10 Questions
Explain the main rationale behind Proposition 1 in Financial Economics.
Tax-deductible interest payments positively affect a company’s cash flows.
What is the key impact of tax shields on the value of a levered company according to Proposition 1?
Tax shields make the value of a levered company higher than the value of an unlevered company.
How does Proposition 2 in Financial Economics describe the relationship between the cost of equity and leverage level?
The cost of equity has a directly proportional relationship with the leverage level.
Define the concept of certainty in Risk and Return in Financial Economics.
Certainty is a situation where the value a variable can take is known with a probability of unity.
What effect do tax shields have on the sensitivity of the cost of equity to leverage level according to Proposition 2?
Tax shields make the cost of equity less sensitive to the leverage level.
Describe uncertainty in Risk and Return in Financial Economics.
In uncertainty, the objective probability distribution of values is not known, but experts can estimate the range of values and their chances of occurrence.
How does extra debt impact the chance of a company’s default, as mentioned in the text?
Extra debt increases the chance of a company’s default.
Why are investors less likely to react negatively to a company taking additional leverage despite the increased default risk?
Investors are less prone to negative reactions due to tax shields that boost the company's value.
Provide the formula for Proposition 2 (M&M II) in Financial Economics.
Re = R0 + (D/E) × (1 - TC) × (R0 - RD)
What is the formula for Proposition 1 (M&M II) in Financial Economics?
V = U + TC × D
Study Notes
Equity Valuation
- Dividend Discount Model: a method to value stocks based on dividend payments
- P/E Ratio Approach: a method to value stocks based on the price-to-earnings ratio
- Irrelevance of Dividends: Modigliani and Miller Hypothesis suggests that dividend policy does not affect a company's value
Risk and Return
- Types of risk: various types of risk associated with investments
- Historical returns: returns of an asset or portfolio over a specific period
- Computing historical returns: methods to calculate returns
- Average annual returns: average return of an asset or portfolio over a year
- Variance of returns: measure of risk or volatility of an asset or portfolio
- Measurement of Risk and Return of an asset: methods to measure risk and return of an individual asset
- Measurement of Risk and Return of a Portfolio: methods to measure risk and return of a portfolio
- Determinants of Beta: factors that affect beta, a measure of systematic risk
- Risk-Return trade off: relationship between risk and return of an investment
Cost of Capital and Capital Asset Pricing Model
- Cost of Capital: the required rate of return on investment
- Debt and equity: sources of capital
- Cost of Debt: interest rate on debt
- Cost of Preference Capital and Equity Capital: cost of preferred stock and common equity
- Capital Market Line: a graph showing the expected rate of return of a portfolio based on its beta
- Capital Asset Pricing Model (CAPM): a model to estimate the expected rate of return of an investment
- Beta of an asset and of a portfolio: a measure of systematic risk
- Security Market Line: a graph showing the expected rate of return of an asset based on its beta
- Use of CAPM model: applications of CAPM in investment analysis and as a pricing formula
Derivative Markets
- Financial derivatives: contracts that derive their value from an underlying asset
- Types of derivatives: forward contracts, futures contracts, options, and swaps
- Forward Contracts: customized contracts for buying or selling an asset at a future date
- Determination of forward prices: methods to calculate forward prices
- Futures Contract: standardized contracts for buying or selling an asset at a future date
- Theories of future prices: cost of carry model, expectation model, capital asset pricing model
- Relation between Spot and Future Prices: relationship between cash and futures prices
- Forward vs. Future contract: comparison between forward and futures contracts
- Hedging in Futures: using futures contracts to reduce risk
- Options: contracts giving the right but not the obligation to buy or sell an asset
- Types of options: call options and put options
- Value of an option: factors affecting the value of an option
- Pay-Offs from Buying and Selling of Options: profits and losses from option trading
- Put-Call Parity Theorem: a relationship between put and call options
- Binomial option pricing model (BOPM) and Black-Scholes option pricing model: models to estimate the value of an option
Test your knowledge on Equity Valuation including Dividend Discount Model and P/E Ratio, Risk and Return concepts like historical returns, variance, and beta, and Cost of Capital principles such as Debt and Equity. This quiz covers Module III and Module IV topics.
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