Finance exam #4

exam on April 8th

systematic risk

risks that influences all assets across an assets class

unsystematic risk

Assets specific risk

how is total risk measured

standard deviation

what is principle of diversification

spreading investment funds across a number of individual assets will eliminate most of the unsystematic risk

two items comprise non-diversifiable risk

• all of the systematic risk

• remainder of the unsystematic risk

if you build large enough portfolio you can diversify away most of ;

and be left with

unsystematic risk

systematic risk

what is beta

a number which indicates the systematic risk of specific asset compared to the systematic risk of an average assets

what does a negative beta mean?

a negative beta indicates that the investment moves in a direction opposite to the particular asset class

what does a beta of zero mean?

a beta of zero indicates that the movement of the asset has no correlation T to the movement of the asset class. as asset with a beta of zero has the same expected return as a risk-free asset.

if the stock market is falling, and all other things equal, should you buy a stock with a beta > 1 or with a Beta < 1

you should buy a stock with a beta < 1, because its price will fall less than the other stocks in its asset class

while the weighted average cost of capital is calculated in terms of an incremental, market-based ___ rate, its main use4 is as a ___ rate in evaluating capital investment projects.

financing rate

discount rate

T or F: the weighted average cost of capital varies from industry to industry because different industries have different capital structures, given by the nature of their businesses

TRUE

firms with high WACCs tend to have ___ Betas; Firms with low WACCs tend to have ___ betas

High Betas

Low Betas

Firms with high proportions of ____ in their capital structures have higher WACCs and Betas; firms with high proportion of ___ in their capital structures have lower WACCs and Betas.

Equity

Debt

T or F: The cost of equity is almost invariably higher than the cost of debt

TRUE

three reasons why the cost of equity is almost invariably higher than the cost of debt?

• equity investors have a higher risk/reward calculus than debt investors

• the tax-deductibility of interest (but no dividends)

• the higher costs of raising equity

T or F: Venture capitalists pool money from various sources and finances new, start- up businesses

True

How do venture capitalists make money?

venture capitalists make their money when one of their portfolio companies goes public or is acquired by another firm

T or F: Venture capitalists like to structure their investment in a start-up company in the form of preferred stock

True

T or F:Venture capitalists can extract very favorable terms for providing financing for start-ups

True

T or F: Bankers never plan to have a loan go bad; venture capitalists expect most ( about 90%) of their investments to fail

True

what are for advantages of going public?

• ability to raise new capital

• stock price provides performance measure

• information more widely available

• diversified sources of finances

what are the four disadvantages of going public?

• equity generally more costly than debt

• major reporting requirements

• more focus on short-term (quarterly) results

• need for shareholder relations function

what are the two key federal laws regulating the issuance of securities?

• the securities act of 1933

• the securities exchanges act of 1934

what is a “registration Statement”

it is a document, filed with the SEC in advance of an initial public offering, which document discloses all material information concerning the company and the proposed offering?

what is a “preliminary Prospectus” also known as a “red herring”

it is a preliminary document which describes for potential investors details of the company and of the proposed offering, without the price

what is a prospectus

it is a legal document describing for potential investors the details of the company and proposed offering, including price

what is a tombstone

it is an advertisement announcing the public offering

what is an underwriter

an underwriter is an investment bank which acts as intermediary between the company and potential investors. Underwriters handle the method of issuance, preparation documents, legal requirements, pricing, and selling the securities

syndicate

a group of underwriters working together

what are tow types of underwritings

• firm commitment

• best efforts

what are blue sky laws

they are state regulations designed to protect investors against securities fraud by requiring sellers of new issues to register their offerings and to provide financial details

what three reasons might underpricing occur for an initial public offering?

• the belief that shares must be underpriced to attract investors

• underpricing is insurance that the underwriters will not be sued for an unsuccessful issue

• as a way of guaranteeing a quick profit to institutional investors who provide the underwriters with their honest opinions on the value of the issue

for what three reasons does the price of existing equity generally decline upon announcement of new equity issue in the future?

• what does management know that we don’t

• a signal of too much debt or too little liquidity

• equity issuance costs can be substantial

T or F: the cost of raising equity generally is (almost) always higher than the cost of raising debt

true

what is a “rights offerings”

under a rights offering, each shareholder is given the right to buy a specified number of new shares from the company, at a specified price, by a specified date.

When rights are issued, shareholders always receive ___ rights for every share of stock that they own

one

what is “dilution”

dilution is the relative loss of shareholder value in terms of percentage of ownership, percentage of market value, percentage of book value, or percentage of EPS

what are the three possible courses of action for holder of rights and which is the only one which result in no dilution?

• exercise all of the right (no dilution)

• sell the right (dilution)

• do nothing, and let the rights expire ( loss of value and dilution)

what is a “Standby Underwriting”

in a standby underwriting, and investment bank agrees to purchase any unsubscribed rights, so that the company is guaranteed to raise the needed amount

what is the long-term debt private placement market?

it is a market where large insurance companies make long-term (10-20 years) syndicated loans to corporations. the loans have covenants like bank loans, and can be multicurrency. the advantages to borrowers are that this market is less costly, avoids SEC registration, and offers the simplicity of dealing with a few lenders, instead of many bondholders

what is a self registration

SEC rule 415 permits a company to register at one time all of the issues that it expects to sell within the next two years. the company then chooses the time when it takes the issue to market

what is a syndicated bank loan

a syndicated bank loan is a commercial loan provided by a group of lenders and structured, arranged, and administered by one or several commercial or investment bank knowns as “arrangers”

T or F: the optimal capital structure is that mixture of debt and of equity which minimizes the weighted average cost of capital

true

the value of the firm is maximized when the weighted average cost of capital is ___

minimized

in good times, financial leverage accelerates the ___ in earnings per share; and in bad times, financial leverage accelerates. the ___ in earnings per share

Increase

Decrease

what is the static theory of capital structure

a firm borrows up to the point where the tax benefit from an extra dollar of debt is exactly equal to the cost that comes from the increased probability of financial distress/failure

T or F: the higher the tax rate, the greater is the incentive to borrow

True

T or F: the greater volatility of its EBIT, the less that a firm should borrow

True

T or F: as to bankruptcy, firms heavy with tangible assets that can be sold without great loss will have an incentive to borrow more. Firms heavy with intangible assets that cannot be sold without great loss will have a disincentive to borrow more

True

T or F: taking on debt increases the risk of( and the cost) both of debt ( by increasing the probability of bankruptcy) and of equity (by making earnings to equity investors more volatile)

True

what are the four capital structure questions for every CFO?

• what is the right amount of financing

• what is the right mix of debt and equity

• what are the right kinds of debt and equity

• how does the current financing preserve financial flexibility

liquidation occurs under ___ of the bankruptcy code, while reorganization occurs under ___ of the code

chapter 7

chapter 11

T or F: liquidation can be voluntary or involuntary

True

T or F: common shareholders are first in the payment cascade in bankruptcy

False

what is a prepackaged bankruptcy

a prepackaged bankruptcy occurs when a company obtains approval in advance from a majority of its creditors of a plan of reorganization and then files chapter 11

total risk

measured in terms of standard deviation

Total risk = systematic risk + unsystematic risk

diversification

the process of spreading investment funds across individual assets, thereby forming a portfolio

principle of diversification

spreading investment funds across a number of individual assets will eliminate most of the unsystematic risk

non diversifiable risk

is the systematic risk and the remainder of the unsystematic risk

capital assets pricing model

• the pure time of value of money (diskless rate)

• the market risk premium for bearing the systematic risk of that asset class

• the amount of risk in a specific asset which risk, as measured by Beta, is greater or less than that of its asset class

capital asset pricing model equation

ER= diskless rate + [(Beta) x (market risk premium)]

stages of venture capital

first stage- build pro-to type, do marketing plan

second stage- begin operations, hire staff

how do venture capitalist make money

make their money when one of their portfolio companies goes public or is acquired by another firm

venture capitalists can extract very favorable terms:

• large percentage of the company’s equity

• representation of the board of directors

• various restrictive covenants

why do venture capitalists usually structure their investment as preferred stock:

• senior status in bankruptcy

• convertible into common stock before IPO

• conversion price is set so that in liquidation all the money goes to the preferred shareholders (common equity with zero)

what is the first issuance of stock by a which company

initial public offering

steps in the issuance of securities

• approval by the company’s board of directors

• registration statement filled with the SEC, which statement discloses all material information concerning the company

• company issues Preliminary prospectus, called a red herring

• on the effective date of the registration, after SEC approval, underwriters price the issue

• the company issues formal prospectus, a legal document describing for potential investors

• underwriters publish a tombstone, an advertisement announcing the public offering

two types of underwriting

firm commitment: underwriters buy the entire issue and bear the risk of resale. fees for “firm commitments” are higher than fees for “best efforts”

best efforts: underwriters does not guarantee any amount of money to the issuer, but promises to use its “best efforts” to sell as much as it can

dutch auction

originated in the 1630s, the underwriter does not set a price for the issue but lets potential investors make competitive bids for the issue. the number of shares bid and the price bid by each bidder determine which bidder will receive shares, how many shares each bidder will receive, and the proceeds which the company will receive.

reasons for underpricing

• the belief that shares must be underpriced to attract investors

• underpricing is insurance that the underwriters will not be sured for an unsuccessful issue

• as a way of guaranteeing a quick profit to institutional investors who provide the underwriters with their honest opinions on the value of the issue

pre-emptive rights

are included in a corporation’s articles of incorporation, then the company must offer any new issue of common stock first to existing shareholders, before offering it to the public.

what happens under a rights offerings

each shareholder is given the right to buy a specified number of new shares from the company, at a specified price, by a specified date

dilution

is the relative loss of shareholder's value in terms of percentage of ownership, percentage of the market value, percentage of book value, or percentage of EPS

standby underwriting

in a standby underwriting, and investment bank agrees to purchase any unsubscribed rights, so that the amount company is guaranteed to raise the needed amount.

this protects the company is shareholders do not exercise the rights, or if the company’s stock price falls below the subscription price

long term debt private placement market

• 1/6 the size of long term public debt market

• term of 10-20 years

• lenders are about 60 insurance companies

• covenants mirror those of bank credit facilities

• over 60% of market is non-US borrowers

• multi currency capabilities

• many advantages over public debt market

  • less costly

  • avoids SEC registrations

  • easier to deal with fewer lenders

league tables

a league table put out by a financial information provider might show the financing deals that each bank has managed during a yearly period, illustrating the combined dollar value of the deals as well as the share of the deal market for the period

Weighted average cost of capital

the minimum return that a company must earn in order to satisfy its long term debt investors and its equity investors

capital structure

the mis of long term debt and of equity ( both preferred stock and common stock)

How is WACC calculated

• the market values of the long term debt and the equity ( both preferred and common)

• the after-tax cost of the long-term debt

what is the basic capital structure decision

how much debt, and how much equity should a firm have in its long-term capital structure

what is the goal of capital structure

minimize the value of the firm, or the value of the firm is maximized when the weighted average cost of capital is minimized

what is optimal capital structure/ target capital structure

is the mix of long term debt and equity which results in the lowest possible weighted average cost of capital

practical implications

• the higher the tax rate, the greater is the incentive to borrow

• the greater the volatility of its EBIT, the less that a firm should borrow

• taking on debt increases the risk of( and the cost) both of debt (by increasing the probability of bankruptcy) and of equity (by making earnings to equity investors more volatile)

• as to bankruptcy, firms heavy with tangible assets that can be used as collateral will have an incentive to borrow more. firms heavy with intangible assets that cannot be borrowed against will have a disincentive to borrow more.

• financial flexibility: maximizing the options open for the next financing (is extremely important )

capital structure questions for every CFO

• what is the right amount of financing

• what is the right mix of debt and equity

• what are the right types of fina dial instruments

• how does the current financing preserve financial flexibility