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- Applied Economics And Management 3240
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- Finance Final Exam Study Set
Finance Final Exam Study Set
Applied Economics And Management 3240 with Curtis at Cornell University
About this deck
By: Lindsey Co
Created: 2011-05-14
Size: 195 flashcards
Views: 68
Created: 2011-05-14
Size: 195 flashcards
Views: 68
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Future Value of a Single Cash Flow Assumptions
1. nominal interest rates are positive
2. investor prefers more wealth to less
Annuity
series of equal cash flows received in consecutive periods
Perpetuity
series of equal cash flows received in consecutive periods forever
Annual Percentage Rate (APR)
the nominal annual interest rate
*quoted/stated rate
**need to express in terms of interest rate/period--> divide APR/#periods
*quoted/stated rate
**need to express in terms of interest rate/period--> divide APR/#periods
**money compounding more than once a year will mean APR understates EAR
Effective Annual Rate
EAR = (1+APR/P)P-1
Rising Interest Rate
--> Falling Bond Price
Falling Interest Rate
--> Rising Bond Price
WACC (before tax)
WACCbt=ki(B/B+P+S) + (kp/1-tc)(P/B+P+S) + (ke/1-tc)(S/B+P+S)
B=market value of debt
B=market value of debt
P= preferred stock value
S= common stock value
ki= issuer's before tax debt
kp= issuer's after tax cost of preferred
ke= after tax cost of common
tc= corporate tax rate
WACC (after tax)
same formula as the before tax formula; multiply by (1-tc)
Before Tax Return
Same formula as WACC; remove any tax component
Traditional Position
WACC can be minimized because cost of equity does not rise fast enough to offset advantage of cheap debt for moderate amounts of debt
Modigliani-Miller Theory Without Taxes
The market value of any firm is independent of its capital structure
Investor has the ability to customize a firm's capital structure to suit own needs
Implications of substituting debt for equity
proceeds of debt issuance will be used to pay a commons stock cash dividend or repurchase shares
How can the individual investor increase risk in an all equity?
Increase risk by a combination of personal borrowing through stocks and purchase shares in an all equity firm
--> this levers the unlevered firm
--> this levers the unlevered firm
How can the individual investor decrease risk in a levered firm?
Lend money through the purchase of bonds (vertical slice strategy)
Debt to Equity Substitution
increase one and decrease other simultaneously. This does not affect the left side of the balance sheet.
Modigliani-Miller Theory with Issuer Taxes
VL = VU + tcB- (PV bankruptcy cost) - (PV SH/BH conflict costs)
ASSUME:
ASSUME:
--no growth firm
--book and market value of debt are equal
--debt outstanding forever
--assume taxable income is greater than interest expense (interest payment = tax savings)
Why is the value of the levered firm equal to the value of the unlevered firm + tcB?
the only value created from the substitution of B dollars of debt for equity is due to the annual tax savings
Costs of Financial Distress (2)
1. Bankruptcy Costs
2. Bondholder/Stockholder Conflicts
Bankruptcy Costs
1. accounting, investment banking, and legal fees which must be paid due to the firm going through bankruptcy proceedings
2. management time lost as a result of reorganization
Bondholder/Stockholder Conflicts
1. "risk shifting"- changes asset structure of the firm
2. managers acting in only shareholder interest will favor risky projects over safe ones or take negative NPV projects
3. bondholders may enforce restrictive debt covenants in financial distress
Optimal Capital Structure
Will involve less than 100% Debt Financing
Traditional Capital Structure
0% < Debt-to-Capital < 100%
MM w.o Corporate Taxes
One Capital Structure is as good as any other
MM w/corp taxes
Go to 100% Debt Financing
Capital Gains Tax Rate
Individual - 15%
Corporation- max 35%
Tax Exempt- 0%
Why is there a strong incentive to minimize taxes and maximize overall firm value by substituting debt capital for equity capital?
Investor tax advantage of equity is generally superseded by tax advantage of debt at corporate issuer level.
Debt in Addition to Equity
*cash of $B brought into the firm but no stockholder payout
*VL = VU + B + tcB
ADDITIONAL Debt in Addition to Equity
*VL' = VL + (Value IN - Value OUT) + tcB
Exchange Offer
company offers to exchange one security for another
ex. common stock repurchase in exchange for new debt issue
ex. common stock repurchase in exchange for new debt issue
may be a voluntary or forced restructure
Restructuring
Broad range of actions relating to a firm's investment and financial policy
Acquisition
one company takes over controlling interest in another company
Golden Parachute
a special separation agreement that provides payment to a corporate executive if he loses his job as a result of the takeover of his company
Greenmail
corporation repurchases stockholdings of a raider through an above the market offer not made to any other stockholders; raider desists from further takeover efforts
In Play
It is certain that the company will soon be taken over by some entity due to multiple threatened takeovers and acquisition of large percentages of the firm's stock by risk arbitrageurs
Leveraged Buyout (LBO)
takeover of a company using borrowed funds
target company's assets serve as security for the loans taken out by the acquiring firm; loans are repaid through cash flows of acquired company
Merger
combination of two or more companies, either through a pooling of interests, a purchase, or a consolidation
Pooling of Interests
accounts of merged companies are combined
Purchase
amount paid over and above acquired company's book value is carried on the books of the purchaser as goodwill
Consolidation
new company is formed to acquire the net assets of the combining companies
Horizontal Merger
combining direct competitors in the same product lines and markets
Vertical Merger
combines customer + company OR supplier + company
Market Extension Merger
combines companies selling the same products in different markets
product extension merger
combines companies selling different but related products in the same market
conglomerate merger
combines companies with none of the above relationships or similarities
Pac-Man Defense
an attempt by a company for which a tender offer has been made to defend itself against takeover by making a counter-tender offer for the aggressor company
Poison Pill
right issued to stockholders of a company threatened by takeover, granting them privileges that are contingent on possession of stated percentage of target's stock. Designed to make takeover very expensive for aggressor
Raider
an individual or group that acquires a block of stock in a target company with an eye to making a tender offer, forcing a proxy fight, or forcing a greenmail repurchase by the target company
Risk Arbitrage
stock speculation by individuals or firms, based on whether or not announced or rumored mergers or related transactions such as leveraged buyouts and corporate reorganizations, will in fact take place
Scorched Earth Policy
technique used by a company that has become the target of a takeover attempt to make itself unattractive to the acquirer
Crown Jewels
the most attractive parts of a business
Shark Repellent/porcupine provision
Measure undertaken by a corporation to discourage unwanted takeover attempts
Takeover
change in the controlling interest of a corporation
Tender Offer
an offer to buy all or part of the stock of a given firm over a stated period, usually for the purpose of taking the firm over
Two Tier Tender Offer
an offer to buy part of a target firm's stock at a stated price, often in cash, and the balance in a different transaction that may be less attractive to the target-company stockholders
White Knight
a third company solicited by a takeover target to outbid the original aggressor, because the white knight is more acceptable to the target than the original aggressor
Divestiture
the disposition of an asset or investment by outright sale, employee purchase, liquidation, etc; asset ownership will be transferred.
Spin Off
form of corporate divestiture that results in a subsidiary or division becoming an independent company
Split Off
One or more of the parent firm's shareholders receive stock of a subsidiary in exchange for parent company stock
Split Up
a firm separates into several parts, distributes stock of each part to its shareholders, and ceases existence
Williams Act of 1968
*protect target and shareholders
*firm with 5% or more of another firm's shares must file a 13d with the SEC to reveal intentions
*tender opens must be open for 20 business days
*can't purchase shares in market during tender offer
Hart-Scott-Rodino Anti-Trust Improvements Act of 1976
*pre-merger notification to the FTC is required if merging firms meet size criteria
*15 days waiting required after FTC notification before making tender offer
*30 days to complete merger
*tell stockholders about position within 10 days
*raider must reveal source of funds
Warrant
holder has the right but not the obligation to buy a share of stock for a fixed price on or before a fixed date
*new shares; comes from the firm
*more valuable if:
-high stock price
-low strike price
-longer time to expiration
Call Option
holder has the right but not the obligation to buy a share of stock for a fixed price on or before a fixed date
*no new shares created because writer is another investor not the firm
More valuable if:
-high stock price
-low strike price
-longer time to expire
Put Option
holder has the right but not the obligation to sell a share of stock for a fixed price on or before a fixed date
-no new shares created at exercise
-writer is obligated to buy the stock if right is exercised
Put Warrant
put option issued by company on its own common stock
-company is obligated to repurchase its own shares at the exercise price
European Option vs. American Option
Euro - only on expiration day
American- any time up to and including expiration day
In the Money
Call Option: asset price > exercise price
Put Option: asset price < exercise price
At the Money
Call & Put: Asset Price = Exercise Price
Out of the Money
Call: Asset Price < Exercise Price
Put: Asset Price > Exercise Price
LEAPS (Long Term Equity AnticiPation Securities)
options with long times to expiration when trading is initiated (3 yrs)
Intrinsic Value
value an option would have if it expired today
CALL: MAX[0,Ps,t-E]
PUT: MAX[0,E-Ps,t]
Time Value
Time Value = Option Price - Intrinsic Value
Call Option Payoff Profile
As stock Ps,t increases by each dollar, put value increases by $1
Pc,t > MAX[Ps,t-E,0]
price of an American call can't be less than zero and can't have a negative price
(owner will have either a positive or ZERO payoff at maturity)
(owner will have either a positive or ZERO payoff at maturity)
Pp,t > MAX[E-Ps,t,0]
put has either positive or zero payoff at maturity (won't exercise if stock price is too high)
Put Option Value Diagram
Upper Bound: exercise price
Lower Bound: exercise price or MAX [E-P, 0]
Call Option Value Diagram
lower bound is the value of call at expiration
upper bound is the price of the stock
How does stock price affect option price?
High Stock Price
*high call value (buy at higher price, then sell and make profit)
*low put value (want to buy at a low price and then sell at higher put value and make a profit... higher stock price yields increasingly less profit)
Stock Return Volatility (sigma)
High Volatility:
*high call value (increased chance for very high stock price and and high profit; or low value but exercise option reduces risk)
*high put value (increased chance for very low stock price and high profit; or value but max loss is $0)
What effect do large dividends have on call option prices?
Negative effect because stock prices usually drop on the ex-dividend day
What effect do large dividends have on put option prices?
Positive effect because stock prices usually drop on the ex-dividend day.
Exercise Price Effects
High exercise price:
*lower call option value (want to pay less when you buy!)
*higher put option value (want to make more $ when you sell!)
Time to Maturity Effects
Longer Time to Maturity:
*more valuable for calls and puts
want more time for price to go either up or down but can't hurt actually
Risk-free Rate Effects
High Risk Free Rate:
*higher European call value (PV of price paid is lower)
*lower European put value (PV of price received is lower)
*lower European put value (PV of price received is lower)
Long Stock Buy Profit/Loss
Loss: Lower bound is amount paid for stock
Gain: unbounded
Short Stock
Gain: amount of current stock price
Loss: unbounded
Long Call Profit
Profit will be the value at expiration less the call value less purchase price of call (sunk cost). Maximum loss is the purchase price. Need price to be above purchase price to make a profit.
Written Call Profit
Profit will be the value at price received from the sale minus the cost at expiration when owner exercises. Maximum loss is essentially unbounded. Want value at expiration above sale price to make a profit.
Long Put Profit
Profit will be the put value minus the price of the stock at expiration minus the purchase price. Max loss is the sunk cost of the purchase price. Put value must be greater than stock price to make a profit.
Written Put profit
Profit will be the Price received for the put less the (put value - price of stock). Max loss bounded at put value less the stock price. Want value at expiration to be less than the put value and purchase price to make a profit.
Long Straddle
Buy 1 Call and 1 Put with same Exercise price
V shape = volatility (buyer bets on big price moves)
V shape = volatility (buyer bets on big price moves)
Written Straddle
Sell 1 Call and 1 Put with the same exercise price
Upside Down V (seller bets on stability)
Put Call Parity Theorem
Long Call = Stock + Long Put + Insurance
*describes the relationship between the price of a put and a call (it does exist)
*describes the relationship between the price of a put and a call (it does exist)
What is a protective put?
put protects from downward movements in stock price and reduces risk in position
*use when combining a long stock with a long put
*use when combining a long stock with a long put
What does the Black-Scholes Option Pricing Model Represent?
The theoretical correct value of a European call
How do convertible bonds relate to option theory?
owner can hold or convert into shares of common stock
think : non-convertible + warrant
How does convertible preferred stock relate to option theory?
owner can hold preferred or convert into shares of common stock
think : non convertible preferred + warrant
How do portfolio managers insure portfolios against stock market declines?
* purchase put options to hedge the decline if the market declines
* replicate put strategy by buying T-bills and broad group of stocks
*T-Bills + futures on a market index (to hedge portfolio losses with gains in futures position with decreasing market)
Program Trading
Trading a broad based group of stocks simultaneously
How can common stock be interpreted as an option on a firm?
Stock ownership in a firm with bonds outstanding = ownership of all option on firm's assets.
**stockholders will be able to "exercise" if value of firm's assets is greater than the amount owed to the bondholders.
What is better; a portfolio of options or an option on a portfolio?
A portfolio of options is BETTER because it is much better to not have the entire portfolio be priced together. If total of both stocks is less than portfolio exercise price then payoff will be zero rather than getting a payoff from one of the stocks
Should a call option every be exercised prior to maturity?
No advantage, but potential disadvantage (if stock ends up BELOW E at maturity)
Should a bond ever be converted prior to maturity?
No advantage and maybe a disadvantage to early conversion unless there is a big dividend being paid.
Employee Stock Option Re-pricing
Companies may re-price (re-strike) the price of their stocks if stock prices fall significantly after employee stock options are issued.
Employee Stock Option Backdating
companies look back in time to select grant date when the stock price was low because they want to issue their stocks to employees at this low price
*Sarbanes Oxley act helps to inhibit this practice by mandating reporting
Implied Volatility
an estimate of the future standard deviation of the return on an asset obtained from the Black-Scholes OPM (also known as implied volatility)
Cash Price (spot price)
the price of a commodity or instrument agreed upon today for immediate delivery
Forward price/futures price
price agreed upon today for delivery of commodity or financial instrument in the future
forward and future price don't have to be equal
forward and future price don't have to be equal
forward contract
obligation to buy or sell an asset at a fixed price at a future date
*exchange cash at the future date
What does it mean to be "short" of a forward contract?
Must deliver the commodity at set date or pay cash settlement
What does it mean to be "long" of a forward contract?
Must pay the forward price.
WIN ==> price is more than forward price and LOSE ==> price is less than forward price
WIN ==> price is more than forward price and LOSE ==> price is less than forward price
Futures contract
conveys obligation to buy or sell property at futures price at a future date
*open margin account to ensure that contractual obligations can be filled
*lots of leverage = lots of risk
Marking to Market
Money from margin account is deposited or withdrawn as price fluctuates every day
*"good faith deposit"- 5-10% of margin account
*"good faith deposit"- 5-10% of margin account
What is the difference between a forward and futures contract?
Futures --> daily cash in/out flow from margin account
Forward --> all $$$ is paid at the end of the period
Hedger
Use futures market to bet on future price movements to decrease risk
*it is only hedging if an initial risk exists
Long Hedger
Buy future contract to guarantee cost of a commodity in the future
Short Hedger
Sell future contract to guarantee price received from sale of commodity in the future
Speculator
bets on future price movements through futures markets... absorption of risk
**if trading with a hedger ... absorb hedger's risk
Price Limits (Daily Trade Limits)
amount a futures price can vary from day to day
Circuit Breaker
curbs trading of futures or stocks at various trigger price
Futures Options
puts and calls on a futures contract
"derivatives of a derivative"
Types of Contracts Traded in the US
1. agricultural contracts
2. chemicals
3. Energy products
4. financial products
5. metals
6. weather (weather derivatives)
Index Arbitrage
futures price changes with relation to fair value relation to stock values. arbitrageur will buy or sell the stocks in an index and buy or sell the futures contract underlying the index. Return prices to good value
Convenience Yield
the value of being able to get your hands on the real thing
Saddam Futures
bet on whether he will be in or out of power by the end of the month
Functions of Capital Markets
1. Facilitate transfer of capital between those with projects + no cash and those with cash + no projects
2. facilitate risk transfer
facilitate process of price delivery
Capital Market Efficiency
if stock prices already reflect all available information, then stock price changes must reflect only unpredictable events ==> random price changes!
Weak Form Efficiency
Prices reflect all information contained in the record of past prices
Semi-strong
prices reflect past prices + all other published information
Strong Form Efficiency
Prices reflect: past + published + insider
Serial Correlation
See if there is a predictable pattern to returns
Runs test
see how many consecutive price moves up or down
January effect
returns are higher in January than in December
returns are lowest in Sept and Oct.
returns are lowest in Sept and Oct.
Halloween Effect
all US industries perform better than in the summer (summer ends in Oct?)
Weekend Effect
Positive Returns => Friday
Negative Returns ==> Monday
Turn of the Month Effect
positive returns from the last day of one month to the 3rd day of the next month. Average DJIA fall on all other days
The Intraday Effect
Prices fall for first 45 minutes of Monday
Rise sharply first 45 minutes Tues-Fri
High returns at end of the day.
Holiday Effect
mean return on the last day before a holiday is 9x what it is on other days
Rosh Hashanah/Yom Kippur effects
rise on Rosh Hashanah and fall on Yom Kippur
Sunshine Effect
High Returns
World Cup Soccer Effect
38 bps drop in losing country
Insider Trading
Corporate insiders do well if trading their own stock
Value Line Recommendations
-above normal returns
-people will generally trade on VL recommendations
Small Firm Effect
small firms have higher returns than large firms
P/E Effect
Stocks with Low P/E ratios tend to do better than stocks with high P/E ratios
VALUE FUND ==> LOW P/E
GROWTH FUND ==> HIGH P/E
VALUE FUND ==> LOW P/E
GROWTH FUND ==> HIGH P/E
Price to Book Effect
Low price to book ratios do better
price to sales ratio
low price to sales stocks do better
dividend yield effect
high dividend yield ==> high returns
may be indicative of underpricing
neglected firm effect
not followed ==> do better
**may not be efficiently priced
**may not be efficiently priced
Short Term Reversals
"up" is likely to be followed by "down"
*violates weak form efficiency
Momentum Strategies
intermediate term trend continuation
**violates weak form!
overreaction effect
winners will do poorly...
losers will bounce back!
post earnings announcement drift
after an earnings announcement ==> price increase ==> takes several days to fully reflect
Volume Effects
Lots of buyers ==> high stock price
big investors exit ==> price decreases
low volume ==> individuals exit
stock is underpriced ==> value increases (arbitrage!)
more buyers now enter the market
this is a cycle!
this is a cycle!
Joel Greenblatt Result
Firms with high capital returns and good prices will do well
Super Bowl Effect
AFC team wins = market falls
Tiger Effects
If Tiger Woods is in a pro-golf tournament, market will go up on Wednesday
Hemline Effect
up = up
down = down
Ben Graham
value investor
Thomas Rowe Price, Jr.
growth investor
mutual fund founder
Growth Companies
- superior research to develop products and markets
- lack of cutthroat competition
- immunity from gov't regulation
- low labor costs ==> high paid employees
Warren Buffett
value vestor
Ben Miller
use PV of future fcf to determine if stock is a bargain
Perfect Stocks (RICH CURTIS SAYS SO)
1. Revenues growing
2. Earnings growing
3. stable to increasing margins
4. PEG ratio <1
5.low price/sales
6. low price/book
7. low price/fcf
8.stock price < PV FCF
9. CR >2
10. QR > 1
11. Low Long term Debt!
Should asset allocation vary with age?
older people should invest in less risky portfolios
Investment "Rule of Thumb"
(100-AGE)% of assets should be placed in equities
investment horizon
length of time until money needed to be spent
Probability Assessments
"what if" scenario- what is the probability of certain amount of wealth at retirement given different asset allocations
Open End Mutual Fund
shares can be issued and redeemed after initial offering
Closed End Mutual Fund
shares cannot be issued or redeemed after initial offering
*malkiel likes these better
Loads on Mutual Funds
paid up front for front or back end funds
Redemption Fees
Annual Amount charged when assets are withdrawn from funds
Expense RAtios
Expenses of a mutual funds expressed as a percentage of the fund's total assets
Technical Analysis
Analysis of past price changes in hopes of forecasting future price changes
Fundamental Analysis
Analyze aspects of a business (other than past prices) in hopes of forecasting price changes ... for example, management, competitors, markets
Growth Stock
company stock that tends to increase in earnings
good for investors who want long term increase in value
Value Stock
trades at lower price than its ratios would indicate ==> generally viewed as underpriced
Stock Screens
filter in the computer to choose stocks that fit certain criteria
Trading vs. Buy/Hold
Trading = short term
buy/hold = long term
buy/hold is much better for individual investors
Dollar Cost Averaging
Invest the same amount of $ at fixed intervals of time
Full Service vs. Discount Brokerage
Choose based on level of personal decisions you are capable of making
Day Trading
Short sales... generally leads to loss
Wh can it be bad to invest in High P/E stocks?
**VERY RISKY
**if growth slows down or P/E decreases... major losses
how can you protect yourself against inflation?
buy TIPS or Series I savings bonds
Real Estate as a good investment?
generally... can diversify your portfolio
529 College Savings Plans
i. After tax contributions - federal level and in certain states
ii. tax deferred/ tax free compounding
iii. tax free withdrawals for educ. expenses
Term Life Insurance vs. Renewable Term Life Insurance
when you die, people get money. renewable is better
Cash Value
high commissions
puts investment in insurance company hands
**payout/insurance + forced savings (Also tax referrals)
not recommended
Umbrella Policies
"insurance on insurance"
kick in when policy is exhausted
About this deck
By: Lindsey Co
Created: 2011-05-14
Size: 195 flashcards
Views: 68
Created: 2011-05-14
Size: 195 flashcards
Views: 68
About StudyBlue
STUDYBLUE makes things that make you better at school.
Things like online flashcards with photos and audio.
Things like personalized quizzes and friendly reminders about when (and what) to study next.
Think of it as a digital backpack™: access to all of your study materials online and on your phone.
STUDYBLUE exists to make studying efficient and effective for every student, for free. Join us.
“I have been getting MUCH better grades on all my tests for school. Flash cards, notes, and quizzes are great on here. Thanks!”
Kathy
Kathy