Chapter 1

Q: Can an individual be indifferent to receiving a dollar now or a dollar

one year from no?

No, a dollar in 1 year in not equal to a dollar today. Interest build upon.
Unless there is zero interest.

A financial asset is a claim to a series of future cash flows. Eg bonds and

shares. They are issued by companies to raise finance need to purchase
real assets.

A real asset is asset that are put to pdtive use to generate income.

Chapter 2

Simple interest – interest is earned on the basis of an initial principal

Nominal cmpding interest - end of each cmpding period, interest earned

is cal to the balance of the principal.

Effective interest- actual rate of interest / the interest rate when cmpded
annually is = to given nominal cmpding interest rate.

Nominal interest rate- stated interest rate and ignore the effects of
cmpding.

Cmpding period interest rate- less than a yr and requires the nominal
quoted rate to be divided by the no of cmpding period within 1 yr.

PV is the amt applicable today = to a single cash flow/ series of cash flows
to be paid or received in the future.

Ordinary annuity- CF of equal amts for a defined period with the first CF at
the end of each period.

Annuity due – similar to OA except that CF occurred at the beginning of

the period

Deferred annuity- is a OA where first CF has been deferred into the future.
Eg more than one period from now.

Perpetual annuity- an annuity that continues forever.

Chapter 3

Value of company = value of debt + value of Equity.

Q: what are the 2 different approaches to valuing a firm?

1. Cal of PV of CF generated by the real (pdtive) assets

2. Cal of PV of firm individual securities that is the E and D securities since

they represent claims on the income generated by real assets .

Q: what distinguish the return on Debt securities from equity securities?

1. The nature of CF accrued to the holder of security.

2. The life of security

3. The right to claim against the assets of company in case of liquidation.

4. the returns. Debt, interest fixed for the life of security and equity
(dividends) vary at the discretion of the mgt.

Q: why is constant dividend model unlikely to be used?

Main limitation is the assumption of constant dividends paid by a company

is unrealistic. A model based on the assumption of growing dividends is
more realistic.

Q: why is required rate of return on firm’s equity higher than the firm’s
debt?

Name the 3 differences as aboved.

The fact that equity ranks behind debt in terms of income payments and
return of principal. Also, returns to equity holders are much more variable
than return to debt holders. These differences constitute additional risk
from the point of view of an investor, hence a higher rate of return will be
required to induce investors to invest in such securities.

Coupon rate is the annual % rate at which interest payments will be made.

When coupon rate is greater than interest rate, price of share will be
greater than face value.

Chapter 4: Capital budgeting

3 stages in accepting a investment project:

1. Forecasting of costs and benefits

2. Application of investment evaluation technique

3. A final choice to accept/ reject.

Q: what criteria shd we use in evaluating capital budgeting techniques?

4 criteria.

1. Does the method correctly identify wealth-increasing projects?

2. Does the method correctly rank competing projects?

3. Does the method recognize the timing of the CF & their relative
magnitude

4. Can mgt understand the results?

NPV involves the discounting of CF to determine the value of a project is

PV terms.

IRR based on discounted CF model but focus on the rate of return.

Payback period is popular as it is used as a capital rationing tool. That is

when projects are equally attractive under PV techniques; the one that
returns the invested funds in the earliest time is ranked more highly.

Method Strengths Weakness

NPV Incorporated time value of Difficulty in forecasting FCF

money
Incorporate risk of the
project
Correctly ranks projects on
wealth maximizing criterion
Problem in estimating
appropriate discount rate
Difficulty for non-finance
trained managers to fully
understand

IRR Incorporate time value of Multiple solutions for +/- CF

money
Scale of project not taken
Incorporate cost of project into consideration

Mgt feel they can Cal is problematic wo

understand financial cal.

Payback Simple to est Arbitrary cut off point

needed.
Clear decision rule- accepts
the project with shortest Ignores CF after cut off
payback period. period

Rank project on time taken Ignore time value of money

to recover cost

ARR Use reported acting no Ignore time value of money

No clear decision rule Does not max shareholder

wealth

Cannot discriminate
between project

* Positive NPV, IRR > required rate of return

Q: Elements to be included in the NPV calculation.

CF generated, opportunity cost and side effects. CF is referring to free CF

(total CF – capital expediture).

Opportunity cost – included. If a company uses a resource in a project

which would otherwise be available for an alt use, the dollar value of that
lost cash inflow is treated as an outflow for the project.

Side effect- included. Impact upon the value of the existing biz. Positive or
negative CF that relates to other aspects of a company biz as a result of
implementing the project.
Sunk cost- ignore. It has been incurred already whether e project proceeds
or not. If include, NPV will be underestimated, introducing a biased
towards the rejection.

Finance charges- interest expenses and loan repayments are excluded.

The reason is simple. We wish to know if the project is value increasing
before we determine how we are to finance it. In other words, we wish to
know if the project achieves the market rate of return for a given level of
risk.

Q: since depreciation is a non-cash expense, the firm does not need to

know the depreciation rate. Comment.

Incorrect. Although depreciation is non cash expense, it provides a

depreciation tax shield which has the effect of lowering the income tax of
the company. Since tax payment is a CF , rate must be known.

Chapter 6: Risk & return.

Risk measured by standard deviation of returns – the extent to which

returns on an investment are expected to differ from its expected value.

Risk of a portfolio comprised of proportionate risk (variance) of individual

assets in the portfolio as well as the interaction (covariance) between
these individual assets.

Covariance measure the raw degree of ass bt 2 variables. Measure

direction.

Correlation Coefficient measure direction and strength. It lies bt +1 and

-1.

If it is +1 = stock returns very uniform (least diversified)

If it is -1 = stock returns offset one another. (well diversified)

Systematic (non- diversifiable) risk – common to all securities and cannot

be diversifies. Driven by broad economic conditions.

Unsystematic (diversifiable) risk – affect individual securities alone. It does

not influence all securities and can be diversifiedby portfolio
diversification. Relates to price movements that are caused by an event
that influence a single company.

Diversification does not eliminate systematic risk.

Q: what is the impact of portfolio diversification on these respective risk

elements?

By combining securities in a diversified portfolio, unsystematic risk of

individual portfolio securities can be eliminated by offsetting movement bt
securities with low/negative correlation.

If price of bond > face value, yield to maturity is below coupon rate.

Standard deviation measure the extent to which a random variable is

expected to differ from its expected value. Useful in measuring total risk
(the extent to which a security return differs from its expected value)
Chapter 7 : Capital asset pricing model

Q: what r/s is represented by the CML?

The CML plots the expectd return on a portfolio (comprised a combination

of the risky asset – the market portfolio- and the risk free asset) against its
standard deviation(risk) i.e the CML represents the risk return trade off on
efficient portfolios.

Q: what is the CML?

It is the efficient set considering both risk free and risky asset(the mkt
portfolio) becoz CML contains the most efficient feasible portfolios, it
implies that a rational investor will invest in a combi of the risk free asset
and the mkt portfolio in order to max their utility.

Q: what r/s is represented by the SML?

SML plots the expected return on an individual asset against its systematic
risk measured by its beta.

Q: what is market portfolio?

Technically, the mkt portfolio is the portfolio at the pt of tangency of the

CML, originating at the risk free asset with the efficient st of risky asset
portfolios. It contains all stocks that are available to the investors.

Q: Define beta

Beta is the expected rs bt returns on a stock and return on the mkt.

usually estimated using historical returns on a stock and as a proxy for the
return on the mkt. negative beta means an increase in mkt returns result
in a decrease in the value of the stock.

Chapter 8: cost of capital

Q: which 2 methods commonly used to estimate the cost of equity?

CAPM and required return from the stock price and fundamentals of the
company.

Q: what is a company cost of capital used for? It is used to find the PV of

firm free CF (CF available for distribution to the owners of a company)

Market premium is used to estimate the CAPM required return of equity.

This return of equity

WACC represents the cost of funding a firm operations. Mgt want to

calculate WACC to determine the return it requires on new investment
projects

Chapter 10: Pricing efficiency of capital markets

3 levels of market efficiency:

1. Weak form – prices reflect historical info

• Price movements expected to be random and nt to exhibit

 any trends.

2. Semi-strong form – price reflect publicly available info

• Stock price shd adjust immediately when new info arrives.

3. Strong-form – price reflect all(private and public) info

• Stock prices will impound all available info. Insider trading

will nt be profitable as prices will already reflect these info.

Q: any test of market efficiency is also a test of the model used to est
expected returns.

We use estimate of return to compare the expected return with the actual
return and the difference is the abnormal return. Any estimate of
expected return from the CAPM will impact on the abnormal return.

Chapter 12: capital structure

Capital structure refers to the mix of debt and equity used by a company
but the focus is on debt.

Q: Is capital structure relevant in a world wo taxes?

Merton Miller and Franco Modigliani (M&M) mathematically proved that

capital structure policy has no impact on shareholder wealth

Capital structure irrelevance main assumptions of M&M: (M&M assumed)

1. Investors borrow at the same rate as the company

2. There are no cost of trading shares

3. all market participants have the same info

4. There are no personal or corporate tax

Investors borrowing at the same rate as company is unlike to be true.

Companies hsd be able to borrow at much lower interest rate than
individuals becoz companies borrow large amt of capital from banks
resulting in sig EOS in borrowing and sig bargaining power.

Firms that borrow excessively face ‘financial distress‘ in case of liquidation

the debtors of the films are paid first and the residual cash if any is paid
out to equit holders. Firm that have high leverage ratios experience higher
probability of financial distress coz they have a fixed interest bill to pay.

Another assumption is that all market participants have the same info. The
existence of info asymmetry bt mgt of a company and its shareholders
means mgt has more info abt the value of the company than its
shareholders do.

Final assumption that there is no personal or corp tax. This is a difficult

issue as debt is preferred to equity. As it is tax deductable at the corp
level and creates a tax shield. Become less clear when personal taxes are
included esp in a dividend imputation envt. Little impact on the value of
the firm from issuing more debt. The reason fo this is there is less benefit
to paying a lower corp tax coz total tax paid on corp income is ultimately
levied at an investor personal tax rate.

M&M highlights the real life conditions under which capital structure may
be relevant to shareholder wealth. M&M structured theory are highly
utopian and unrealistic.

Q: identify the cost of financial distress.

It is caused by a fall in assets values below the value of debt. The ultimate
cost of financial distress is liquidation where company assets are sold and
return to debtors first and any residue will be given to the equity holders.
The cost of financial distress includes legal and administrative costs,
forced asset sales and lower market value.

Q: reducing debt ratios will reduce the cost of debt and cost of equity,
making everybody better off.

It advtg to shareholders as reduction of debt reduces the threat of

financial distress as shareholders are residual claimers. As less cash is
being paid out in interest payments, potentially there is more cash
available for dividend payouts. Interest amounts nvr increase coz it is a
fixed amt. Reduction in debt increases certainity in biz but does nt always
results in reduction of the cost of debt/equity.

I. Traditional view of capital structure: The weighted average cost of

capital (WACC) is the average cost of equity and debt weighted in
proportion to their contribution to the total capital of the company. Debt is
generally less expensive than equity capital. The so-called traditional view
of capital structure states that when a company starts to borrow, the
advantages outweigh the disadvantages. The cheap cost of debt,
combined with its tax advantage, will cause the WACC to fall as borrowing
increases. However, as gearing (debt/equity ratio) increases, the effect of
financial leverage causes shareholders to increase their required return
(i.e., the cost of equity rises). At high gearing the cost of debt also rises
because the chance of the company defaulting on the debt is higher (i.e.,
bankruptcy risk). So at higher gearing, the WACC will increase. The main
problem with the traditional view is that there is no underlying theory to
show by how much the cost of equity should increase because of financial
leverage or the cost of debt should increase because of default risk.

II. Modigliani and Millers Theory: In contrast to the traditional view,

Modigliani and Miller (MM) set out to show what ought to happen to the
cost of capital when a company increases or decreases borrowing. MM
argue that for any individual company, WACC will be the same at all levels
of gearing (as measured by debt/equity ratio). In other words, there is no
optimal level of gearing and no minimum WACC one capital structure is as
good as another. Per MM, there is only one advantage of borrowing (debt
is cheaper because it is less risky to the investor) and one disadvantage
(the cost of equity increases with borrowing because of financial
leverage). Modigliani and Miller show that these effects cancel out exactly.
The use of cheap debt gives shareholders a higher rate of return, but this
higher return is precisely what they need to compensate for the increased
risk from financial leverage.