies in similar lines of business Chapter 13 -Capital Structure: mixture of debt and equity maintained by a firm -Financial Leverage: extent to which a firm relies on debt -EPS versus EBIT and ROE versus ROA: SEE PAGES 396-399 -Homemade Leverage: use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed -M&amp;M Proposition I: the value of the firm is independent of its capital structure; states its completely irrelevant how a firm chooses to arrange its finances; Pie Model PG 402 -Proposition I with Taxes: SEE TABLE 13.4 PG 407 -M&amp;M Proposition II: a firm's cost of equity capital is a positive linear function to its capital structure; says cost of equity depends on three things: 1) required rate on return on firm's assets, RA 2) the firm's cost of debt, RD 3) the firm's debt-equity ratio, D/E -Business Risk: equity risk that comes from the nature of the firm's operating activities; depends on the firm's assets and operations; TOTAL SYSTEMATIC RISK of firm's equity depends on these two types of risk -Financial Risk: equity risk that comes from the firm's financial policy (capital structure) of the firm -Relevance Theory: -Bankruptcy Costs: a limit to the amount of debt a firm might use -Direct Bankruptcy Costs: costs that are directly associated with bankruptcy, such as legal and administrative expenses -Indirect Bankruptcy Costs: cists of avoiding a bankruptcy filling incurred by a financially distressed firm; -Financial Distress Costs: direct and indirect costs associated with going bankrupt or experiencing financial distress -Stockholders versus Bondholders: until the firm is legally bankrupt, the stockholders control it-- since they can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid it; the bondholders are primarily concerned with protecting the value of the firm's assets and will try to take control away from the stockholders--they have a strong incentive to seek bankruptcy to protect their interests and keep stockholders from further dissipating the assets of the firm; the net effect of all this fighting is a long, drawn out and potentially expensive legal battle **These are all indirect costs--whether or not the firm goes bankrupt, the net effect is a loss of value b/c the firm chose to use debt in its capital structure -Static Theory of Capital Structure: theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress; difference between M&amp;M value with no taxes is the gain from leverage, net of distress costs -The Capital Structure Question: SEE FIGURE 13.6 PG 410 -Bankruptcy: legal proceeding dor liquidating or reorganizing a business -Liquidation: termination of the firm as a going concern; Chapter 7 bankruptcy liquidates assets and distributes to claimants by priority of claim (Absolute Priority Rule) -Reorganization: financial re-structuring of a failing firm to attempt to continue operations as a going concern; Chapter 11 bankruptcy **Which bankruptcy occurs depends on whether the firm is worth more dead or alive SEE PG 414-415 Chapter 15 -Private Financing: 1) Angel investors 2) Venture Capital Investors 3) Stages of Investment 4) Required Returns 5) Investor Involvement Venture Capitalist Stages: 1) First Stage Financing might be enough to get a prototype built or manufacturing plan completed 2) Second Stage Financing might be a major investment needed to actually begin manufacturing; Venture Capitals often specialize in different stages--some specialize in early seed money or ground floor financing or later stages such as mezzanine level, referring to the level just above the ground floor *At each stage of financing, the value of founder grows and probability of success rises; venture capitalists will also sometimes actively participate in running firm, providing experience and business expertise-- especially true when founder's have little hands-on experience -Public Financing: 1) Registration and the SEC 2) Issuance Process 3) IPO and SEO defined -Registration Statement: statement filed with SEC that discloses all material info concerning the firm making a public offering, while SEC is examining registration statement, the firm may distribute a PROSPECTUS: legal document describing details of the issuing corp. and the proposed offering to potential investors--a RED HERRING is a preliminary prospectus distributed to prospective investors in a new issue of securities; a TOMBSTONE is an advertisement announcing a public offering -Initial Public Offering (IPO): company's first equity issue made available to the public -Seasoned Equity Offering (SEO): a new equity issue of securities by a company that has previously issued securities to the public -Alternative Issue Methods: for equity sales, there are two kinds of public issues -General Cash Offer: an issue of securities offered for sale to the general public on a cash basis -Rights Offer: a public issue of securities in which they are first offered to existing shareholders -Underwriters: investment firms that act as intermediaries between a company selling securities and the investing public and they: 1) formulating the method used to issue securities 2) pricing the securities 3) selling the securities -Spread: compensation to underwriter, determined by the difference between the underwriter's buying price and offering price -Syndicate: group of underwriters formed to share the risk and to help sell an issue -Underwriter Selection: -Competitive Offer Basis: firm can offer its securities to highest bidder; cheaper, bonds -Negotiated Offer Basis: negotiate directly with u/w; expensive, IPO, equities -Types of Underwriting: -Firm Commitment Underwriting: type of u/w in which the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares; the issuer sells the entire issue to u/w, and they attempt to sell it; b/c offering price isn't usually set until the u/w have investigated how receptive market is to issue, the risk is usually MINIMAL; EXPENSIVE -Best Efforts Underwriting: type of u/w in which the underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer w/o financial responsibility; BIG RISK to company -Green Shoe Provision: contract provision giving the u/w an option to purchase addt'l shares from the issuer at an offering price; reason for Green Shoe is to cover excess demand and oversubscriptions -Aftermarket: period after a new issue is initially sold; lead u/w frequently will stabilize or support the market price for a relatively short time following offering--this is done by issuing 115% of the issue, if price rises in aftermarket, the u/w will exercise the Green Shoe approach to purchase extra 15% needed; if price declines, however, the u/w will step in and buy stock in the open market, thereby supporting the price -Lock-Up Agreements: part of u/w contract that specifies how long insiders must wait after an IPO before they can sell stock -Flotation Costs: 1) Underpricing: difference between issue price and subsequent market price, usually 15%; losses arrive from selling the stock below true value 2) Spread: difference from issue proceeds and what company gets 3) Direct costs: legal, paperwork, accounting, audit 4) Indirect Costs: management time and effort 5) Abnormal Returns (SEO): Fall in stock price on announcement of SEO's (-) -Issuing Long-Term Debt: registration statement for bonds must have an indenture -Term Loans: direct business loans of typically 1-5 years (banks, insurance companies); cheaper -Private Placement: loans, usually long-term, provided directly by a limited number of investors -Differences between direct private LT financing and public issues: 1) long-term loan avoids cost of SEC registration 2) direct placement likely to have more restrictive covenants 3) easier to renegotiate private placement or term loan in case of default, harder for issue b/c hundreds of holders involved 4) life insurance companies and pension funds dominate private placement and commercial banks in term-loans 5) costs of distributing bonds are lower in private market -Shelf Registration: allows a company to register all issues it expects to sell within 2 years at a time, with subsequent sales at any times between those 2 years (SEC Rule 415) Chapter 18 -American Depository Receipt (ADR): security issued in U.S. representing shares of foreign stock, allowing that stock to be traded in U.S. -Eurobonds: Int'l bonds issued in multiple countries but denominated in a single currency (usually issuers, good for gov. to raise capital) -Eurocurrency: money deposited in a financial center outside of country whose currency is involved -London Interbank Offer Rate (LIBOR): rate most int'l banks charge one another for overnight Eurodollar loans -Exchange Rate: price of one country's currency expressed in terms of another country's currency -Types of Transactions: 2 basis types of trade in foreign markets -Spot Trade: agreement to trade currencies based on exchange rate today for settlement within 2 business days -Forward Trade: agreement to exchange currency at some time in future; allows businesses to lock in a future exchange rate today, thereby eliminating any risk from unfavorable shifts in exchange rate -Purchasing Power Parity (PPP): idea that exchange rate adjusts to keep purchasing power constant among currencies -Absolute PPP: a commodity costs the same regardless of what currency is used or where it is selling; The Law of One Price; for Absolute to hold absolutely, several things must be true: 1) transaction cost of trading apples--shipping, insurance, etc. must be zero 2) there must be no barriers to trading apples such as tariffs, taxes, or other political barriers 3) an apple in NYC must be identical to an apple in London--it won't work for you to send apples in London when they only eat green apples -Relative PPP: does not tell us what determines the absolute level of the exchange rate, instead, it tells us the change in the exchange rate over time (inflation); basically the difference in the inflation rates of 2 countries -Currency Appreciation and Depreciation: Since we are quoting exchange rates as units of foreign currency per dollar, the exchange rate moves in the same direction as the value of the dollar: it rises as the dollar strengthens, and it falls as the dollar weakens