Corporate Finance Final Exam...

Stock options

the right, but not obligation to buy or sell the underlying security at a strike price

Strike price

set price

Call option

option to buy securities at a set price for a specified time period

Put option

option to sell securities at a set price for a specified time period

Why would someone have a call option?

in theory there is unlimited gains

Why would someone have a put option?

used as a hedge against falling security prices

Futures

the obligation to complete a purchase or sale transaction on a later date

Why would someone enter a futures contract?

lock rates or profit from rate increase

The cost to a firm for capital funding =

the return to the providers of those funds

Cost of equity

the return required by equity investors given the risk of the cash flows from the firm

Two major methods for determining the cost of equity

Dividend Growth Model

SML or CAPM

Advantages of the Dividend Growth Model

easy to understand and use

Disadvantages of the Dividend Growth Model

• 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.

• Does not explicitly consider risk

Advantages of SML

• Explicitly adjusts for systematic risk

• Applicable to all companies as long as beta is available

Disadvantages of SML

• Must estimate the expected market risk premium, which does vary over time

• Must estimate beta, which also varies over time

• Relies on the past to predict the future, which is not always reliable

The cost of debt =

the required retuen on a company’s debt