::PV Viswanath::

Dr. P.V. Viswanath

pviswanath@pace.edu

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	Based on Corporate Finance, Berk and DeMarzo and Financial Economics, Second Edition by Zvi Bodie, Robert C. Merton and David L. Cleeton Question Pool for Quizzes Financial Markets and Institutions Corporate Governance Financial Statement Analysis Arbitrage and Time Value of Money Investment Criteria Forecasting Cashflows in Capital Budgeting Bond Pricing Stock Pricing Capital Markets Capital Structure Terms and questions for self-study by chapter Financial Markets and Institutions (Chap. 2 from Bodie, Merton and Cleeton) The Corporation (Chap. 1) and Corporate Governance (Chapter 29 of Berk and DeMarzo) Introduction to Financial Statement Analysis (Chap. 2) Arbitrage and Financial Decision Making (Chap 3) and The Time Value of Money (Chap 4) Interest Rates (Chap 5) Fundamentals of Capital Budgeting (Chap. 7) Valuing Bonds (Chap 8) Valuing Stocks (Chap 9) Capital Markets and the Pricing of Risk (Chap 10) Capital Structure (Chaps 14, 15 and 16)

	Question Pool for Quizzes Financial Markets and Institutions: What is the financial system? What are the different functions of the financial system? Give two examples of how the financial system allows the transferring of resources across time and space. Explain how the financial system facilitates the sharing and transfer of risk. Provide three different examples. How does the financial system facilitate payments? Give two different examples. How does the financial system facilitate the pooling of resources? Provide two different examples. How does the financial system facilitate the sharing of information? Give three different examples. What is adverse selection? Give an example of adverse selection in the context of a corporation. What is moral hazard? Give an example in the context of a business. How does the financial system mitigate moral hazard problems? How does the financial system mitigate adverse selection? Corporate Governance: What are the salient characteristics of a corporation? Who controls a corporation? What happens to the control of the firm in bankruptcy? What is the relevance of the stock market to the concept of a corporation? Why is it important to maximize firm value? If firm value is paramount, why is stockholder value relevant? What is the agency problem in a corporation? How can the agency problem vis-a-vis corporate managers be resolved? Can it be fully resolved? Why or why not? Is the market for corporate control, part of the solution or the problem? What is the purpose of the Annual Meeting from a Corporate Governance point of view? What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well? How is the role of the stock market in stock value maximization? How might one argue against using stock prices as measures of stockholder wealth? What are some of the potential social costs and benefits of the operation of a firm that do not accrue to or borne by the firm? What is the problem with not having these social benefits accrue to the firm or having these costs affecting the firm? How are some of these costs and benefits internalized? Finanical Statement Analysis: Why does a business need financial statements? What is the purpose of creating common-size statements? Give an example. Depreciation is the amount of money that a firm actually spends on maintaining machinery and equipment. True or false? Explain. Stockholders' equity cannot be negative because stockholders have limited liability. True or false? Explain. What does the market-to-book ratio tell you? What sorts of firms are likely to pay out more of their earnings in dividends? What are the three components into which the Dupont identity decomposes return on equity? Why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during a period? What is the difference between the income statement and the balance sheet? What is the difference between ROE and the rate of return on investing in a stock? What do liquidity ratios measure? What do profitability ratios measure? What do turnover ratios measure? What do financial leverage ratios measure? What is the difference between the sustainable growth rate and the internal growth rate? Arbitrage and Time Value of Money How does the market ensure that the Law of One Price holds? What can prevent the operation of the law of one price? How can the existence of bid and ask prices be consistent with the notion of the law of one price? What is an asset? What is the role of primary assets in the Law of One Price? How is a discount rate similar to a price? Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate? What are the determinants of expected rates of return on assets in an economy? What is the difference between the nominal rate of interest and the real rate of interest? What information do we get from a yield curve? Investment Criteria: Questions: What are the advantages of using NPV as an investment criterion? What are the advantages of payback as a investment criterion? Why can the IRR method not always be used when choosing between mutually exclusive projects? What is the profitability index? When should it be used? Quantitative Problems: Problems on using IRR and NPV for decision-making Problems illustrating the difficulties with using IRR Forecasting Cashflows in Capital Budgeting: Questions: Sasha goes to his boss and suggests using a currently unused floor of the company's building to operate a new venture. His boss imputes a cost for the use of the unused space and finds that Sasha's project is unprofitable. Sasha objects and says that the floor is not being used anyway -- hence the implicit cost assigned to the space should be zero! What do you think? You propose the introduction of a new product to your boss. You show him that the present value of cashflows from the new product is much greater than the initial outlay that it would require. Your boss objects that introducing the new product would reduce sales of existing models by 30%! You feel that this objection is not fair. Are you right or is your boss right? What additional investigation might you do to convince your boss to go ahead with the introduction of your new product? Working Capital requirements need not be taken into account in evaluating a new project -- after all, working capital is not consumed; it can be recovered once the project is completed. True or False? Explain. What sort of sensitivity analysis would you do in evaluating a project? Quantitative Problems: Problems requiring computation of free cashflow Problems using multiples for valuation. Capital Markets: How do you estimate the volatility of returns on a stock? The larger the number of periods used to estimate stock return volatility, the more precise our estimates will be. True or False. Explain. The estimated expected return on a stock is 12% per annum. The estimated volatility of returns is 7% per annum. Compute a range of returns for this stock such that you are 95% sure that the returns on this stock, next year, will be within this range. The 95% confidence interval for next year's return on a stock will be greater than the 95% confidence interval for the average of the next two years' returns on that same stock. True or False. Explain. How is beta different from standard deviation of returns as a measure of risk? If you regress expected returns of portfolios of large asset classes against their standard deviations of returns, they tend to line up. However, if you do the same for individual stocks, they don't. Why? Explain. Why is an asset's idiosyncratic risk irrelevant for determination of that's asset's market price? What does the CAPM say? How would you measure the beta of an asset that is traded? How would you measure the beta of a new project that is under consideration for adoption? Consider the following set of industries and rank them in order of their market beta magnitudes. Explain: Food Processing Semiconductors Auto and Truck Manufacturers Electric Utilities Which of these are idiosyncratic risks and which are systematic risks? The risk that your main production plan is shut down due to a tornado. The risk that there will be a strike at the Tennessee plant of your company. The risk that the economy slows, decreasing demand for your firm's products. The risk that your best employees will be hired away. The risk that the new product you expect your R&D division to produce will not materialize. The risk that there will be a banking crisis in the country next year. Stocks of firms that make luxury products will have higher betas than stocks of firms that make staple commodities. True of False? Explain. Stocks of companies that have higher leverage will have higher betas than stocks of companies in the same industry that have lower leverage. True or False? Explain. Does the CAPM work well in practice? Explain. What factors other than the beta of a stock estimated with respect to a large diversified equity portfolio seem to be empirically important in predicting the average return on stocks? Quantitative and Conceptual Problems: Computing expected return, standard deviation of return, variance of return. Computing 95% confidence intervals Questions testing your ability to understand the difference between diversifiable and non-diversifiable risk. Questions testing your understanding of the CAPM Questions testing your understanding of the Efficient Markets Hypothesis Stock Pricing: When will it be true that all investors will value a stock in the same way independent of their investment horizons? Can we say that the stock price is the discounted present value of the firm's future earnings? What are the determinants of the rate of growth of a firm's earnings? How would you modify the dividend discount model to take into account share repurchases? What is the enterprise value of a firm? Your friend suggests the following formula to price a stock -- [PV(future free cashflows to the firm) + Cash - Market Value of Debt]/(No. of Shares Outstanding). Argue against this formula. How would you go about using comparables to value a firm? Show this in the context of valuing Dell Computers (DELL). How would you evaluate the multiples approach in relation to the DCF approach to valuation? Explain the Efficient Markets Hypothesis. Stock prices typically rise when the firm makes an announcement of a new product. Why should this be so, according to the Efficient Market Hypothesis? What should happen, according to the Efficient Markets Hypothesis, when a firm announces a dividend cut. Explain. Your friend believes he has spotted the following pattern -- if the market goes up on two successive days, it always goes up on the third day, as well. Do you believe your friend? How might you argue against his theory? Your friend has spotted the following pattern -- if a stock goes down on a given day, it tends to go down on the following day, as well. This happens to be particularly true of small stocks. Explain how this might be possible, even if investors are on the lookout for mispricings? What are the implications of the Efficient Markets Hypothesis for CEOs? Quantitative Problems: Using the DDM to compute the value of the equity of a firm. Using the FCF model to compute the value of the equity of a firm. Computing stock price given some combination of information about dividends, ROE, reinvestment rates, etc. Bond Pricing: Questions: What is the relationship, if any, between coupon rates and yields to maturity? A corporate bond, paying semi-annual coupons and selling at par has a 6% coupon rate. What is the promised effective annual rate of return on the bond? The holding period return is always greater than the yield-to-maturity. True or False? Explain. Bond prices, in general, will rise over time as they approach maturity. When will this statement be true? When stocks go ex-dividend, the stock price drops. Why don't we see this happening with bonds when the coupon is paid? Which prices are more volatile -- those of long-term bonds or those of short-term bonds? Why? Expected yields-to-maturity have to be lower than promised yields-to-maturity for corporate bonds and treasury bonds. Is this true or false? Explain. Quantitative Problems: Problems exploiting the relationship between bond price, coupon rate and YTM. Problems testing your understanding of coupon bonds as portfolios of zero-coupon bonds. Problems looking at the relationship between bond rating, yield spreads and bond price. Capital Structure: Questions: Under what circumstances is capital structure irrelevant for the value of a firm? Explain. What is the cost of capital of the firm under perfect capital markets? How does it change if interest payments are tax deductible? Under Perfect Capital Markets, we know that Capital structure is not irrelevant for firm valuation. Now, the cost of equity capital increases when the firm's leverage increases. So does the cost of debt capital. If so, how could the WACC, the weighted average of the costs of equity and debt capital remain constant when leverage increases? "Issuance of new equity dilutes earnings. Hence it's bad." Is true or false? Explain. Interest payments are deductible for corporate tax purposes. Hence, one would think that debt should increase the value of a firm. However, your friend is convinced that if all taxes are taken into account, debt could actually decrease the value of a firm. How could this be? Interest payments are deductible for computation of corporate tax. This would suggest that all firms would want to maximize their interest rate deductions. Still, the average ratio of amount of interest paid to EBIT was rarely above 50% for S&P 500 firms from 1975 to 2005. How would you explain this? What are some of the factors that explain variation in debt ratios across firms? What is the most important source of capital for firms? Can you explain why this might be so? Name two industries that use a lot of debt relative to equity? Explain why these firms use so much debt. Name two industries that use very little debt relative to equity? Explain why these firms use so little debt. Suppose financial restructuring could be achieved costlessly in bankruptcy. Would the prospect of bankruptcy affect the optimal choice of capital structure under these circumstances? Explain. What are the direct costs of bankruptcy? Name five different categories of indirect costs of bankruptcy? Explain each of them. What sorts of firms should have less debt, from the bankruptcy cost point of view? Explain the underinvestment problem. What are agency costs? What are the agency costs of debt? What are some of the advantages of debt? Quantitative and Conceptual Problems: Questions testing your ability to understand the irrelevance of capital structure in perfect markets. (That is, capital structure becomes relevant only to the extent that it affects "leakages" or payments to non-security holders of the firm.) Problems requiring you to compute the value of tax-shields. Questions testing your understanding of how the tax advantage of debt affects a firm's capital structure. Questions testing your understanding of what agency costs are and how they affect a firm's optimal capital structure. Questions testing your understanding of how bankrutpcy and bankruptcy costs are important in a firm's capital structure decision. Terms and Questions for Self-Study Financial Markets and Institutions (Chap. 2 from Bodie, Merton and Cleeton) Terms agency costs: costs incurred by the firm due to the conflicts referred to above -- conflicts between management and shareholders, conflicts between shareholders and bondholders, etc. agency problem auction markets Capital Budgeting capital market Capital Structure Chief Financial Officer corporation dealer markets financial market Financial Institutions financial intermediary: an organization that raises money from investors and provides financing for individuals, companies and other organizations. financial assets limited liability liquidity money market mutual funds partnership pension fund primary markets real assets secondary markets sole proprietorship stakeholders Working Capital Short Questions What are some examples of financial institutions? What are their functions, in brief? What are the functions of a chief financial officer (CFO)? What are the primary characteristics and advantages of the corporate form of organization? What should the objective of the firm's managers be? Justify your answer. If you were coming up with a new form of business organization, how would you go about it? What principles would you have in mind? What are some of the conflicts between managers and stockholders? How might they be resolved? What are some of the conflicts of interest between stockholders and bondholders? How might stockholders exploit bondholders? How can this conflict be resolved? Why should a firm's manager worry about the impact of his firm's activities on the environment, or on society, in general? (For the purpose of this question, assume that the manager is amoral and does not care about ethics.) What does a real asset mean? The Corporation (Chap. 1) and Corporate Governance (Chapter 29 of Berk and DeMarzo) Terms Short Questions Introduction to Financial Statement Analysis (Chap. 2) Terms Accounts Receivable Accounts Payable balance sheet Book Value Cash flow to creditors Cash flow to stockholders Cash flow from assets income statement net working capital liquidity GAAP: General Accepted Accounting Principles -- the common set of standards and procedures by which audited financial statements are prepared. financial leverage: the use of debt in a firm's capitall structure. average tax rate marginal tax rate Operating cash flow: Cash flow that results from teh firm's day-to-day activities of producing and selling. Capital Spending Free Cash flow: Cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments. Statement of Cashflows common-size statements current ratio quick ratio cash ratio times-interest-earned ratio cash coverage ratio inventory turnover Day's sales in inventory receivables turnover Day's Sales in Receivables profit margin return on assets return on equity total asset turnover earnings per share P/E ratio The Dupont identity Market-to-book ratio internal growth rate sustainable growth rate Short Questions What is the purpose of creating common-size statements? Give an example. What does the market-to-book ratio tell you? What sorts of firms are likely to pay out more of their earnings in dividends? What are the three components into which the Dupont identity decomposes return on equity? What are SIC codes and why are they useful? What is the difference between the average tax rate and the marginal tax rate? Which is more important for decision-making and why? Why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during a period? End-of-chapter questions. Arbitrage and Financial Decision Making (Chap 3) and The Time Value of Money (Chap 4) Terms discount factor annuity perpetuity inflation real value nominal interest rate real interest rate effective interest rate annual percentage rate Short Questions What is the difference between real and nominal cashflows? What is the difference between real and nominal interest rates? How can we compare interest rates quoted over different time intervals? Interest Rates (Chap 5) Terms coupon face value/par value coupon rate maturity yield to maturity/yield discount bond premium bond bond indenture/ deed of trust unfunded debt collateral note seniority sinking fund: an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. call provision call premium call protection protective covenant bond rating zeroes collar floating-rate bond bid price ask price bid-ask spread real rate of interest nominal rate of interest The Fisher Equation (Effect) term structure of interest rates yield curve inflation premium interest rate risk premium default risk premium dividend growth model dividend yield capital gains yield common stock cumulative voting straight voting proxy preemptive right dividend preferred stock cumulative dividend non-cumulative dividend arrearage dealer broker primary market secondary market exchange member seat commission broker specialist floor broker superDOT system floor trader order flow specialist inside quote bid ask ECNs Short Questions What is the difference between debt and equity? What is the difference between a registered bond and a bearer bond? Why is the yield curve not flat? What is the Dividend Growth Model? What is the Gordon Growth Model? Recent newspaper articles have accused the specialist of "front-running," i.e. using the information that they have on limit orders in the order book and using it for trading decisions. How might this happen? Fundamentals of Capital Budgeting (Chap. 7) Terms internal rate of return EBIT marginal corporate tx rate net working capital straight-line depreciation unlevered net income opportunity cost cannibalization project externalities free cashflow overhead expenses depreciation tax shield tax loss carryfowards break-even sensitivity analysis sunk cost scenario analysis Short Questions Valuing Bonds (Chap 8) Terms clean price dirty price corporate bonds coupon bonds couopn rate default spread face value on-the-run bond Treasury bills Treasury bonds yield-to-maturity zero-coupon bond pure discount bond premium par Short Questions Valuing Stocks (Chap 9) Terms share repurchase expected return portfolio portfolio weight cost of capital trailing P/E forward P/E valuation multiple retention rate dividend payout rate dividend-discount model capital gain Short Questions Capital Markets and the Pricing of Risk (Chap 10) Terms systematic, non-diversifiable or market risk unsystematic, diversifiable or non-market risk diversification beta coefficient security market line market risk premium Capital Asset Pricing Model variance standard deviation probability distribution realized return standard error independent risk common risk efficient portfolio efficient markets hypothesis 95% confidence interval Short Questions Does it make sense for managers to assume that the securities that they issue are fairly priced by the market? In other words, is it possible for managers to time their security issuances profitably? Why or why not? What are some examples of diversifiable risks? What are some examples of non-diversifiable risks? Capital Structure (Chaps 14, 15 and 16) Terms venture capital IPO (Initial Public Offering) firm commitment underwriter spread best efforts basis prospectus red herring underpricing flotation costs seasoned offering rights offering general cash offer shelf registration financial restructuring financial leverage business risk operating risk tax shield financial distress pecking order theory of capital structure trade-off theory of capital structure financial slack Short Questions When is financial slack not desirable? If interest tax shields are valuable, whey don't all tax-paying firms borrow as much as possible? How do venture capital firms design successful deals? (see text for answer) How do firms make initial public offerings and what are the costs of such offerings? (see text for answer) What are some of the significant issues that arise when established rfirms make a general cash offer or a private placement of securities? (see text for answer) What is the role of an underwriter in an issue of securities? (see text for answer)