Corporate Finance Theory and Past Paper Questions

Theory Concepts

Chapter 1: Introduction to Corporate Finance

Real assets: assets used to produce goods and services

Financial assets: financial claims to the income generated by the firm’s real assets
Public companies: companies listed on the stock exchange
Private companies: privately held shares, do not trade stocks on public exchanges
Limited liability: shareholders cannot be held personally responsible for the
corporation’s debt
Unlimited liability: sole proprietorships and general partnerships
Hurdle rate/Cost of capital: Minimum acceptable rate of return on investment
Opportunity cost of capital: Investing in a project eliminates other opportunities to use
invested cash
Agency cost: Managers do not attempt to maximize firm value, Shareholders incur
costs to monitor managers and constrain their actions
Agency problem I: Conflict between shareholders and management, Managers are
agents for stockholders and are tempted to act in their own interests rather than
maximizing value
Agency problem II: Conflict of interest between majority and minority shareholders,
Differing nature of corporate governance
Dispersed ownership: (US, UK) Typical listed firm has a huge number of small
shareholders — conflict between shareholders and management (Agency Problem I)
Concentrated ownership: (Europe, Asia) A dominant shareholder holds a large block
of shares typically family owned, Actively monitor firms that they invest in intensively,
CEO cannot take actions against interest of the family — conflict between majority and
minority shareholders (Agency Problem II)
Corporate governance: system by which companies are directed and controlled
Independent director: a member of the board of directors who does not have a
material relationship with a company and is neither part of its executive team nor
involved in the day-to-day operations of the company.
Code Daems/Code Buysse: corporate governance codes in Belgium for listed firms/for
private firms
Stock options: Gives the owner the right to buy stocks in the future at a predetermined
price.
Board of directors: an executive committee that jointly supervises the activities of an
organization.
Market for corporate control: the process by which ownership and control of
companies is transferred from one group of investors and managers to another, Market
for acquisitions and mergers in a competition for control rights
Proxy fight: the act of a group of shareholders joining forces and attempting to gather
enough shareholder proxy votes to win a corporate vote (could be in an attempt to
replace management)

Chapter 2: How to Calculate Present Values

Present value: Value today of a future cash flow

Future value: Amount to which an investment will grow after earning interest
Discount factor: 1/(1+r) → used to compute the present value of any cash flow
NPV: the present value of the cash flows at the required rate of return of your project compared
to your initial investment. PV-required investment. → general rule: accept investments if we
have a positive npv.
Perpetuity: Financial concept, in which a cashflow is theoretically received forever.
Annuity: An asset that pays a fixed sum each year for a specified number of years.
Perpetuity with constant growth rate: g= the annual growth rate of a cashflow.
Effective Annual Interest Rate: Interest rate that is annualized using compound
interest
Annual Percentage Rate (APR): Interest rate that is annualized using simple interest

Chapter 3: Valuing Bonds

Bond: security that obligates the issuer to make specified payments to the bondholder
Face Value: Payment at maturity of bond
Coupon: interest payments to bondholder
Coupon rate: annual interest payments as a percentage of face value.
Maturity: Time when the bond issuer must repay the original bond value to the bond
holder.
Yield to maturity: The IRR (internal rate of return) on an interest-bearing instrument.
Rate of return: (coupon income+ price change)/ investment
Interest rate risk: risk that changes in interest rates may reduce (or increase) the
market value of the bond. (yield to maturity is only guaranteed if you keep your bond to
maturity)
Duration: the weighted average at the moment when your cash flows occur (when on
average do we receive our cash flows)
Modified duration/volatility: duration/(1+yield) = the extent to which bond prices
fluctuate due to changing interest rates. A measure of interest rate sensitivity.
Spot rate: the actual interest rate today (i.e. when t=0)
Forward rate: the interest rate, fixed today, on a loan made in the future at a fixed time.
Future rate: The spot rate that is expected in the future.
Law of 1 price: price in financial markets will adjust itself to ensure it gives a yield
consistent with the term structure.
Yield curve: a representation of the relationship between market remuneration rates
and the remaining time to maturity of debt securities. A yield curve can also be
described as the term structure of interest rates.
Leading indicator: any measurable or observable variable of interest that predicts a
change or movement in another data series, process, trend, or other phenomenon of
interest before it occurs.
Term structure: term structure of interest rates, commonly known as the yield curve,
depicts the interest rates of similar quality bonds at different maturities.
Expectations theory: states that the yields on financial assets of different maturities
are related primarily by market expectations of future yields. Interest for long term
investment is the average of short term returns. In other words, long term interest rates
will be higher than short term rates if interest rates are expected to rise.
Nominal interest rate: rate you actually pay when you borrow money.
Real interest rate: the theoretical rate you pay when you borrow money, as determined
by supply and demand. (rate adjusted for inflation)
Inflation: the rate of increase in prices over a given period of time
Treasury Inflation Protected Securities (TIPS): provide protection against inflation.
The principal of a TIPS increases with inflation and decreases with deflation, as
measured by the Consumer Price Index. When a TIPS matures, you are paid the
adjusted principal or original principal, whichever is greater.
Default risk: the risk that a bond issuer may default on its bonds.
Credit risk: Risk of default on a debt that may arise from a borrower failing to make the
required payments.
Default premium: additional yield on a bond that investors require for bearing credit
risk
Investment grade: Bonds that are rated Baa or above (Moody’s) or BBB or above
(Standard & Poor’s)
Junk bonds: Bonds with ratings below Baa or BBB
Rating: labels given to bonds based on their default risks
Yield spread: the difference of interest rates between risky bonds and “risk less” bonds.
Foreign currency bonds: Bonds that are sold to local investors in another country’s
bond market.
Sovereign bonds: foreign currency debt. Taking on debt in a currency that is not your
own.
Chapter 4: The Value of Common Stocks

Primary market: newly issued securities get traded on the primary market
Initial public offering (IPO): refers to the process of offering shares of a private
corporation to the public in a new stock issuance for the first time. Thus refers to shares
traded on the primary market.
Secondary Market: where previously issued shares are traded .
Common stock: Ownership shares in publicly held corporation.
Preferred stock: shares of a company's stock with dividends that are paid out to
shareholders before common stock dividends are issued. If the company enters
bankruptcy, preferred stockholders are entitled to be paid from company assets before
common stockholders.
Electronic Communication Networks (ECN): Computer networks that allow electronic
trading→ investors can trade among each other
Exchange-Traded Funds (ETF): Stock portfolios bought/sold in single trade. You have
a mutual funds that are traded on the stock market, they are traded as though they are
one
Standard & Poor’s Depository Receipts (SPDR): ETFs tracking several S&P indexes→
Try to find undervalued stocks(hard to do in reality)
Tracker: an investment fund or exchange-traded fund (ETF) designed to replicate the
performance of a specific financial market index. Often favored by investors seeking a
low-cost and diversified way to invest in a particular asset class or market.
Markets in Financial Instruments Directive (MIFID): a regulatory framework
implemented by the EU to harmonize and regulate financial markets and investment
services within the EU and the EEA. Aims to enhance the transparency, efficiency, and
integrity of financial markets while promoting fair competition among financial
institutions.
P/E ratio: Price per share divided by earnings per share
Book value: net worth of firm according to bs
Market value of balance sheet: Financial statement that uses market value of assets
and liabilities
Dividend yield/capital gain: A financial ratio (dividend/price) that shows how much a
company pays out in dividends each year relative to its stock price. The capital gains
yield will equal a company’s total stock return if a company does not pay dividends. So
a company that pays no dividends will have a 0% dividend payout ratio, a 100%
retention ratio and a 0% dividend yield.
Expected Return: percentage yield forecast from specific investment over time period
Dividend Discount Model (DDM): Computation of today’s stock price: share value
equals present value of all expected future dividends
Market capitalization rate: Allows investors to understand the relative size of one
company versus another. Measures what a company is worth on the open market as
well as the market’s perception of its future prospects, as it reflects what investors are
willing to pay for its stock.
Cost of equity: the compensation the market demands in exchange for owning the
asset and bearing the risk of ownership.
Return on Equity (ROE): measures the profitability of a business in relation to the
equity.
Payout ratio: Fraction of earnings paid out as dividends
Plowback ratio: Fraction of earnings retained by firm
Present Value of Growth Opportunities (PVGO): Net present value of firm’s future
investments
Sustainable growth rate: steady rate at which firm can grow: plowback ratio x return
on equity
Valuation horizon/Terminal Value: is the value of an asset, business, or project beyond the
forecasted period when future cash flows can be estimated. It assumes a business will grow at a
set growth rate forever after the forecast period→ used in valuing a business or project
Discounted Cash Flow Model (DCF): A method of valuing security, project, company,
or asset using the concepts of the time value of money.
Enterprise value: the present value of all future free cash flows
Free Cash Flow: Cash Flow to Creditors + Cash Flow to Stockholder= cash flow from
assets
Operating Cash Flow: measure of the amount of cash generated by a company's
normal business operations. EBIT*(1-Tc)+ Depreciation – NWC
NWC: Change in Net Working Capital = Ending NWC - Beginning NWC (= current
assets – current liabilities)
Cash flow from assets: Operating cashflow – Net capital spending- Change in NWC
Capital Spending: Ending Net Fixed Assets - Beginning Net Fixed Assets +
Depreciation
Net Free Cash Flow: takes a look at how much cash a company generates, which
includes cash from operating activities, investing activities, and financing activities.
Cash Flow to Creditors: Interest paid - Net new borrowing
Cash Flow to Stockholders: Dividends Paid - Net New Equity Raised

Chapter 5: Net Present Value and other investment criteria

Net Present Value (NPV): PV- required investment→ accept investments that pave a positive
npv
Zero coupon bond: Has a duration equal to maturity, no coupon.
Book rate of return: Average income divided by average book value over project life,
also called accounting rate of return. Components reflect tax and accounting figures, not
market values or cash flows
Payback period: Number of years before cumulative cash flow equals initial outlay
Payback Rule: Only accept projects that pay back within desired time frame. Ignores
later year cash flows and present value of future cash flows
Discounted payback period: The discounted payback period of a project is the
number of years it takes before the cumulative discounted cash flow equals the initial
outlay
Discounted payback rule: only accept projects that “payback” in the desired time
frame.
Internal rate of return (IRR): the discount rate that gives a zero NPV. The internal rate
of return is to accept an investment project if the opportunity cost of capital is less than
the internal rate of return
Profitability index (PI): Tool for selecting between project combinations and
alternatives. Set of limited resources and projects can yield various combinations.
Highest weighted average PI indicates optimal project.
Weighted average profitability index (WAPI): Highest weighted PI indicates optimal
project combinations.
Capital rationing: Limit set on amount of funds available for investment
Soft rationing: Imposed by management
Hard rationing: Imposed by unavailability of funds in capital market

Chapter 6: Making investment decisions with the Net Present Value rule

Incremental cash flows: what actually changes, w.r.t cash flows, in the firm as a result
of taking on this project= the change in cf
Inflation: increases in costs but also in the price we can ask for our products.
Nominal rate of return: total return of the investment without considering inflation
Real rate of return: annual percentage of profit earned on an investment, adjusted for
inflation.
Depreciation Tax Shield: As you depreciate, you incur a cost. At the end since your
revenues are lower due to depreciation, you pay lesser taxes. A depreciation tax shield
is a tax reduction technique under which depreciation expense is subtracted from
taxable income.
Nominal cash flows: the cf that goes with the nominal rate of return
real cash flows: the cf that goes with the real rate of return
Equivalent Annual Cash flow (EAC): the cash flow per period with the same present
value as the theoretical cash flow as the project

Chapter 7: Introduction to Risk and Return

Risk premium: the additional return or compensation that investors expect or require
for taking on higher levels of risk compared to a risk-free investment.
Equity premium (EP): Stock return, the return SHs get from investing in the equity of a
company by buying stocks.
Maturity premium: The amount of extra return you’ll see on your investment by
purchasing a bond with a longer maturity date. Maturity risk premiums are designed to
compensate investors for taking on the risk of holding bonds over a lengthy period of
time rather than shorter periods.
Market risk premium (MRP): The average return that investors require over the risk
free rate for accepting the higher variability in returns that are common for equity
investments. (i.e MRP reflects a minimum threshold for investors in order to be willing to
invest)
Risk free rate (Rf): the theoretical rate of return on an investment with zero risk of
financial loss.
Return index: The difference in value between the two periods divided by the
beginning value.
Perfect negative correlation: When there is a perfect -ve correlation, there is always a
portfolio strategy that will completely eliminate risk.
Variance/standard deviation: measures of risk or volatility associated with an
investment or a portfolio of investments.
Covariance/correlation: statistical measures to assess the relationship between the
returns of two or more assets or investments.
Diversification effect: diversification reduces risk because it reduces variability;
diversification works because prices of different stocks do not move exactly together;
the extent of the diversification effect depends on the correlation coefficient of the
shares
Unique/diversifiable/specific risk: risk factors affecting only that firm
Dow Jones risk: Dow Jones Risk & Compliance is a global provider of third party risk
management and regulatory compliance solutions
Market risk/Systematic risk: economy-wide sources of risk that affect the overall stock
market. Also called “systematic risk.”
Market portfolio: portfolio of all assets in the economy (usually uses broad stock
market index to represent market)
Beta: sensitivity of stock’s return to return on market portfolio

Chapter 8: Portfolio Theory and the Capital Asset Pricing Model

Efficient Portfolio: weighted combinations of stocks that create the lowered stdev.
These are the portfolios that maximize return and minimize risks
Markowitz portfolio theory: combining stocks into portfolios can reduce the risk
(stdev) below the level obtained from a simple weighted average calculation. The
correlation coefficient is what makes this possible.
Efficient frontier: the set of optimal portfolios that offer the highest expected return for
a defined level of risk or the lowest risk for a given level of expected return. Portfolios
that lie below the efficient frontier are sub-optimal because they do not provide enough
return for the level of risk
Capital Market Line (CML): the most effective combinations of investments, will never
be able to go above CML.
Sharpe ratio: measure of how well the fund has performed. Tells us how much return is
being generated per unit of risk of the portfolio. Thus, higher sharp values are preferred.
Security Market Line (SML): Tells us each stock should have a return dependent on its
market risk.
Capital Asset Pricing Model (CAPM): Model in which expected returns increase
linearly with an asset’s beta.
Arbitrage Pricing Theory (APT): model in which expected returns increase linearly
with an asset’s sensitivity to a small number of pervasive factors.
Fama & French three factor model: there is a degree of riskiness that is not explained
by capm. This comes from the size differences between companies. This model looks at
3 factors to calculate expected return (not just 1 like capm): SMB (small minus big)
accounts for publicly traded companies with small market caps that generate higher
returns, HML (high minus low) accounts for value stocks with high book-to-market ratios
that generate higher returns in comparison to the market, and the portfolio’s return less
the risk free rate of return.
Multi-factor models: describe the return on an asset in terms of the risk of the asset
with respect to a set of factors.
Growth stock: low book-to-market ratio. Expected to outperform the overall market
over time because of their full potential.
Value stock: high book-to-market ratio. Offers a higher return.
Chapter 9: Risk and the Cost of Capital

Market model: says that the return on a security depends on the return on the market
portfolio and the extent of the security's responsiveness as measured by beta.
Cost of capital (COC): minimum acceptable rate of return on an investment→ based on the
average Beta of assets→ rassets = rdebt (D/V) +requity(E/V)
Company COC: estimated as WACC, means the average rate of return demanded by
investors in the company’s debt and equity.
Opportunity COC: what you can get in alternative investments with similar risk and
reward profiles.
Asset beta: how sensitive are a company’s activities to movements in the market
equity beta: how sensitive is company’s equity to movements in the market.
debt beta: how sensitive is a company’s bonds to market movements
Industry beta: a measure of an asset's risk in relation to a specified stock market index
Weighted Average Cost of Capital (WACC): represents a firm's average after-tax cost
of capital from all sources, including common stock, preferred stock, bonds, and other
forms of debt. It is the average rate a company expects to pay to finance its assets.
Project cost of capital: represents the minimum rate of return that the project must
generate to create value for the company
Certainty Equivalent (CEQ): what % of cash flow is a company willing to give up to be
100% sure that they actually realize this cash flow

Chapter 10: Project analysis

Sensitivity analysis: analysis of the effects of changes in sales, costs, etc. on a project
Scenario analysis: project analysis, given a particular combination of assumptions
Simulation analysis: estimation of the probabilities of different possible outcomes
Break-even analysis: analysis of the level of sales (or other variables) at which the
company breaks even
Operating leverage: the degree to which costs are fixed
Degree of operating leverage (DOL): percentage change in profits given a 1 percent
change in sales
Decision tree: diagram of sequential decisions and possible outcomes. They help
companies determine their options by showing the various choices and outcomes.
Real option: Option to expand, option to abandon, production options, timing options

Chapter 13: Efficient Markets and Behavioral Finance

Random walk theory: The movement of stock prices from day to day DO NOT reflect
any pattern. Statistically speaking, the movement of stock prices is random.
Weak form (in)efficiency: market prices reflect all historical information
Semi-strong form (in)efficiency: market prices reflect all publicly available information
Strong form (in)efficiency: market prices reflect all information, both public and private
Technical analysis: concerned with price action, which gives clues as to the stock’s
supply and demand dynamics- which is what ultimately determines the stock price.
Fundamental analysis: research the value of stocks using NPV and other
measurements of cash flow.
Price anomaly: abnormal or unusual market behaviors where the market price of a
security or asset appears to deviate significantly from its intrinsic or fair value.
Abnormal return/Cumulative Abnormal Return (CAR): describes the unusual profits
generated by given securities or portfolios over a specified period. The performance is
different from expected ROR for the investment. Indicates a market inefficiency.
Arbitrage: the act of buying a security in one market and simultaneously selling it in
another market at a higher price, enabling investors to profit from the temporary
difference in cost per share.
Sub-primes: refers to a category of loans or borrowers who have a higher credit risk
compared to prime borrowers.
Anchoring bias: comparing the current price to the first price you bought the security
in. So if the price loses value then gains value you won't be satisfied if it's lower than the
initial price you paid.
Herding: following other investors, causing overvaluation of a stock.
Bullish/Bearish investors: Bullish: someone who believes that stocks will go up.
Bearish: someone who believes stocks will go down.
Prospect theory: assumes that losses and gains are valued differently and thus
individuals make decisions based on perceived gains instead of perceived losses. Also
known as loss-aversion theory.
Overreaction hypothesis (De Bondt & Thaler): the supposition that investors
overreact to unanticipated news resulting in exaggerated movements in stock prices
followed by corrections.

Chapter 17: Does Debt Policy Matter?

Perfect capital market: Where there is no taxes or transaction costs

Modigliani & Miller Proposition I: When firms pay no taxes and capital markets
function well, there is no difference if the firm borrows or the individual shareholders
borrow. Therefore, the market value of a company does not depend on its capital
structure.
Modigliani & Miller Proposition II: Rate of return they can expect to receive on their shares
increases as the firm's debt-equity ratio increases. (expected rate of return rE ↑, as DE↑).
Traditionalist view on WACC: traditionalists believe there is an optimal debt-equity
ratio that minimizes return on assets

Chapter 18: How much should a corporation borrow?

Optimal capital structure: refers to the proportion in which it structures its equity and
debt. It is designed to maintain the perfect balance between maximizing the wealth and
worth of the company and minimizing its cost of capital.
Unlevered/Levered: different approaches to measuring the financial performance or
value of a company or investment (with or without financial leverage).
Interest tax shield: Tax savings resulting from deductibility of interest payments.
Personal tax rate on equity/Personal tax rate on debt: refers to the tax treatment of
income earned from equity/debt investments
Notional interest rate deduction: To raise the equity of the firms governments allow
firms to deduct certain percentage from their taxable income. Companies are able to
lower their effective tax rate
Costs of Financial Distress: costs arising from bankruptcy or distorted business
decisions before bankruptcy
Limited liability: Shareholders cant be held responsible for corporation's debts in case
of bankruptcy
Unlimited liability: The owner is personally and fully responsible for all losses and
debts of the business
Agency cost of debt: refers to an increase in cost of debt when the interests of
shareholders and management diverge in a publicly owned company. when a firm has
debt, a conflict might develop between the interest of the shareholders (owners) and the
interest of the bondholders. When management basically acts in the interest of the
shareholders/stockholders.
Trade-off theory of debt: theory that capital structure is based on trade-off between
tax savings and distress costs of debt
Pecking order theory: theory stating firms prefer to issue debt over equity if internal
finances are insufficient
Financial slack: refers to the excess financial resources or cash reserves that a
company holds beyond what is needed for its immediate operating and investment
requirements. It represents the surplus liquidity or financial cushion that a company
maintains.
Past paper questions

1. An investor buys the shares of companies when the stock exchange

publicly announces that a particular stock will be included in the stock
market index and sells them when the stock is included in the index. As a
result of this strategy, he finds out that his portfolio performs better than
expected. What kind of (in)efficiency of the market does this indicate. (5
points)

OR

Jack and John are friends. Jack tells John that his firm is about to release a
new product that could impact the share price. When John gets home he
invests in Jacks firm. He experiences abnormal high returns. What kind of
(in)efficiency of the market does this indicate. (5 points)

OR

Due to Covid 19, Netflix announces subscribers rise, investor A buys stock
and realizes abnormal positive return, what kind of (in)efficiency of the
market does this indicate? (5 points)

Semi-strong form inefficiency: In a semi-strong form efficient market, stock

prices incorporate not only historical information and publicly available financial
data but also all publicly disclosed information, including news and
announcements. Thus, investors should not be able to consistently earn
 abnormal returns by trading on publicly available information because stock
prices should adjust quickly and accurately to new information.

2. Explain what underpricing means in an IPO and link this to the winners/
Weiner’s curse. (5 points)

Underpricing: Issuing securities at an offering price set below the true value of
the security.
Calculation: (First Aftermarket Price – Offer Price)/Offer Price)
This under-pricing can be explained by asymmetric information (Before the
IPO, underwriters have access to detailed information about the company going
public but potential investors have limited access to this information and rely on
what is disclosed).
The Winner's Curse is a phenomenon observed in IPOs and auctions. It
suggests that the winning bidder, or the buyer who is willing to pay the most,
often ends up overpaying for the asset. This happens because they may have
overestimated the value of the shares based on limited information, leading to a
higher bid.
In summary, underpricing in IPOs is related to the Winner's Curse, as it is a
strategy used by underwriters to manage the risk of overvaluation by winning
bidders. The underpricing creates an incentive for investors to participate in the
IPO because they anticipate immediate gains when the stock starts trading on
the open market.

3. An investor has invested in a portfolio that gives him a return above the
expected return. He now believes this shows that he is a good investor.
Explain why this is not necessarily true and link it to the Capital Market
Line and Sharpe Ratio. Also show graphically where his portfolio would be
with respect to the Capital market line (clearly label the axes) (10 points).

An investor achieving a return above the expected return doesn't necessarily

make them a "good" investor, as there are critical factors and concepts to
consider, such as risk and risk-adjusted return, which are linked to the Capital
Market Line (CML) and the Sharpe Ratio.

The Sharpe Ratio is a measure of the risk-adjusted return of an investment or

portfolio (Ratio of the risk premium to the standard deviation). A higher Sharpe
Ratio indicates better risk-adjusted performance.

The CML demonstrates that there is a trade-off between risk and return. As you
move along the CML from left to right, you take on more risk in pursuit of higher
 returns. Conversely, moving from right to left means reducing risk but accepting
lower returns.
- If the investor's portfolio is on or above the CML, it implies they have
achieved returns that compensate for the level of risk in their portfolio.
This could be considered "good" performance, as they efficiently utilize
risk to generate returns.
- If the investor's portfolio is below the CML, it suggests they are not
achieving returns that justify the level of risk they are taking, which might
be suboptimal.

In the graph above, the investor's portfolio is represented. If it lies on or above

the CML, it indicates that the portfolio is providing a return consistent with its risk
level, which is a good performance. However, if it falls below the CML, it
suggests that the investor might be taking on too much risk for the returns
achieved, indicating a suboptimal investment strategy.

In summary, achieving a return above the expected return is not a sufficient measure of
being a "good" investor. To assess investment performance, it's essential to consider
risk-adjusted metrics like the Sharpe Ratio and evaluate the portfolio's position relative
to the Capital Market Line, as these factors provide a more comprehensive view of
investment efficiency and risk management.

4. An investor has invested in a portfolio that gives him an abnormal return.

He believes this shows that markets are inefficient. Explain why this is not
necessarily true (in other words discuss two criticisms on the CAPM) and
link it to the 3-factor model of Fama and French. Also show graphically
where his portfolio would be with respect to the security market line
(clearly label the axes) (10 points)

An investor achieving an abnormal return does not necessarily prove market

inefficiency. The Capital Asset Pricing Model (CAPM) is a foundational theory for
understanding the relationship between risk and return, but it has been subject to
criticism and limitations.

Criticisms of the CAPM:

- Single-Factor Model: The CAPM relies on a single factor, the market beta
(thus considering only market/systematic risk), to explain expected
returns. It can be argued that this oversimplification doesn't account for all
the factors that influence asset prices (such as firm-specific risk).
 - Real-world returns do not always align perfectly with the predictions of the
CAPM, suggesting that other factors may influence returns beyond what
the CAPM considers.

Fama and French extended the CAPM by introducing a three-factor model that
accounts for additional sources of risk:
- Market Factor (Mkt-RF): This factor is similar to the market factor in the
CAPM and captures the systematic risk associated with the overall
market.
- Size (SMB - Small Minus Big): This factor accounts for the historical
outperformance of small-cap stocks relative to large-cap stocks. Small-cap
stocks are considered riskier because they tend to be less diversified and
more susceptible to business cycles.
- Value (HML - High Minus Low): This factor addresses the difference in
returns between value stocks (those with low price-to-book ratios) and
growth stocks (those with high price-to-book ratios). Value stocks are
typically riskier due to their lower valuation and potential for value traps.

SML securities and Markets line is a graphical representation of CAPM:

- If stocks lie above the security line they are undervalued
- If stocks lie below the security line they are overvalued.

This investor's portfolio gave him abnormal returns, so the stock is overvalued
and lies below the SML.

5. Show CML, graph it and explain.

The Capital Market Line (CML) is a graphical representation of the relationship

between risk and expected return for a portfolio that includes a risk-free asset
and a risky portfolio of assets. The CML is used in finance to help investors make
investment decisions based on their risk preferences. It shows the trade-off
 between risk and return for a combination of a risk-free asset (like government
bonds) and a portfolio of risky assets (like stocks).

6. Show graphically the cost of debt, the cost of equity and the cost of capital
in a perfect capital market, in a world with corporate taxes and in a world
with financial distress capital structure – explain. What is the agency cost
of debt? How does this link.

The agency cost of debt arises from conflicts of interest between shareholders
and debt holders. When a firm takes on debt, shareholders may be tempted to
undertake risky projects to maximize their wealth at the expense of debt holders.
This risk-shifting behavior can lead to financial distress or bankruptcy, which
ultimately harms debt holders.

In a perfect capital market, there are no taxes, and financial distress costs are
negligible. Leverage has no impact on total firm value. The cost of debt (Rd) is
the pre-tax cost of borrowing, the cost of equity (Re) is determined by the Capital
Asset Pricing Model (CAPM), and the cost of capital (WACC - Weighted Average
Cost of Capital) is a weighted average of these costs based on the firm's capital
structure.
 Cost of capital

Equity cost of capital (rE)

rWACC = rA

Debt cost of capital (rD)

Debt to value ratio (D/E)

In a world with corporate taxes, the cost of debt is tax-advantaged, as interest

payments are tax-deductible. The cost of equity remains the same, but the cost
of capital (WACC) is adjusted to account for the tax benefit of debt.Thus the
agency cost of debt can be linked to this scenario.

Cost of financial distress are costs arising from bankruptcy or distorted business
decisions before bankruptcy. An indirect cost of financial distress is that
management will be occupied with ways to solve the financial distress.
Bankruptcy leads to a direct cost. In a world with financial distress and varying
capital structures, the cost of debt can increase as the firm takes on more debt,
leading to increased financial distress costs. These costs might include higher
interest rates on debt, legal fees, and potential bankruptcy costs. The cost of
equity remains the same, and the cost of capital increases as the firm's debt level
rises. As a result of agency cost of debt, managers of firms in financial distress
will accept projects with negative NPV if it is the only way to get out of financial
distress and avoid bankruptcy. Therefore, the agency cost of debt is one factor
that can contribute to the increasing cost of debt in firms with high leverage.

Market Value: value of all equity financed

+ PV Tax shield
- PV costs of financial distress

7. What does prospect theory say about attitudes towards similar

gains/losses, how does that influence risk taking behavior?

The prospect theory says that investors value gains and losses differently,
placing more weight on perceived gains versus perceived losses. People are
 typically more averse to losses than they are attracted to equivalent gains. Due
to loss aversion, individuals are more inclined to take risks when facing potential
losses compared to when they anticipate equivalent gains. In summary,
individuals tend to be risk-averse with respect to potential gains but risk-seeking
with respect to potential losses.

8. True or false? If expected inflation increases, the forward rates on the

market will increase as well as the future nominal cash flows and therefore
also value of firms.

False.
Forward Rates: interest rates, fixed today, on a loan made in the future at a
fixed time. They are very helpful, because as a company if you know that next
year you need to borrow money, you can determine today how much interest you
will pay next year.
As inflation increases, nominal cash flow (since it is variable and impacted by
inflation) takes into consideration inflation and will also rise, but not forward rates
as they are fixed!

9. How do pecking order theory and trade-off theory differ in their view on
optimal capital structure (explain the theories briefly)? Show the optimal
capital structure also graphically in a world with corporate taxes and costs
of financial distress and explain your graph. (10 points)

Pecking order theory:

- Suggests that firms have a preferred hierarchy for financing their
investments; internal sources of funds (e.g., retained earnings) first, then
debt, and equity issuance is considered the last resort.
- Based on the idea that information asymmetry between managers and
investors can lead to adverse selection costs when issuing equity.
- Argues that there is no optimal capital structure optimal D/E ratio
- Says that a firm’s capital structure is a result of financing decisions driven
by the availability of internal funds and the need for external financing.

Trade-off theory:
- Says that firms aim to balance the tax advantages of debt (e.g. interest tax
shield) with the costs of financial distress (e.g. bankruptcy costs, agency
costs).
- There is an optimal capital structure and D/E ratio
- According to this theory, firms actively manage their capital structure to
maintain it near the optimal debt-to-equity ratio.
10. Giving stock options to the management will reduce agency problem 2:
true or false?
False, reduces agency problem 1.

11. Graphically show and discuss the relationship between risk and return for
2 stocks if the correlation coefficient is -1; +1 and 0.

E(R)

B
p = -1
p = +1
-1 < p < +1

S.D