intro to finance 6

25 flashcards · Other · by Daniel F.

1. Return on equity (ROE)

   Net Income / Shareholders equity

2. Earnings per share (EPS)

   Net income / No. shares outstanding

3. Financial leverage

   borrowing funds to buy an investment, estimating that future profits will be more than the cost of borrowing

4. capital structure with debt vs capital structure without debt

   in situation 2 half of equity financing is replaced by debt financing no tax, share price unchanged higher leverage means higher return to stockholders same share price less shares less equity higher risk with larger variation of EPS higher risk due to interest payments EPS can be negative -> when EBIT = 0 you still pay interest if I predict that EBIT will be high, I take on more debt if I predict EBIT will be low, I reduce debt

5. Break even EBIT

   EBIT / Shares outstanding = EBIT- Interest / Shares outstanding the firm is earning enough to pay for the debt

6. Modigliani & Miller (MM) optimal capital structure (No tax)

   value of the firm is independent of the firms capital structure Proposition 1 - No taxes Firm value is not affected by leverage V: Firm market value = Present value of expected future cashflows VALLUE = OCF / WACC as perpetuity Value of levered firm (V_L) = Value of firm w equity (V_E) Proposition 2 leverage (D/E) increases the financial risk and required rate of return for equity

7. Financial risk vs business risk

   Business Risk The equity risk that comes from the nature of the firm's operating activities. Financial Risk The equity risk that comes from the financial policy (the capital structure) of the firm. Causes cost of equity R_E to rise with D/V rising (as firm gets more levered)

8. MM Graph, WACC is constant (No tax)

   WACC stays the same cuz the change in the capital structure weights (E/V and D/ V) is exactly offset by the change in the cost of equity (RE) R_D stays the same Capital structure irrelevancy: The value of the firm doesn't change cuz WACC is constant No optimal capital structure

9. MM (with tax)

   value of the firm increases with leverage cuz tax benefits VALUE: VL=VU+TC∗DV_L = V_U + T_C * DVL​=VU​+TC​∗D T_C * D: corporate debt tax shield Levered vs Unlevered firm: As the company take on more debt the WACC decreases cuz tax reduces the effect of R_D WACC decreaes cuz the change in the capital structure weights (E/V and D/ V) is not offset by the rise in cost of equity (RE) cuz the D/V gets lower because of the corporate tax shield -> more leverage increases value of firm With no bankrupt…

10. Direct bankruptcy costs vs indirect bankruptcy costs

    Direct Bankruptcy Costs - The costs that are directly associated with bankruptcy, such as legal and administrative expenses Indirect Bankruptcy Costs -The costs of avoiding a bankruptcy filing incurred by a financially distressed firm Both: financial distress costs Increases cost of debt R_D as D/V increases (firm gets more levered)

11. MM with tax with bankruptcy risk with optimal WACC

    As leverage increases the cost of debt increases cuz bankruptcy costs -> WACC has an optimal minimum Static trade-off model (has practical relevancy): optimal debt is different from every firm and exists

12. pecking order hypothesis

    firm has preferred order of raising capital internal financing (retained earnings) may not be the cheapest but it is readily available issue cheapest security: debt cheapest cuz debt is less risky than equity, guaranteed interest expense, gets paid first in case of bankruptcy issue equity as a last resort implications no target capital structure in this theory profitable companies borrow less companies want more liquidity

13. types of dividends

    Regular cash Dividends Stock Dividend Stock Split

14. important days in the dividends lifetime

    Declaration date: The board of directors declares a payment of dividends. Record date: The declared dividends are distributable to shareholders of record on a specific date. Ex-dividend date: A share of equity becomes ex-dividend on the date the seller is entitled to keep the dividend; under stock exchange rules, shares are traded ex-dividend on and after the second business day before the record date. Payment date: The dividend cheques are mailed to shareholders of record.

15. price behaviour around ex-dividend date

    The share price will fall by the amount of the dividend on ex-dividend date (Time 0)

16. Does dividend policy matter

    it should not matter Even though payment is 110 (or 90) when we want a 100 If the dividend paid is larger than desired dividend -> Buying more by using extra 10 If the dividend paid is smaller than desired dividend. -> selling shares to get extra 10.

17. factors affecting dividends

    taxes flotation costs dividend restrictions desire for current income

18. an investor is more likely to prefer a higher dividend payout if a firm

    has few, if any, positive net present value projects. the firm doesn't need to keep the money in the firms so investors want to due to fear of agency problems has lower income tax rates. paying higher dividends costs a lot in tax to the company, investors don't want that has a share price that is decreasing rapidly. you can only keep up the required rate of return if there is more dividend

19. factors affecting dividend payouts

    information content of dividends: the market can react negatively or positively to a change in dividends that can change the share price clientele effect: different dividends attract different types of investors

20. share repurchase

    the firm is buying back its shares should be the same as paying out dividends shareholder value increases by how much is repurchased to keep it the same real world differences lower taxes for repurchases flexibility of repurchases dividends send positive signals to the market dividends require no monitoring

21. What can a stock do

    pay dividend split reverse split

22. Liquidity Management vs Cash Management

    Liquidity Management: The optimal quantity of liquid assets a firm should have on hand. Cash Management: The optimization mechanisms for collecting or disbursing cash.

23. reasons to hold cash

    The Speculative Motive: The need to hold cash to take advantage of additional investment opportunities, such as bargain purchases The Precautionary Motive: The need to hold cash as a safety margin to act as a financial reserve The Transaction Motive: The need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations

24. cash discounts

    discount given to encourage prompt payment e.g: 2/10, Net 30 If paid in 2 days 10 percent discount otherwise it has to be paid in 30 days The buyer is effectively borrowing 980 for 20 days & paying 20 of interest on the "loan" interest rate is 20/980 = 2.0408% which is nominal annual rate = 0.02041 * 18.25 = 0.3725 effective rate = EFFECT(0.3725, 18.25) & 0.4459