Finance 12

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  1. Risk-return trade-off
    Greater the reward, the greater the risk
  2. Total dollar return
    income from investment + capital gain (loss) due to change in price
  3. You bought a bond for $950 one year ago. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return?
    • Income = 30 + 30 = 60
    • Capital gain = 975 – 950 = 25
    • Total dollar return = 60 + 25 = $85
  4. Dividend yield
    income / beginning price
  5. Capital gains yield
    (ending price – beginning price) / beginning price
  6. Total percentage return
    dividend yield + capital gains yield
  7. You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40.
    What is your dollar return?
    What is your percentage return?
    Dollar return = 1.25 + (40 – 35) = $6.25

    • Dividend yield = 1.25 / 35 = 3.57%
    • Capital gains yield = (40 – 35) / 35 = 14.29%
    • Total percentage return = 3.57 + 14.29 = 17.86%
  8. What is the importance of financial markets?
    • -Financial markets allow companies, governments and individuals to increase their utility
    • -Savers have the ability to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing so
    • -Borrowers have better access to the capital that is available so that they can invest in productive assets
    • -Financial markets also provide us with information about the returns that are required for various levels of risk
  9. Risk Premiums
    • The “extra” return earned for taking on risk
    • Treasury bills are considered to be risk-free
    • The risk premium is the return over and above the risk-free rate
  10. Average Annual Returns and Risk Premiums for
    Large Companies
    Small companies
    Long term corporate bonds
    long term gov't bonds
    US treasury bonds
    • Large Companies-- Average Return=11.9 Risk Premium=8.2
    • Small companies- Average Return=16.7 Risk Premium= 13
    • Long term corporate bonds Average Return=6.2 Risk Premium= 2.5
    • long term gov't bonds-Average Return=5.9 Risk Premium=2.2
    • US treasury bills Average Return=3.7 Risk Premium= 0
  11. What does Variance and Standard Deviation mean/do? (volatility)
    • Variance and standard deviation measure the volatility of asset returns
    • The greater the volatility, the greater the uncertainty
    • Historical variance = sum of squared deviations from the mean / (number of observations – 1)
    • Standard deviation = square root of the variance
  12. What is an Efficient Capital Market?
    • Stock prices are in equilibrium or are “fairly” priced
    • If this is true, then you should not be able to earn “abnormal” or “excess” returns
    • Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market
  13. What Makes Markets Efficient?
    • There are many investors out there doing research
    • As new information comes to market, this information is analyzed and trades are made based on this information
    • Therefore, prices should reflect all available public information
    • If investors stop researching stocks, then the market will not be efficient
  14. Common Misconceptions about EMH
    • Efficient markets do not mean that you can’t make money
    • They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns
    • Market efficiency will not protect you from wrong choices if you do not diversify – you still don’t want to put all your eggs in one basket
  15. What are the 3 forms of market efficiency?
    • 1. Strong Form
    • 2. Semistrong form
    • 3. Weak Form
  16. What is strong form market efficiency?
    • Prices reflect all information, including public and private
    • If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed
    • Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

    Don’t bother to look for trends, or interview management, etc. Everyone has the same info + we are all equally smart. Technical + fundamental analysis would be a waste of time)
  17. What is semi strong form market efficiency?
    (all publicly available information is available at the same time for everyone. If that is the case, investors cannot realize an admirable return, fundamental analysts are a waste of time. Why? Because all the info is available to all investors at the same point of time, what is a fundamental analyst doing? It’s already been done
  18. Weak Form Efficiency
    • Prices reflect all past market information such as price and volume
    • If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information
    • Implies that technical analysis will not lead to abnormal returns
    • Empirical evidence indicates that markets are generally weak form efficient
  19. Technical analysts
    looks for trends in the numbers
  20. fundamental analysts
    not looking for trends in the numbers (Warren Buffet)
  21. What is Venture Capital?
    • Private financing for relatively new businesses in exchange for equity
    • Usually entails some hands-on guidance
  22. Many VC firms are formed from a group of investors that pool capital and then have partners in the firm decide which companies will receive financing
    • The company should have an “exit” strategy
    • Sell the company – VC benefits from proceeds from sale
    • Take the company public – VC benefits from IPO
  23. How do you choose a venture capitalist?
    • Look for financial strength
    • Choose a VC that has a management style that is compatible with your own
    • Obtain and check references
    • What contacts does the VC have?
    • What is the exit strategy?
  24. Selling Securities to the Public
    • Management must obtain permission from the Board of Directors
    • Firm must file a registration statement with the SEC
    • The SEC examines the registration during a 20-day waiting period
    • A preliminary prospectus, called a red herring, is distributed during the waiting period
    • If there are problems, the company is allowed to amend the registration and the waiting period starts over
  25. Can securities be sold during the waiting period?
    No. And the price is determined on the effective day of the registration.
  26. TYPES OF OFFERS (edit this)
  27. Services provided by underwriters
    • Formulate method used to issue securities
    • Price the securities
    • Sell the securities
    • Price stabilization by lead underwriter
  28. Syndicate
    group of investment bankers that market the securities and share the risk associated with selling the issue
  29. Spread
    difference between what the syndicate pays the company and what the security sells for initially in the market
  30. Firm Commitment Underwriting
    • Issuer sells entire issue to underwriting syndicate
    • The syndicate then resells the issue to the public
    • The underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold
    • The syndicate bears the risk of not being able to sell the entire issue for more than the cost
  31. Best Efforts Underwriting
    • Underwriter must make their “best effort” to sell the securities at an agreed-upon offering price
    • The company bears the risk of the issue not being sold
    • The offer may be pulled if there is not enough interest at the offer price. 
    • In this case, the company does not get the capital, and they have still incurred substantial flotation costs
  32. Dutch Auction Underwriting
    • Underwriter accepts a series of bids that include number of shares and price per share
    • The price that everyone pays is the highest price that will result in all shares being sold
    • There is an incentive to bid high to make sure you get in on the auction but knowing that you will probably pay a lower price than you bid
    • The Treasury has used Dutch auctions for years
    • Google was the first large Dutch auction IPO
  33. Green Shoe provision
    • Allows the syndicate to purchase an additional 15% of the issue from the issuer
    • Allows the issue to be oversubscribed
    • Provides some protection for the underwriters as they perform their price stabilization function
  34. Lockup agreements
    • Restriction on insiders that prevents them from selling their shares of an IPO for a specified time period
    • The lockup period is commonly 180 days
    • The stock price tends to drop when the lockup period expires due to market anticipation of additional shares hitting the street
  35. IPO Underpricing
    • May be difficult to price an IPO because there isn’t a current market price available
    • Private companies tend to have more asymmetric information than companies that are already publicly traded
    • Underwriters want to ensure that, on average, their clients earn a good return on IPOs
    • Underpricing causes the issuer to “leave money on the table”
  36. New Equity Issues
    • Stock prices tend to decline when new equity is issued
    • Possible explanations for this phenomenon
    • Signaling and managerial information
    • Signaling and debt usage
    • Issue costs
    • Since the drop in price can be significant and much of the drop may be attributable to negative signals, it is important for management to understand the signals that are being sent and try to reduce the effect when possible
Card Set
Finance 12
Finance chapter 12
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