Essential Theory Questions PDF

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L1: Options Essential theory: 1. What is an option? 2. What is the payoff of a put/call option? 3. What is the intrinsic value of a put/call option? 4. What is the difference between a profit and payoff diagram? 5. The four drivers of intrinsic value are (give its correlation to price): 6. The two drivers of time value are (give its correlation to price): 7. The difference between an American and European option is: 8. What are the trade-offs to consider when exercising early? 9. Give an example of how a company could use a call/put to reduce potential future losses. Theory answers: 1. An option gives the holder the right, but not the obligation to buy or sell an asset at a predetermined price at some time in the future. 2. Call payoff = Max(Pexpiry – exercise price, 0), Put payoff = Max(exercise price - Pexpiry, 0) 3. Call intrinsic value = Call payoff now, Put intrinsic value = Put payoff now 4. Payoffs show the value of exercising the option at a certain asset price (see 2). Profit diagrams are the same, but subtract the premium. 5. Asset price. As it goes up, calls go up and puts go down in value. Exercise price. As it goes up, calls go down and puts go up in value. Interest rates. As they go up, calls go up (lowered PV of future outflow) and puts go down (lowered PV of future inflow) Dividends. In they occur before expiry, puts go up (lowered asset price) and calls go down. 6. Time to expiry. Both calls and puts go up as it increases. Greater probability of finishing deep in-the-money. Volatility. Same as above. 7. American options can be exercised before expiry. European only at the time of expiry. Holding an American option is therefore preferred.

8. Pros: Secure your profit or avoid the price drop before a dividend. Cons: a complete loss of time value. 9. Buy a call on an asset you will buy in the future to set a cap on the price you pay. Buy a put on an asset you will sell to set a minimum price you will receive.

L2: Payout Policy Essential theory: 1. Order and explain the following events: Ex-dividend date, announcement date, payment date, record date, cum-dividend date. 2. What is the dividend drop-off ratio? What would you expect it to be? 3. What is the MM dividend irrelevance theorem? 4. Explain how investors can replicate their preferred dividend payout policy themselves. 5. What assumptions does MM’s theory make? 6. Explain six additional factors to dividend policy. 7. Explain the imputation tax system and define a grossed-up dividend. 8. Give the reasons for and against dividends from the investor’s point of view. 9. What is meant when dividend payout policies are called ‘sticky’? 10. What are two issues with high dividend payouts ratios? 11. List the four types of buyback. 12. Explain the tax implications of each type of share buyback. 13. List the benefits of choosing a share buyback over paying dividends. 14. What type of businesses prefer dividends/buybacks? 15. What type of businesses prefer off/on-market buybacks? 16. Compare regular and special dividends.

Theory answers: 1. Announcement date: The firm releases the intention to pay a dividend; record and payment dates announced. Cum-dividend date: The last day shares with the right to a dividend are traded. Exdividend date: The first day shares are traded without the dividend right. Record date: Shareholders owning eligible shares are recorded to receive the dividend. Payment date: Dividend cheques mailed out. 2. It is the ratio between the fall in share price (between the cum and ex-dividend dates) and the dividend paid. In a perfect capital market without taxes it will be 1. However, it is dependent on tax differences between dividends and capital gains, over 1 if dividends are taxed lower than capital gains and less than 1 otherwise. It is even more uncertain in imperfect markets. 3. In perfect capital markets, the value of a firm (and its cash flows) are independent of its payout policy. 4. To replicate a dividend, investors sell a proportion of their shares equal to the desired dividend yield. To replicate no dividends, investors spend their dividend on new stock. 5. That: •

There are no tax differences between dividends and capital gains.

•

Companies can issue new stock to replace cash with no additional costs.

•

Companies do not use excess cash for bad projects.

6. Resolution of uncertainty: Psychologically, shareholders may prefer the cash asset over the uncertainty of the share. However, they can sell the share and create a homemade dividend themselves. Flotation and transaction costs: Costs of flotations (issuing shares) and transaction costs (in paying dividends) do reduce firm value. Information asymmetry and signalling: Dividends may show to investors that the business in is good health with good cash flow prospects. Agency costs: If the company keeps its cash flows, the NPV of projects may reduce and money may be wasted and management may ‘empire build’. On the other hand, dividends discipline management to use funds effectively and source debt finance from institutions who can better assess the firm’s financial position.

Taxes: Selling the share cum-dividend increases capital gains taxes, selling exdividend incurs a tax on the dividend. Shareholders can delay tax with capital gains and avoid double taxation (in the classical system.) 7. Allows firms to maintain a franking account, which stores credits to claim back company tax paid. These credits can be included in a dividend to add back the tax already paid, at which point the dividend is considered ‘grossed-up’. Shareholders pay income tax on both the dividend and the value of the franking credits. The credit then offsets tax paid by its value. 8. Investors will usually prefer dividends if the tax on dividends are less than that on capital gains. If not, dividends may still be preferred because of the double taxation of capital gains. In Australia, investors also pay less in capital gains tax if they hold the share for 12 months. Foreign investors often don’t receive imputation credits. 9. Drops in dividends send a negative signal to investors, which may drop the share price. Therefore, firms often keep their payouts conservative and steady over the long-term. 10. A high payout ratio may be unsustainable and need to be dropped. This causes a negative signal. It may also leave the firm without enough cash, at which point it needs to do share issues, debt financing or a dividend reinvestment plan. 11. Equal access buyback: repurchase from all shareholders on a pro-rata basis Selective buyback: repurchase from a subset of shareholders (requires >75% approval from non-selling shareholders) On-market buyback: Repurchase on the market Employee share scheme buyback 12. All include capital gains tax. However, off-market buybacks can be done with a combination of cash (capital component), a ‘dividend’ and potentially franking credits. A low capital component may result in a capital loss, which is then discounted and reduces taxable personal income. However, the Government now treats the tax loss as the capital component as ‘deemed consideration – dividend’, and capital loss as ‘purchase price - capital component’. The deemed consideration is the VWAP over the 5 days before the announcement multiplied by the change in the market index from announcement to buyback close plus one. It effectively swaps the ‘buyout price’ for a fair market price in CGT calculations. 13. May improve EPS by reducing the number of issued shares Signal undervaluation

Financial flexibility; not as sticky as dividends Do not lead to a price drop-off (so better for the employees that hold the shares) 14. To pay dividends, you likely need high, permanent cash flows, whereas buybacks may be preferred by firms with higher temporary, non-operating, volatile cash flows. Dividends follow good stock performance, buybacks poor. 15. Firms prefer off-market buybacks when they have franking credits and the buyback is large. On-market buybacks are better when the stock is undervalued. 16. Many firms pay a regular dividends at set intervals, and occasionally pay special dividends when they have experience a potentially unsustainable increase in cash flows (e.g. from the sale of an asset.)

L3: WACC & Capital Structure Policy Theory questions: 1. What are two interpretations of the WACC? 2. What are the two components of the cost of debt? How can you find them? 3. How does the tax shield on debt work? What is lambda in equation 7? 4. What is a firm’s beta? 5. How should the WACC weights be calculated? 6. When is in inappropriate to discount with the WACC? 7. Compare and explain business and financial risk. 8. What is default risk? 9. Explain the numerical process of finding the optimal capital structure. 10. What is MM’s irrelevance theorem? 11. What are MM’s two propositions? 12. Explain trade-off theory. 13. What are the costs of financial distress? 14. Explain pecking order theory. 15. Provide two conflicts between shareholders and debtholders.

Theory answers: 1. The return the firm must earn to maintain its value, or the required rate of return on projects with risk similar to existing operations. 2. The risk-free rate (US Government bond rate) and the default spread (look at S&P/Moodys rating, a ratio such as interest coverage ratio). 3. Paying interest on debt reduces profit and thus corporate tax paid. The actual amount of tax paid is the ‘effective’ tax rate, which takes into account how much corporate tax would be claimed back by shareholders via franking credits. Lambda represents this proportion of corporate tax claimed. It is 0 in the classical system, 1 in pure dividend imputation systems, and may lie in the middle due to unfranked dividends or foreign shareholders. 4. The correlation between the stock’s price and the overall market. Increases with the gradient of the linear regression fit to stock return(x) vs market return(y). 5. Look at the market values of debt and equity rather than book value. Use the optimal capital structure/structure after project acceptance. 6. When the risk of the project is different to the basic risk of the rest of the company. 7. Business risk is the uncertainty of overall cash flows due to industry risk, competition, technology, macroeconomic factors etc. Financial risk has to do with the fact that safe cash flows are used to pay interest, increasing the risk for shareholders. 8. The chance that the firm will be unable to pay its interest on debt, bringing it into financial distress. 9. 1. Estimate the cost of debt and cost of equity at different debt proportions. 2. Calculate the WACC at each debt proportion. 3. Choose the proportion with the best effect on firm value. 10. That the value of a firm is independent of its capital structure; an unlevered firm’s value is the same as a levered one. The pie’s size does not change, and investors can source their own debt. 11. As the proportion of debt increases, the tax shield of debt grows, but so does the probability of costly financial distress. These two factors of firm value should be balanced. 12. Proposition 1 states that capital structure has no effect on firm value. Proposition 2 says that the cost of equity increases with the debt ratio.

13. There are small direct costs (legal, court, advisory) but larger indirect costs (opportunity cost, scared customers and suppliers, reputation). 14. Managers prefer internal equity -> debt -> hybrids -> external equity. This is due to flotation costs, agency costs of equity and asymmetric information. Companies with higher cash flow will have no need to raise debt/raise equity to pay for debt and will have a lower leverage ratio. 15. In financial distress, shareholders prefer to get paid out rather than have the money put in projects that debtholders can claim (debt overhang/underinvestment). Shareholders prefer the business to take big risks (even on NPV negative projects) to save the business during financial distress. But this destroys debtholder value.

L4: Raising Capital - Equity Theory questions: 1. What are the characteristics of equity? 2. Where can unlisted firms raise capital? 3. Where can listed firms raise capital? 4. What are some of the advantages of going public? 5. What are some of the disadvantages of going public? 6. Outline the use of a prospectus. 7. Outline the purpose of an underwriter. 8. Describe the three methods of deciding on an IPO issue price. 9. Explain the purpose of a roadshow. 10. What is the difference between the primary and secondary market? 11. How do underwriters get paid? 12. State the underpricing formula. 13. Explain the five key reasons for underpricing. 14. Give three reasons why firms underperform after IPO. 15. What three factors influence the choice of seasonal offer? 16. Briefly explain private placements, rights issues and dividend reinvestment schemes. 17. State the pros and cons of private placements. 18. What options does a shareholder have in a renounceable rights issue? 19. What are S, N, M, X and R in the rights issues formulae?

20. State the pros and cons of rights issues. 21. Why might the ex-rights price not match the theoretical value? 22. What is an accelerated entitlement offer? Theory answers: 1. Shareholders can vote, and get a residual claim on assets in liquidation, and a right to return on capital. Ordinary shareholders get full voting rights. 2. “Angel” finance from high net worth individuals. Venture capitalists, an intermediary who usually invest in high-tech start-ups with staged financing and control of company decisions. They can IPO, but then they’re listed. Finally, they can use their own savings, friends and family. 3. Private placements to groups of investors, rights issues to existing shareholders or dividend reinvestment plans. 4. Access to capital, let VC’s cash out, let investors diversify, better equity liquidity, find firm value, give stock to employees, increase recognition. 5. IPO fees (legal, accounting, investment banking), dilution of control, greater degree of disclosure, no more special deals, time-consuming investor relations. 6. A prospectus is a legal document containing information about the float. They required by law in Australia. 7. The underwriter guarantees that all issued shares will be sold. This means that they are liable to purchase any that are not sold. 8. Fixed pricing, where a price is set, prospectuses are sent out and offers are received. This is vulnerable to price movements. Common in Australia. Book-building, where underwriters see what institutional investors are willing to pay. Lower risk but creates a conflict of interest. Common in the US. Open auctions, where investors submit bids and the shares are sold to the successful bidders. 9. Roadshows are done by investment bankers to market the float. If book-building, this is when non-binding offers are collected from potential investors. This prevents the price from being too high and undersubscribed or too low causing an opportunity cost. 10. To the firm, the primary market is when they are paid for the share. The secondary market is between other parties and does not involve the cash of the firm.

11. Underwriters may charge a direct administrative cost for management, lawyers, accountants, registration etc. However, they also receive the spread; the difference between the price the underwriter buys the securities from the issuer and the price of the float. 12. (Closing price - offer price) / offer price 13. Winner’s curse/information asymmetry: the overall positive trend keeps everyone in the market (even those who are uninformed) Market feedback: To find an appropriate issue price, investors need to offer a good deal to get investors to reveal their bids. Investment banking conflicts: Underpricing reduces the cost to the investment bank and benefits clients. Litigation insurance: Subscribers receive a positive return and are therefore less likely to sue for misstatements/omissions in connection with the IPO. Signalling: Leave a good taste with the market to make it easier to do seasonal offerings. 14. Clientele effects: Optimism dissipates over time. Impresario hypothesis: Investment bank’s efforts to create the illusion of high demand is only temporary. Window of opportunity: Firms time the issue with a ‘hot’ market, and it cools back down. 15. Costs, time and transfer of votes & wealth. 16. Private placements involve selling the shares to an institutional investor or a subset of shareholders. Rights issues are issued on a pro-rata basis to existing shareholders. Finally, DRP’s let shareholders use dividends to buy new shares. 17. Pros: Very fast, low issue costs (no underwriting), no prospectus. Cons: Shares issued at a discount, transfer of wealth due to discount, dilution of votes. In Australia, max 15% per 12 months without shareholder approval. 18. They can exercise the right to buy new shares (no wealth or power loss), let them expire (loss), or sell them on the ASX (power loss). 19. S: Subscription price. N: 1:N entitlement rate. M: cum-rights price. X: ex-rights price. R: Price of the right. 20. Pros: No restrictions, preserves voting patterns. Cons: Takes time, requires a prospectus and underwriting, admin fees

21. New information on the date, general movement, transaction costs, taxes, unexercised rights. 22. A rights issue where different shareholders are given different conditions. Accelerate it by offering it to institutional shareholders first to get some capital in quickly. Lets everyone participate.

L5: Raising Capital - Debt & Leases Theory questions: 1. What are the characteristics of debt? 2. What are the four types of bank loans? 3. What are the three types of debt securities? 4. Explain debt covenants and give some affirmative and restrictive examples. 5. What is a lease? Who are the lessor and lessee? 6. Describe operating leases. 7. Describe finance leases. 8. What are the six factors in the borrow-to-buy/lease decision? 9. Provide three reasons why leasing may be NPV positive for both parties. Theory answers: 1. Debt is the contribution of capital for a specified time. They have no voting rights, but it is the least risky type of investment because they have a fixed and prior-ranking contractual right to return on capital and a return of capital. It is usually more frequent than equity financing, involves interest payments and repayment of principal of maturity, can be defaulted, is protected by covenants and gives debtholders the right to take the firm’s assets in default. 2. Bank overdrafts (negative bank balance), inventory loan (extra cash to pay for stock), bridge loan (financing between big expected cash flows), term loans (longer fixed or variable rate loans.) 3. Commercial papers/bills of exchange (short term issues), debentures (medium-long term, secured by assets), corporate bonds/unsecured notes (long-term, pays coupons). 4. Debt covenants are provisions in the debt contract to protect lenders. Affirmative covenants: maintain assets, provide audited financial statements. Restrictive

covenants: limit access to further debt, restrictions on investment type, dividend limits. 5. A lease is a contract where the lessor, the legal owner or financier of the asset, receives fixed payments from the lessee, in return for the use of the asset. 6. Typically a short-term rental agreement. It is cancellable by the lessee with short notice without substantial penalty. The risk of ownership is borne by the lessor, who is often is / is close to a supplier of the asset. 7. A longer-term agreement that might extend over the life of the asset. Noncancellable/cancellable with substantial penalty. Risk of ownership is on the lessee. Lessor is generally a financial institution, and the lessee uses it as a source of finance. The lessee will usually the owner of the asset by the end of the lease. 8. Cost of asset, lease payments, tax shield from lease payments and depreciation, residual value, tax gain/loss on sale. 9. Company taxation (lessor has a higher tax rate), different costs of capital (lessor has a lower WACC), transaction costs (simper in default, standardization).

L6: Advanced Capital Budgeting (Sensitiv...