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73 Cards in this Set
- Front
- Back
Legal types of firms |
Sole proprietorship |
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Direct Agency Cost |
Capital expenditure benefitting CEO but not shareholders Monitoring CEO actions |
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Indirect Agency Costs |
Opportunity costs because of short term objectives being set by CEO |
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Minority - Majority shareholder relationship |
Majority shareholders can abuse their powers by appointing biased directors |
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Shareholder - Debtholder relatioship |
CEO sometimes favour one type of principle over the other. |
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Net Present Value Formula |
Look at formula sheet |
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NPV need to be adjusted according to |
Unexpected events Possible changes in cash flows Future Opportunities |
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Sensitivity Analysis |
it provides the best, worst and expected scenario according to underlying assumptions. Gives a matrix of NPV |
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International Principles of Corporate Governance |
OECD 2004 |
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Risk Analysis techniques |
Sensitivity Analysis Monte Carlo Simulation Decision Tree Present value break even Accounting break even |
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Costs of financial distress |
Direct costs Indirect costs |
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Direct costs |
Administrative costs Negotiation costs |
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Indirect costs |
Loss of reputation Loss of key employees |
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Trade off theory |
Tax benefits of debt should balance with cost of financial distress |
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Pecking order theory |
Use internal funds first, then debt, then equity |
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Market timing theory |
CEO will issue debt or equity depending on whether he believes the firm is under or overvalued. He will issue equity if overvalued and debt if undervalued and price adjusts. |
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Agency cost of debt |
Over investment Under investment |
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Over-investment |
When managers take excessive risk (invest in negative NPV projects) to try and achieve profits and pay dividends to shareholders. |
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Under-investment |
When managers doesn't invest in positive NPV projects because they want to pay out large dividends to shareholders. |
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Agency costs of equity |
Empire Building Wasteful investment Shirking Monitoring costs Managerial peaks |
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Leverage effect on agency costs |
Leverage increases debt agency costs - Creditors anticipate problem and increase interest rate and place debt covenants - Encourage over- and underinvestment Leverage reduces equity costs by committing firm to future interest rate payments. |
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Financial Distress |
When a firm's operating cash flows cannot satisfy it's legal obligations. |
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Financial distress strategies |
Asset expansion policies Operational contraction policies Financial policies External control activities Change in managerial control Wind up company |
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Two ways of external funding |
Issuing securities --> Equity financing Borrowing funds and public issue of debt --> Debt Financing |
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Public Placement |
Public offering of shares done via investment bank. - Banks act as underwriter's and buy all new shares at a discount (against risk of not selling all shares) |
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Private Placement |
Private equity firms act as underwriters, sold to institutional investors and funds. |
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Types of Debt financing |
Bonds - Public - Private Bank Loans - Line of credit - Loan commitment |
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Line of Credit |
Maximum amount is determined but interest rate is not set and can hence be changed. Firm is flexible to accept or decline offer at any time. |
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Loan commitment |
Revolving loan commitment - Firm can borrow more or pay down the low during the term Non-revolving loan commitment - Fund is restricted |
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Option |
The right to buy or sell an asset at a predetermined right |
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Long Position |
The holder of the right of an option |
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Short position |
The holder of the obligation to the owner of the option |
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Call option |
The right to buy an asset at a predetermined price |
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Put option |
The right to sell an asset at a predetermined price |
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Protective Put Strategy |
Buy a stock and a put option for the price you bough the stock. You can maximum lose the premium but potential return is infinite. |
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Purchasing a synthetic share |
The return of a share can actually be replicated by buying a call option and a bond and selling a put option, all sharing the same price and date of maturity. |
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Option Valuation Methods |
Black Scholes Model Binomial Option Model |
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Option Combinations |
Protective put Synthetic share Long guts Call bullish spread |
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Long Guts |
Buying a call option with the higher strike price and a put option for the low price with the security and same maturity. |
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CEO compensation usually involves |
Base cash salary Cash bonuses Retirement bonuses, restricted stocks and options |
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Advantages of options as compensation |
Aligns objectives with shareholders Can offer lower base salary Make executives pay dependent on firm performance |
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Disadvantages of options as compensation |
Only aligns interest with that of shareholders No upper limit of pay |
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Warrant |
Gives the owner the right to buy shares in a company at a given price for a fixed price. (A call option for shares) |
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Convertible bonds |
Gives the owner the right to exchange the bond for a given number of shares up until the maturity of the bond. |
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Why do firms issue warrants and convertible bonds |
They don't have the credit rating to issue normal debt (Usually employed by smaller and high growth firms because convertibles are insecure) |
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Call Bullish spread |
Buying a call option with a lower strike price and selling a call option with a higher strike price on the same security with the same maturity. |
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Strategies that options and other derivatives can be used for |
Hedging Increase risk and return |
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Forward contract |
A contract obliging the partners to complete a transaction at a set date at a set price |
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Futures contract |
Standardized forwards contract that can be traded. Price is marked against the market everyday. |
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Swap Contracts |
An arrangement to exchange cash flows over time |
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Interest rate swaps |
Firm pays a fixed interest rate against the receiving the floating interest rate, The received floating interest can be use to match and hedge against floating interest obligations |
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Currency swaps |
Two firms or organisations swap principals and interests received to hedge against exchange rate risks. |
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Derivative securities |
Forwards, futures, options and swaps. An investment whose payoff is dependent on the performance of underlying assets. |
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Securitization |
Repackaging of "pools" of loans and other receivables to create a new financial instrument that can be sold to investors. |
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Pros of globalization |
Easier to hedge against risks Better and more effective use of capital |
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Cons of globalization |
Traders can exploit differences in country specific regulations Global economy is more exposed Higher degree of complexity in financial system |
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Direct quote |
Quoting the exchange rate with the domestic currency first |
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Indirect quote |
Quoting the exchange rate with the foreign currency first |
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Vehicle currency |
The currency actively used in many international transactions around the world |
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Cross rate |
Exchange rate between two currencies not involving the vehicle currency |
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Arbitrage |
Earning risk free profit at the expense of someone else |
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Transaction exchange risk |
The possibility of taking a loss in foreign exchange transaction due to the uncertainty of the currency exchange rate. |
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Purchasing Power |
What a unit of a currency can buy in another country given the price level in that country |
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Purchasing Power Parity |
Explains how much of a currency would be needed to buy the same basket of goods in two different countries |
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Absolute Purchasing Power Parity |
PPP adjusted for inflation |
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Relative PPP |
Considers the inflation rate in different countries and suggests the future exchange rate should reflect the inflaton |
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Interest Rate Parity |
The relation between current spot exchange and the future FX rate should reflect the interest rates in the countries |
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Unbiased Forward rates |
Explains the relation between current and future exchange rate |
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International Fisher Efffect |
Different countries can have different inflation and interest rate but the difference between these two factors should be the same throughout the countries to prevent arbitrage. |
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Callable Bond |
A bond that allows the issuer of the bond to redeem the bond before the maturity date. |
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European Call Option |
Can only be exercised on expiration date |
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American Call option |
Can be exercised at any point up until the maturity date |
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Put Call Parity |
The relationship saying that a call option and the present value of the exercise price is equal to the put option and the underlying stock or arbitrage is possible. |