Cheat Sheet Essays

Submitted By AsthaKaushal1
Words: 3227
Pages: 13

Previous knowledge
Perpetuity:
Valued at time zero. Starts paying at time 1

Annuity: 1st payment time 1
Annuity: last payment time t
Interest rates given are effective annual rate

Interest rate: .

Fwd rate no = arbitrage
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Company Value
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MARKET EFFICIENCY * Market prices reflect all relevant info * P = PV(Cashflows) * Not possible to make abnormal returns Weak | Analysis of past price & return can’t be used to make abnormal returns | Semi Strong | Public info can’t be used to make abnormal returns | Strong | Not even private info can be used… | Abnormal returns = actual return – expected return = (Current Return – Previous Return)/Previous Return – (Rf + β* (Rm-Rf)) Strong form not true: * If true, regulation not needed * People do make money (trading before takeovers) Lessons from Efficient Market Hypothesis * Always take positive NPV projects * Accounting practices are irrelevant * Timing is irrelevant (price = value) * Only takeover if add value
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caPITAL STRUCTURE Capital structure: mix of securities issued to finance projects MM 1: Under perfect capital markets, capital structure irrelevant. ie VL=VU Perfect Capital Markets * No tax * Efficient * No bankruptcy or transition costs * No conflicts MM1: If we buy only 1% Equity stocks of a levered firm, Return = 1% *(Profits - Interest ) Alternative is to take 1%DLevered debt on our own And buy 1% stock on unlevered firm, again Return = 1%(Profits – Interest ) EPS Fallacy “Debt is better when it makes EPS go up” * Not true as debt riskier * Don’t compare P/Es when debt leverage dif MM 2:

Solving for re Similarly

rE increases proportional to increase in D/E (Because of increased risk with increased proportion of debt)

Leverage = EPS b/c leverage = risk Why Capital structure matters: Interest tax deductible, dividends not As Leverage increases, after tax WACC decreases bcoz interest on debt reduces tax payable. Tax shield benefit = Tc × Interest = Tc × Rd × D PV (Tax Shield) = = TcD (Assuming debt stable) VL = VU +PV (tax shield) Why not 100% D? * Personal taxes * Multiply bond payments by (1-personal_tax_on_bonds) * Multiply eqty payments by (1-personal_tax_on_eqty) * If no dividends and low cap gains, eqty_tax << bnd_tax * Costs of Financial distress

VL = Vu + PV (tax shield) – PV(cost financial distress) Debt overhang * Positive NPV project * Investors incur full investment cost NOW * Investors receive only part of payoff in FUTURE (if bad scenario, payoff goes to debtors) * risky debt = tax on investment * Use E(Re) to discount cashflows and test if shareholder should invest Asset Substitution * Substitute asset you own part (or more) of for asset with upside for you but downside for debtors * Gamble with debtors money To replicate a firm with same value but dif leverage: * Buy same % of other firm * Borrow (or…