62 Cards in this Set
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Risk
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chance of loss (of time, effort and money)
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What is the cardinal rule of risk?
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no risk, no (or low) return; some risk, some return; lots of risk, lots of return
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What are the absolute measures of risk?
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variance and standard deviation
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What are the relative measures of risk?
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coefficient variation and beta
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What is the coefficient variation?
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risk / return
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What is beta?
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how an investment moves relative to the stock market
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What are the two types of inherent risk that stocks tend to have?
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market (or systematic) risk and company risk
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What are the three types of stockholder return?
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Required Return: what the investor requires from the firm before investing in the firm
Expected Return: what the investor expects to receive
Actual Return: what the investor actually receives from the firm after investing
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What is the Security Market Line?
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a line relating beta (risk of the stock markets) to return
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What is the Capital Asset Pricing Model?
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a model showing what the return of an investment should be given its risk
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What is common stock?
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a certificate of ownership in a corporation
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What are the three different types of stock?
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1. Ordinary Common Stock
2. Founder's Shares
3. Classified Stock
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What is selling ("floating") new stock for existing public companies?
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done through an underwriter who buys stock at a discount and sells it to public at market pric
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What is selling ("floating") new stock for new companies going public for the first time?
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done through an IPO, where the price is purposely set low
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What is the difference between overvalued and undervalued stock?
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the market price of overvalued stock is greater than its intrinsic value, whereas undervalued stock is less than it
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What are the advantages of raising money via equity?
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- never have to repay the principal
- dividends aren't legally mandatory
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What are the disadvantages of raising money via equity?
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- Dividends are not tax deductible
- Dividends are effectively taxed twice for shareholders
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What is preferred stock?
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a hybrid between stocks and bonds. They are like bonds because they are constant payments just like interest payments, and they are paid before common stock just like interest bonds
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What is an efficient market?
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markets in which prices fully and immediately reflect all available information
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What does the efficient market theory say?
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that price changes are random because they are caused by people reacting to the news, and the news is random; therefore, price changes are random
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What does cost of capital show you about the big picture?
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if returns on capital (R) are greater than cost of capital (K), you're profitable
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What are the two types of capital?
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Debt Capital: borrowed money
Equity Capital: shareholder's money, which can be either stock or retained earnings
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What is the cost of debt?
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after-tax cost of borrowing; = i ( 1 - t )
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How are securities sold to the public?
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firms use underwriters which charge a flotation cost
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What two kinds of return do shareholders want?
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1. Div return (% = div/price)
2. Capital gains return (% = change in P / P)
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What types of equity are available to a firm?
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Retained Earnings and new equity
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Overall Cost of Capital = _______
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Weighted Average Cost of Capital
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Cost of New Capital = ________
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Marginal Cost of Capital
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What is the optimal capital structure?
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% Debt v. % Equity;
mix which minimizes overall cost of capital
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What is capital budgeting?
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the process of planning out long-term investments
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What are capital items?
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long-term assets being bought
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What is a capital budget?
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a listing of the dollar amounts which the firm plans to spend on its various investments
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What are the four steps in the Capital Budgeting process?
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1. Identify all possible investment projects.
2. Estimate cash flows for each project
3. Evaluate the estimated CFs using one or more CB tools
4. Implement those projects which pass the CB criteria
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What are the four major capital budgeting tools?
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1. Payback method
2. Net Present Value
3. Benefit/Cost Ratio
4. Internal Rate of Return
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What is the payback method?
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calculates the number of years required to recover the original cost of the investment
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What are the advantages and disadvantages of the payback method?
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Advantage: simple to calculate and understand
Disadvantages:
1. ignores time value of money
2. ignores CFs past the payback period
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What is the formula for NPV?
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PV (CF) - Cost
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What is NPV sometimes called in Europe?
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Discounted CFs (DCF)
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What is the crossover-rate?
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the discount rate at which NPV profiles cross over, ie. NPVs are equal
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What is the B/C formula?
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PV ( CF) / Cost
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What is the intuitive way to define IRR?
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IRR is the effective annual yield on the money invested in the project
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What is the technical way to define IRR?
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IRR is the interest rate which causes NPV = 0
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What is capital rationing?
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the process of not investing in all positive NPV projects
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What is cannibalization in terms of cash flow estimation?
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a decrease in sales of an existing product/service caused by the new project
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What are some ways to adjust for uncertain cash flows?
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1. consider the variability of each project's cash flows (ie. more variability = less desirable)
2. determine how each project's CFs correlate with your existing CFs (ie. more negative correlation = better)
3. consider the coefficient of variation of the proposal's CFs (ie. higher CV = …
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What are derivatives?
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a security which derives its value from another asset; "contingent claim"
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What are derivatives used for?
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- hedging: reducing risk
- speculation: purposely incurring risk in hopes of a profit
- price reflection: derivatives reveal what people expect future prices to be
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What are the three major types of derivatives?
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1. Options
2. Futures
3. Swaps
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What is an option?
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a security giving the holder the right to buy or sell an asset in the future at a specific price
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Call options give the holder the right to ____ the asset, while put options give the holder the right to ___ it.
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buy; sell
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What are the elements of an option?
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1. Premium - the price paid for an option
2. Exercise/striking price - the price at which the underlying asset can be bought or sold
3. Expiration date - the date on which the option expires
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What is a holder?
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the person/firm who buys (holds) the call or put
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What is a writer?
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the person who creates and sells the call or put
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In the money means the option _______, while out of the money means the option _______.
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has intrinsic value; has no intrinsic value
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What are the two basic operating principles for options?
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Buy calls if you expect prices to go up.
Buy puts if you expect prices to go down.
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What are futures?
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abbreviated term for "futures contracts" which are legally binding agreements to buy or sell an asset sometime in the future at a price agreed upon today
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What are two types of futures?
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"Going long" - means entering a futures contract to buy the asset
"Going short" - entering the contract to sell
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What are the three elements of a futures contract?
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1. Futures price - the contract price which the buyer and seller agree upon
2. Delivery month - the month in the future during which the seller delivers the asset to the buyer
3. Basis - the difference between the spot price and the futures price
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What does "Marked to the market" mean?
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the process of posting daily gains/losses to a futures trader's margin account
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What are the two basic operating principles for futures?
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Go long if you expect the prices to go up.
Go short if you expect them to go down.
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What are swaps?
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an agreement in which two parties agree to swap (exchange) something
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What are two types of swaps?
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Interest-rate swap - two parties agree to swap interest payments
Currency swap - two parties agree to swap currencies
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FIN 301: EXAM 2