1
Q
Types of dividends
A
- Cash dividends
- Extra/special/irregular dividends
- Liquidating dividend
- Stock dividend
- Stock split
2
Q
Cash dividend
A
Periodic dividend payments made in cash on the ex-dividend date.
- Firms generally want stable dividends.
- U.S. firms pay out quarterly, while Euro and Asian companies pay out semiannually and annually, respectively.
- Cash dividends reduce cash assets and equity. This results in a lower quick and current ratio and higher leverage (D/E ratio).
3
Q
Extra/special/irregular dividend
A
A cash dividend supplementing a regular dividends, or dividends from a firm that typically does not pay out dividends.
- These may be paid if a firm has a particularly profitable year but does not want to make dividending a regular occurrence.
4
Q
Liquidating dividend
A
Dividends paid by a firm when the whole firm or part of the firm is sold, or when dividends in excess of cumulative RE are paid. A liquidating dividend is a RETURN OF CAPITAL versus a return on capital.
5
Q
Stock dividend
A
A non-cash dividend in the form of additional shares. A stock dividend will provide equity holders more shares and the cost per share will be lower. This DOES NOT change proportionate ownership since every equity holder is given the same percentage stock dividend.
- Shareholders are usually not taxed on stock dividends.
- Does not affect a firm’s capital structure. No change in ratios.
6
Q
Stock dividend example:
Imagine a firm earning $100,000 annually has 100,000 shares outstanding w/ a price per share of $10. EPS thus equals ($100,000 ÷ 100,000) = $1. P/E = $10 ÷ $1 = 10. Suppose the firm declares a 10% stock dividend, what are the new shares outstanding and EPS? What is the new value of the shareholders stocks?
A
Shares outstanding = 100,000 * (1.1) = 110,000
EPS= ($100,000 ÷ 110,000) = 0.9091
Stock price per share= 0.9091 * 10 (original PE) = $9.09
Total value of shares= $999,900 (virtually identical)
7
Q
Benefits of stock dividends
A
- Makes long-term investing more desirable.
- May reduce COE.
- Increases liquidity.
- Decreases stock price.
8
Q
True or false: Firms that pay the same regular cash dividend per share following a stock dividend have effectively decreased their cash dividend?
A
False, they have effectively increased it.
9
Q
Stock split
A
When a company increases the # of its shares to boost the stock’s liquidity by lowering its price per share. The number of shares outstanding increases by some multiple.
- 2-for-1 splits and 3-for-1 splits are the most common.
- A 2-for-1 split is equal to a 100% stock dividend.
- Does not affect a firm’s capital structure. No change in ratios.
10
Q
Reverse stock split
A
Much less common than regular stock splits. This is where a firm decreases its # of shares outstanding to increase the price per share. Typically, this is done to attract institutional investors and mutual funds.
11
Q
Dividend reinvestment plans (DRP)
A
Offered by some companies that reinvest dividends on behalf of the shareholders that opt out of receiving cash dividends. So essentially the shareholders is just buying more shares instead of taking the dividend. DRPs can be open market where the shares are bought from the capital markets or DRPs can be newly issued stock.
12
Q
3 theories of dividend policy
A
- Dividend irrelevance
- Dividend preference theory/bird-in-hand argument for dividend policy
- Tax aversion
13
Q
Dividend irrelevance
A
Based on the M&M assumptions that maintain that dividend policy has no effect on the price of a firm’s stock or cost of capital. This based on M&M’s homemade dividend concept where if a dividend is too big, the shareholder can reinvest part or all of the dividend and if the dividend is too small, they can sell part or all of their stock to make up for it. The conclusion here is that investors don’t care about the dividend policy since they can create their own.
- This theory only holds in a perfect world with no taxes, brokerage costs, and infinitely divisible shares.
- MM discussion pertains to the firm’s total payout policy versus just the dividend policy.
14
Q
Dividend preference theory/bird-in-hand argument for dividend policy
A
This is based on theory from Myron Gordon and John Lintner. These two argue that since ROE decreases as dividend payouts increase, investors are less certain of receiving future capital gains since there is less RE. The main argument here is that investors place more importance on receiving a certain $ of dividends than $ of capital gains. The argument is based on the fact that when measuring total return, dividend yield has less risk than the growth component. Recall, the Gordon growth model = [ D ÷ (r - g) ].
- Higher dividends lead to higher stock prices.
15
Q
Tax aversion theory
A
This theory states that since dividend taxes are higher than capital gains taxes, shareholders will prefer to not receive dividends and instead see NI reinvested through RE. The result of this is that smaller dividends result in higher stock price and lower COE. In 2003, tax laws in America changed to where dividends and long-term capital gains are now taxes at 15%. This makes this theory untrue in the U.S.
16
Q
Info Asymmetry
A
Differences in info available to a company’s board/mgmt (insiders) and the investors (outsiders).
17
Q
True or false: A dividend initiation is always a positive signal to the markets?
A
False, a dividend intitiation is ambiguous. It could mean that a company is optimistic about the future and wants to share its wealth- a positive signal. Or it could mean that a company has a lack of profitable reinvestment opportunities- a negative signal.
18
Q
True or false: A dividend omission (decrease) is usually a negative signal to the markets?
A
True.
- In rare cases it may be a positive sign as mgmt may believe that profitable reinvestment opportunities are available.
19
Q
True or false: A dividend increase is usually a negative signal to the markets?
A
False, positive.
20
Q
Agency costs between shareholders and managers
A
The cost of inefficiencies due to the divergence of interests between mgmt and stockholders (ex: mgmt may have an incentive to overinvest leading to poor investments). One way to reduce agency costs is to increase the payout of free CFs as dividends.
21
Q
Agency costs between shareholders and bondholders
A
The cost of inefficiencies due to the divergence of interests between bondholders and stockholders. One way to reduce these agency costs is via provisions in the bond indenture that can include restrictions on dividends, maintenance of certain b/s ratios, etc.
22
Q
Factors that affect dividend policy:
A
- Investment opportunities
- Expected volatility of future earnings: when earnings are volatile, firms are reluctant to change dividends.
- Financial flexibility: Excess cash on hand and a desire to maintain financial flexibility may lead a firm to stock repurchases instead of dividends.
- Tax considerations
- Flotation costs: the higher the flotation costs (costs related to raising new equity (ex: payment of investment bankers) the lower the dividend payout.
- Contractual and legal restrictions
23
Q
Reasons why a lower tax rate for dividends does not necessarily mean firms will raise their dividend payouts?
A
Taxes on dividends are paid when the dividend is received, whereas taxes on capital gains are only paid when the shares are sold. Tax-exempt institutions will be indifferent.
- In the case of a shareholder’s death, capital gains tax may not have to be paid.
24
Q
Common contractual and legal restrictions related to dividends:
A
- The impairment of capital rule: in some countries this is a legal requirement where dividends cannot exceed RE
- Debt covenants: These protect bondholders and dictate things a company can or cannot do.
25
Double-taxation system
How dividends are taxed in the U.S. Earnings are taxed regardless of whether dividends are paid and then if dividends are paid they are taxed separately.
Calculation: Corporate tax rate + (1 - corporate tax rate) * (individual tax rate)
26
Effective tax rate on dividend example:
A U.S. company's earning are $300 and the corporate tax rate is 35%. Assume the dividend payouts comprise 100% of earnings. What is the effective tax rate on # of corporate earnings paid out as dividends assuming a 15% tax rate on dividend income.
Effective tax rate = 0.35 + ( 1 - 0.35) * (0.15) = 44.75%
27
Split-rate corporate tax system
Taxes earnings distributed as dividends at a lower rate than earnings that are retained in order to offset the double tax rate applied to dividends.
Calculation: Corporate tax rate applicable to dividends + [ (1 - corporate tax rate applicable to dividends) * individual tax rate ]
28
Split-rate corporate tax system example:A firm's earnings are $300 and the corporate tax rate on RE is 35%, whereas the corporate tax rate on dividends is 20%. Assuming that the company pays out 50% of its earnings as dividends and the individual tax rate for dividends is 30%, what is the effective tax rate?
Effective tax rate = .20 + [ (1 - .20) * .30 ] = 44%
29
Imputation tax system
Taxes are paid at the corporate level but attributed to the shareholder. Then, the shareholders deduct their portion of the taxes paid by the firm from their tax return. Under the imputation system, the effective tax rate on the dividend is just the shareholder's tax rate. If the shareholder's tax bracket is lower than the company rate, the shareholder would receive a tax credit equal to the difference between the two rates. Oppositely, if it's higher than the company rate, the shareholder would pay the difference.
30
Imputation tax system example:
A shareholder owns 100 shares of a stock in a corporation that makes $1 per share in pretax income. The corporation pays out all its income as dividends. The shareholder has a 20% individual tax bracket whereas the firm has a 30% tax rate. What is the effective tax rate for the shareholder?
$1 * 100 shares = $100 in pretax income.
$100 * (1 - .30) = $70= NI.
Shareholder tax due = $100 * (.20) = $20.
Since, shareholder tax < corporate tax, the shareholder will receive a tax credit worth ($30 - $20) = $10.
Effective tax rate on dividends = 20/100 = 20%.
31
Stable dividend policy
This dividend policy focuses on consistent dividend payouts, even if earnings are volatile year-to-year. Companies may use a target payout adjustment model in order to gradually increase their dividend towards the target dividend payout ratio.
32
How to estimate future dividends if the current payout ratio is below the target payout ratio?
Expected increase in dividends = [ [ (expected earnings * target payout ratio) - previous dividend ] * adjustment factor ] + previous dividend
Adjustment factor = 1 ÷ (# of years over which the adjustment in dividends will take place)
33
Constant dividend payout ratio policy
A dividend policy where a % of total earnings are paid out as dividends. This practice is seldom used in reality.
34
What are the three broad trends in corporate payout policies?
1. Globally, in developed markets, the proportion of firms paying cash dividends has trended downward over the long-run.
2. The # of firms making stock repurchases has risen drastically in the U.S. since 1980, Europe since the 1990s, and Asia since 2010.
3. Lower proportion of U.S. companies pay cash dividends as opposed to European companies.
35
Fourth methods used for stock buybacks:
1. Open market transactions: most flexible approach
2. Fixed-price tender offer.
3. Dutch auction
4. Repurchase by direct negotiation.
36
Stock buybacks through open market transactions
This approach allows a firm to buy back shares in the open market at the most favorable terms (when the price is attractive).
37
Stock buybacks through fixed-price tender offer
An approach where a firm informs all of their shareholders that it intends to buys a predetermined # of shares at a certain price, typically at a premium over the shares' market value.
## Footnote
* This approach is quicker than the open market transactions approach but it does not give the firm the flexibility (the ability to buyback shares at the most opportune time).
38
Stock buybacks through Dutch auction
An approach where a firm specifies a range of prices to the market it is willing to buy back its shares at. The shares that are priced the lowest will be sold first (to the shareholder who was willing to accept the lowest of the range). The lower the price the shareholder is willing to receive, the more likely the order will be executed. This approach is cheaper than fixed price tender but slower.
39
Stock buybacks through repurchase by direct negotiation
This approach involves buying back shares from a major shareholder, typically at a premium over the shares' fair value. This method is often used in a greenmail scenario where a shareholder is paid a premium to leave the company. Sometimes, the shares can be bought back at a discount if the shareholder needs cash quickly.
40
How do share repurchases affect EPS?
When repurchases are financed with the firm's cash, cash in the firm's b/s will be low and therefore equity will be lower. This will in turn increase leverage ratios. After the repurchase, EPS will likely increase because outstanding shares will decrease. If earnings yield (EPS ÷ stock price) > after-tax opportunity cost of cash, EPS would increase.
## Footnote
* When repurchases are financed with debt, the reduction in net income from the cost of borrowed funds must also be factored in to determine the impact on EPS. If earnings yield (EPS ÷ stock price) > after-tax opportunity cost of debt, EPS would increase.
41
Shares repurchase effect on EPS example:
Firm A has 10,000,000 shares outstanding w/ a NI of $50,000,000. The company repurchases 2,000,000 shares at a premium of 25% over the current market price of $40. What is the effect on EPS if cash is used and if debt w/ a 3% interest rate is used?
If cash:
Current EPS = ($50,000,000 ÷ 10,000,000) = $5
Repurchase price = $40 * (1.25) = $50
Total cost of repurchase = $50 * 2,000,000 = $100,000,000
New EPS = $50,000,000 ÷ (10,000,000 - 2,000,000) = $6.25
If debt:
After-tax cost-of-funds = $100,000,000 * .03 = $3,000,000
New earnings = $50,000,000 - $3,000,000 = $47,000,000
New EPS = $47,000,000 ÷ (10,000,000 - 2,000,000) = 5.875
42
What are the five common rationales for share repurchases vs dividends?
1. Potential tax advantages: When tax rate on capital gains < tax rate on dividend income, share repurchases have an advantage.
2. Share price support/signaling: Firms buying back their own shares can signal to the market that the firm thinks its own stock is currently a good investment.
3. Added flexibility: Share repurchases can supplement dividends.
4. Offsetting dilution from employee stock options: Repurchases offset EPS dilution that results from the exercise of employee stock options.
5. Increasing financial leverage: When funded by new debt, share repurchases increase leverage.
43
How to calculate MVE after a dividend/repurchase
[ (Shares outstanding prior to transaction * Pre-dividend MV of share) - share buyback total ] ÷ Shares outstanding after transaction
44
Impact of share repurchase and cash dividend of equal amounts example:
Firm A has 20,000,000 shares outstanding with a MV of $50 per share. The firm made $100,000,000. The firm is comparing paying a cash dividend of $1.50 per share to its shareholders to doing a stock buyback of $30,000,000 at $50 per share. Which method is better for shareholders? Assume tax treatments are the same.
Dividend: After the dividends are paid out on the ex-dividend date, a shareholder of a single share would have $1.50 in cash and [ (20,000,000 * $50) - $30,000,000 ] ÷ 20,000,000 = $48.50 per share, which results in total wealth of $50.
Share repurchase: Firm A could repurchase $30,000,000 ÷ $50 = 600,000 shares. MVE of share after repurchase = [ (200,000,000 * $50) - $30,000,000 ] ÷ (20,000,000 - 600,000) = $50
45
How to calculate EPS after share buyback?
(Total earnings - after-tax cost of funds) ÷ total shares outstanding after buyback
After-tax cost of funds= shares outstanding after buyback * share price at the time of buyback * after-tax cost of borrowing
46
Share repurchase when the after-tax cost of debt < earnings yield example:
Firm A borrows $30,000,000 to repurchase shares. Share price and shares outstanding at the time of the buyback are $50 and 20,000,000. EPS before buyback is $5. Earnings yield = $5 ÷ $50 = 10%. After-tax cost of borrowing= 8%. Planned buyback= 600,000 shares. What is the EPS after the buyback?
Total earnings = $5 * 20,000,000 = $100,000,000($100,000,000 - (600,000 * $50 * .08) ) ÷ (20,000,000 - 600,000) = $5.03= EPS after buyback
Since the after-tax cost of borrowing (8%) < earnings yield, the share buyback will increase EPS.
47
Dividend safety
The metric used to evaluate the probability of dividends continuing at the current rate for a company.
48
Dividend payout ratio
A type of dividend safety metric.
Calculation: Dividends ÷ NI
## Footnote
* Higher ratio indicates a higher probability of a dividend cut.
* Compare a firm's ratio w/ the industry average.
49
Dividend coverage ratio
A type of dividend safety metric.
Calculation: NI ÷ dividends
## Footnote
* Higher ratio= better
* Lower ratio indicates a lower probability of dividend sustainability.
* Compare a firm's ratio w/ the industry average.
50
Free Cash Flow to Equity (FCFE)
The CF available for distribution to stockholders after WC and fixed capital needs are accounted for. FCFE is a measure of equity capital usage.
Calculation: CFO - CAPEX + net debt
51
FCFE Coverage ratio
FCFE ÷ (dividends + share repurchases)
## Footnote
* A ratio significantly < 1 is considered unsustainable. In this situation, a firm is drawing down its cash reserves for dividends and repurchases.
52
True or false: If the price paid for repurchase < pre-purchase BV per share, BV per share will decline?
False, it will increase
53
BV per share calculation
Total stockholders equity ÷ total shares outstanding
54
What has led to global variations in ownership structures?
Global differences in legal, social, political, and economic factors.
55
Structures of corporate ownership
1. Concentrated
2. Dispersed
3. Hybrid
56
Concentrated corporate ownership structure
The most common form of corporate ownership. This is where a single shareholder or group of shareholders have control over the corporation.
57
Dispersed corporate ownership structure
Where the shareholders are numerous and none have control.
58
True or false: Percentage of ownership will tell an analyst which shareholders have control?
False, not necessarily.
59
Vertical ownership/pyramid ownership
An arrangement where a shareholder or group of shareholders have a controlling interest in holding companies, which in turn could have controlling interests in subsidiaries. Thereby, the shareholder or group of shareholders has control over several companies.
60
Horizontal ownership
An arrangement where firms w/ common suppliers or customers cross-hold each other's shares.
61
Cross holding
A situation where one publicly-traded company holds a significant number of shares of another publicly-traded company
62
Dual-class shares
One class of shareholders has fewer voting rights, while another class has superior voting rights.
63
Dispersed ownership and dispersed voting power
1/4 potential conflicts within different ownership structures. This is a situation where shareholders, called weak shareholders, do not hold power over mgmt, called strong managers. This problem can be mitigated by having controlling shareholders.
## Footnote
* This is the potential conflict that can lead to the most severe principal-agent problem.
64
Concentrated ownership and concentrated voting power
1/4 potential conflicts within different ownership structures. This is a situation where strong shareholders have power over minority shareholders and weak managers. In this scenario, the controlling shareholders can control the board and mgmt.
65
Dispersed ownership and concentrated voting power
1/4 potential conflicts within different ownership structures. This is a situation where minority shareholders are able to control a company through pyramid structures or dual-class shares.
66
Concentrated ownership and dispersed voting power
1/4 potential conflicts within different ownership structures. This situation occurs when there are voting caps, where the voting rights of large share positions are restricted. Voting caps are often done by sovereign nations to discourage foreign investors from taking a controlling position in a firm belonging to an important industry.
Ex: An investor owns 50% of shares but their voting power is capped at 10%.
67
Categories of influential shareholders:
* Banks: can lend money and thus exert influence over a firm
* Families: Can lead to poor mgmt if there is partiality towards family members.
* State-owned enterprises
* Institutional investors: Can typically pressure a firm's mgmt and board to act in the interest of shareholders. They can also reduce principal-agent conflicts.
* Group companies: Can lead to cross holding which can make it difficult for outside investors to acquire shares and also lead to related-party transactions that do not provide return for minority shareholders.
* Private equity firms: Can reduce principal-agent conflicts.
* Foreign investors
* Mgmt and board
68
Interlocking directorates
Where one person sits on the board of directors of multiple companies
69
State owned enterprise (SOE)
A firm that is partially owned by a government but trades on an exchange.
70
True or false: One advantage of families sitting on the board of directors is that it may reduce principal-agent conflicts?
TRUE
71
Major ownership structure factors that impact corporate governance:
* Director independence: This is especially important when there is severe principal-agent conflicts
* Board structures
* Special voting arrangements: Some countries attempt to provide an advantage to minority shareholders through these arrangements for board nomination and election.
* Corporate governance codes, laws, and listing requirements.
* Stewardship codes.
72
Director independence
When a board member has no significant remuneration, ownership, or employment relationship with the firm, the board member is considered independent. Independence means that the board is looking out for the shareholders and not just mgmt. Independent directors are important in countries with dispersed ownership where the principal–agent problem is greater and thus the board's role of monitoring managers is key.
73
Board structures' impact on corporate governance
Boards of directors can generally be categorized as one- or two-tier. A one-tier board is the most common and is made up of both internal (executive) directors and external (nonexecutive) directors. Under a two-tier structure (required in countries such as Russia, Germany, and Argentina), a management board is overseen by a supervisory board. The supervisory board determines mgmt compensation, supervises external audits, and reviews financial records. The supervisory board limits the power of the mgmt board. Kind of like checks and balances.
74
True or false: If banks have ownership in a company, they may misuse their power to lend to the company at higher-than-market interest rates?
TRUE
75
Stewardship codes
A code requiring institutional investors to be transparent about their investment processes, engage with investee companies and vote at shareholders' meetings.
76
Shareholder activism
Techniques used by shareholders to force management to act in shareholders' interests.
77
Six factors that determine a board's effectiveness
1. Structure of the board: analysts specifically want to look for CEO duality.
2. Board independence: independent directors are more likely to prevent management from self-serving behavior.
3. Board committee
4. Skills and experience of board
5. Composition of board: small, diverse boards of directors are generally more effective than large boards made up of directors w/ similar backgrounds
6. Other board evaluation considerations
78
CEO duality
When the chairman of the board is also the CEO of the firm.
## Footnote
* This is typically a negative quality in the board
79
True or false: Ideally, a board of directors should primarily be comprised of outside directors?
TRUE
80
True or false: Board members w/ long tenures is always an asset?
False, it can be an asset but it can also be a liability due to resistance to change.
81
Clawback policies
Policies that allow firms to reclaim past compensation if inappropriate conduct comes to light (ex: violation of law, misreported financial statements).
82
Say-on-pay rules
Rules that give shareholders the opportunity to vote on executive compensation.
## Footnote
* This is especially relevant in recent years as the difference between executive and avg. employee pay has been increasingly scrutinized.
83
True or false: For both dividend and FCFE coverage ratios, ratios that are below industry averages OR trending downward over time indicate problems for dividend sustainability?
TRUE
84
True or false: Board committees related to financial reporting, management selection, and management compensation do not need to be sufficiently independent?
False, they should be. With some companies, sufficiently may just be majority.
85
What makes ESG factors material?
Their impact on a firm's share price, its operations, or other financial aspects.
86
When evaluating ESG, analysts should first determine which ESG factors are most relevant to that industry:
* ESG data providers
* Industry organizations
* Proprietary methods: Which reports to look at (ex: 10Ks, annual reports, etc.)
87
True or false: The amount of required ESG disclosures has increased and become more important in recent years?
True, however these disclosures are purely voluntary and there is no uniformity. Analysts should consider the investment horizon and materiality of info.
88
True or false: The methods used to identify applicable ESG factors between fixed-income and equity securities is the same and so is the way we evaluate them?
False, the methods used to identify applicable ESG factors between fixed-income and equity securities is the same, however we must evaluate them differently.
89
How to identify and evaluate fixed-income securities for ESG risk
Fixed-income analysts usually will focus on ESG factors' downside risks (risks that would make the price of the security decline). For instance, potential lawsuits might cause analysts to adjust certain ratios.
90
Stranded asset issue
When a company's assets are likely going to become obsolete.
## Footnote
* ESG factors may render equipment obsolete. The value of a firm's long-term bonds are sensitive to this issue.
91
How to identify and evaluate equity securities for ESG risk
Equity analysts will usually consider the upside and downside impact of ESG factors when valuing a firm's stock. For example, an analyst may use a lower discount rate for a company that has environmentally friendly manufacturing processes.
92
Green bonds
Debt instruments used to fund projects related to the environment. Valuation of these bonds are the same as a normal bond, except that green bonds may command a price premium.
93
Greenwashing
Where a green bond's proceeds are not actually used for the environmental purpose advertised.
94
True or false: A company's projected cash flow statement, IS, or B/S may be adjusted by analysts to account for ESG factors?
TRUE
95
True or false: Management repurchases shares when they believe a stock is overvalued?
False, when a stock is undervalued
96
True or false: When calculating the WACC, we use the target weights of the company for debt and equity?
True.
For the CFA exam's purpose, assume that current market value-based weights reflect the company's target capital structure UNLESS TOLD OTHERWISE.
97
Top-down (macro) factors that impact the cost of capital:
* Capital availability: Economies with plentiful availability of capital will have lower cost of capital. Developed markets have more capital availability.
* Market conditions: inflation, interest rates, and the state of the economy. Lower inflation leads to lower interest rates and the better an economy is doing, the less lenders need to add for a risk premium.
* Legal and regulatory considerations: Common law systems typically have lower risk premiums.
* Tax jurisdiction: The higher the marginal tax rate, the greater the tax benefit of using debt.
98
Bottom-up (firm specific) factors that affect cost of capital:
* Business/operating risk: The more volatility to a firm's operations (revenues), the higher the risk premium on debt.
* Asset nature and liquidity: Since firms' assets serve as collateral for debt, and therefore assets with a higher recovery rate (less risk) will require a lower risk premium.
* Financial strength and profitability: Firms w/ higher profitability, cash generation, and lower leverage have a lower risk premium. Debt/EBITDA is a common ratio used.
* Security features: Embedded call options make a security less desirable and raise the risk premium. Secured debt has a lower risk premium.
99
Customer concentration risk
Companies that generate most of their revenue from only a few customers
## Footnote
* Leads to higher operating risk
100
True or false: Firms with tangible, non-specialized, and more liquid assets have a higher recovery rate and therefore a higher risk premium?
False, firms with tangible, non-specialized, and more liquid assets have a higher recovery rate and therefore a lower risk premium.
101
Cumulative preferred stock
Preferred stock w/ a provision that says if any dividends are missed in the past, the dividends owed must be paid out to cumulative preferred shareholders first.
102
Weighted average cost of capital
The cost of debt and equity that finance a company's assets
103
Cost of debt
The effective interest rate that a company pays on its debt
104
Cost of equity
Return investors require to willingly lend their funds.
105
Factors that affect the estimated of COD
* Whether the debt is publicly traded
* How much liquidity does the debt have?
* Whether the debt is rated or not
* Which currency the debt was issued in: Every currency has its own yield curve
106
How to value COD if the debt is publicly traded vs thinly traded?
If publicly traded: The YTM for the longest maturity straight debt outstanding is the best estimated for COD.
If not traded: Use a proxy- the YTM on similar companies' debt. We can also use matrix pricing to consider the yields on traded securities w/ the same maturity and credit ratings.
107
How to estimate COD using matrix pricing
1. Calculate the YTMs of each of the comparable bonds
2. Construct a matrix with maturities of the comparable bonds on the y-axis and coupon rates on the x-axis.
3. Calculate the average yield for each y-axis value.
4. Use linear interpolation to determine the YTM for the maturity of bond you are trying to value.
108
Linear interpolation calculation
Interpolated yield = yield of the comparable bond w/ the shorter maturity + [ (yield of the comparable bond w/ the longer maturity - yield of the comparable bond w/ the shorter maturity) ÷ (the higher of the maturities of the comparable bonds - the lower of the maturities of the comparable bonds) ] * (maturity of the bond you are trying to value - lower of the maturities of the comparable bonds)
109
How to estimate COD w/ a bank loan
Use the interest rate the bank charges
110
How to estimate COD of a lease
Use rate implied in the lease (RIIL). RIIL calculation: This is a time value of money equation where you will need a calculator. Maturity is the length of the lease, payment is the annual payment due, the FV is the lease residual value. And we need to calculate PV.
PV of RIIL: PV of lease payments + PV of residual value ORMV of leased asset + lessor's initial direct cost
111
How to estimate COD of a lease if the terms of a finance lease are not disclosed?
Usually, the terms of a finance lease are disclosed, but if they aren't use the incremental borrowing rate (IBR).
Incremental borrowing rate = the rate on a new secured loan over the same term
112
Country risk rating (CRR)
For foreign borrowers, COD should include a country risk premium. CRR reflects risks related to economic conditions, political stability, exchange rate risk, and the level of capital market development.
113
Equity risk premium (ERP)/market risk premium
The extra return over the risk-free rate that an investor demands in order to invest in equities.
114
Historical estimates
1/2 types of ways to estimate ERP. This is the difference between the historical mean return of a broad-based equity index and the risk-free rate. Analysts using the historical method have four important decisions:
* Index selection
* Sample period: typically, the longer the better.
* Mean type: Arithmetic or geometric mean. Geometric mean is usually preferred while arithmetic is easier. Arithmetic is used to calculate one period return. Geometric is better for terminal value calculations.
* Risk-free proxy: short-term or long-term government bonds.
115
Pros and cons of historical estimates:
Pros: Simple & objective
Cons: There is an assumption that the mean and variance of the returns are constant over time. Also, it may have survivorship bias- it will be upward-biased if only firms that have survived during the period of measurement are included in the sample.
116
Forward-looking estimates/ex-ante estimates
1/2 types of ways to estimate ERP. These use current info and expectations concerning economic and financial variables. Three main types of forward-looking estimates:
* Survey estimates.
* Dividend discount models.
* Estimates from macroeconomic modeling.
117
Survey estimates
Survey estimates of ERP are simply a consensus of opinions among finance experts.
## Footnote
* Typically result in higher ERPs for developing markets.
* Tend to be biased toward recent market returns.
118
Dividend Discount Model/Gordon Growth Model/Constant Growth Model
Recall, the Gordon Growth Model is used to value the intrinsic value of a stock. However, we can also use it to find ERP of a market.
Calculation: ERP = (D ÷ V) + g - RfD = Expected dividend yield on a broad-based index
V = earnings growth rate for the index
g = constant growth rate/capital gains yield on the index. This assumes a constant growth rate in earnings and dividends.
119
What comprises a company's ERP?
Systemic ERP (market risk premium) and company's individual risk premium (company's risk compared to average firm's risk)
## Footnote
* A company's individual risk premium can be negative (less risky than the average firm)
120
Pros and cons of forward-looking approach:
Pros: Do not rely on assumptions & less subject to survivorship bias
121
Macroeconomic models
We use the Grinold-Kroner model. Recall, under the Grinold-Kroner model, capital gains yield (g) = Real EPS growth + inflation + △ in shares outstanding + expected repricing (△ in P/E)
## Footnote
* △ in shares outstanding reflects the net buyback of stocks
* So, we can use this to find ERP: ERP = (Dividend yield + △ in P/E + inflation + Real EPS growth +△ in shares outstanding) - Rf
122
How to estimate expected inflation
[ (1 + YTM on a U.S. Treasury) ÷ (1 + YTM on an inflation-protected Treasury security) ] - 1
123
Macroeconomic model example:
Assume the S&P 500 is used as an index. Dividend yield = 1.2%. Real GDP growth = 3%. 10-year Treasury yield = 2.4%. 10-year TIPS yield = 0.25%. There is no net change in shares outstanding and the Rf is 0.50%. Calculate ERP
inflation = [ (1 + .024) ÷ (1 + .0025) ] -1 = 2.14%
dividend yield = .012
change in P/E = 0
change in shares outstanding = 0
expected repricing = .03
ERP = .012 + .03 + .0214 + 0 - 0.005 = 5.84%
124
Dividend Discount Model (DDM)
1/4 ways to estimate COE for a specific company.
Calculate: COE = Dividend yield + capital gains yield
* This formula can only be used if earnings growth is constant. If it's not constant, we use a 2-stage approach.
2-stage DDM: current stock price (CF0 on calculator) + (dividend in period 1 ÷ (1 + COE)) + (dividend in period 2 ÷ (1 + COE)^2) ... + ((dividend in period n + expected stock price) ÷ (1 + COE)^n).
* Use each of these to compute IRR which will serve as our COE figure.
125
Bond-yield-plus-risk-premium (BYRPM) method
1/4 ways to estimate COE for a specific company. This is an approach for estimating COE for a firm that has publicly traded debt. An issue w/ this approach is that the risk premium is rather arbitrary and if a firm has several debt securities, there is no perfect one to use.
Calculation: YTM of firm's long-term debt + risk premium.
* Risk premiums is usually the average of the historical difference between COE and COD.
126
BYRPM example:
Firm A has bonds w/ 15 years to maturity, a coupon of 8.2%, and a price of 101.70. The risk premium is 3.8%. What is COE using BYRPM?
YTM:
N=15,
I/Y=x,
PV=101.70,
Coupon= (100 * .082) = 8.2,
FV=100 → I/Y = 8.00%
COE = .08 + .038 = 11.8%
127
CAPM method
1/4 ways to estimate COE for a specific company. This is a risk-based model.
Calculation: COE = Rf + β * market risk premium
* We can use the market model to estimate CAPM's beta. This is where we regress historical return on the stock against the return on a broad-based equity index.
* To estimate the beta of a private company, the beta of a comparable public firm may be used after unlevering and relevering it.
128
Multifactor models
1/4 ways to estimate COE. These are risk-based models. These models can have greater explanatory power compared to CAPM.
Calculation: COE = Rf + risk premium 1 + risk premium 2 ... + risk premium n
Risk premium = factor sensitivity (a.k.a factor beta) * factor risk premium
129
Fama-French model
A type of multifactor model that adds two additional factors to the CAPM model.
COE = Rf + β1* market risk premium + β2 * size premium + β3 * value premium
Size premium= avg. difference in return of small-cap portfolios over large-cap portfolios. Believes that small-cap stocks are riskier than large-cap.
Value premium= avg. difference in return of high book-to-market portfolios over low book-to-market portfolios. This is the relationship between BV and equity value.
β3 can be negative or positive. If growth is in style, β3 would be negative.
130
Five-factor Fama-French model
COE = Rf + β1* market risk premium + β2 * size premium + β3 * value premium + β4 * profitability premium + β5 * investment premium
* profitability premium= avg. difference in portfolio returns of firms w/ robust profitability over weak profitability
* investment premium= avg. difference in portfolio returns of firms w/ conservative investments over firms w/ aggressive investments*
131
How to estimate COE for private companies
Since private companies do not have market price data, the CAPM model and Fama French model cannot be used. A lack of liquidity and transparency increase the risk of investing in private companies. Appropriate risk premiums for private companies include: size premium, industry risk premium, and specific company risk premium.
## Footnote
* Specific company risk premium covers the unique risks of a private company- geographical risk, management risk, etc. These risks are difficult to diversify away.
132
Qualitative and quantitative factors that affect specific company risk premium (SCRP)
Qualitative:
* Industry that the firm operates
* Quality of corporate governance
* Type of asset (liquid asset = better collateral= less risk)
* Customer and supplier concentrations
* Geographic concentration
* Competition in the industry
* Mgmt quality
Quantitative:
* Operating and financial leverage, earnings volatility and predictability, and CF volatility.
* Higher volatility and higher leverage leads to more risk.
133
Expanded CAPM for private companies
COE = Rf + βpeer + size risk premium + industry risk premium + specific company risk premium
* Uses an industry beta
134
Build up approach
Starts w/ the risk-free rate, then adds the ERP (estimated using public company data), then adds size risk premium, industry premium, and specific company risk premium.
135
True or false: Since there are unique risks w/ emerging markets, we must add an additional risk premium for these types of firms?
TRUE
136
Country-spread model
Estimates a country risk premium (CRP)/country spread premium for a specific emerging market.
Calculation: ERP of emerging market = ERP of the developed market + (λ * CRP)λ = exposure of the company to the emerging market economy.
137
Sovereign yield spread
The difference in yields of emerging market government securities and developed market benchmark securities. We can use this as an estimate of CRP.
Calculation: CRP = sovereign yield spread * (σ of emerging market's equity market ÷ σ of emerging market's bond market)
138
Global CAPM (GCAPM)/Extended CAPM
A way to estimate COE for firms operating globally. This approach uses a global market index to estimate ERP.
## Footnote
* Since the beta coefficient uses a global market proxy, it's usually low or even negative. To adjust for this, we MAY add a second factor representing the local market.
139
International CAPM (ICAPM)
A way to estimate COE for firms operating globally. This is a 2-factor model based on a global market index and a foreign currency-denominated ***wealth-weighted market index***.
COE = Rf + βg * [ (global market return - Rf) + βc * foreign currency index return - Rf ]
βg = sensitivity to the global market index. Measures the firm's relationship w/ the local economy relative to the global economy. Lower values indicate less integration w/ the global economy.
βc = sensitivity to the foreign currency index. Measures the sensitivity of the firm's CFs to changes in its local currency exchange rate.
140
True or false: Companies w/ global operations in developed markets or developing markets should use GCAPM and ICAPM?
False, for firms w/ operations only in developed markets, GCAPM or ICAPM are appropriate approaches for estimating COE. For companies w/ operations in developing economies, the appropriate approach is less well defined. We can use a CRP if we assume that the historical estimate is an accurate representative of the risk premium going forward.
141
Synergies
The concept that the combined value and performance of two companies will be greater than the sum of the separate individual parts. Synergies can be:
Cost synergies= lower expenses (ex: economies of scale, reduction of redundant functions)
OR
revenue synergies= high revenues (ex: reduced competitive pressure)
OR
a combination of the two
142
True or false: There can be negative synergies?
True, negative synergies can arise inefficiencies such as diseconomies of scale.
143
Types of corporate transactions:
* Investment transactions
* Divestment transactions
* Restructuring transactions
144
Investment transactions
Transactions that increase the size or scope of the company or scope of the company's operations, which will thus increase the company's revenues and/or revenue growth rate.
## Footnote
* Firms do this to realize synergies, increase growth, improve capabilities, acquire personnel, or just to acquire an undervalued target.
145
Divestment transactions
Transactions that sell of subsidiary business interests. These are transactions that reduce the size or scope of a company by eliminating functions of the company that have lower profitability, slower growth, or higher risk.
## Footnote
* Firms do this for liquidity, valuation, to refocus on a certain function, or for regulatory purposes.
146
Restructuring transactions
Transactions that do not change the size or scope of the company but improves the cost structure and capital structure to increase profitability, increase growth, or reduce risk. Companies may use these types of transactions to recover from financial challenges, including bankruptcy and liquidation.
## Footnote
* Cost restructuring may be evaluated as estimated savings as a percentage of sales.
147
What are the two top-down drivers (what macro variables have a role in corporate restructuring) of each of the three types of corporate transactions?
* High security prices: When security prices are high (economy is doing well), there is more corporate transactions due to greater CEO confidence, lower cost of capital, and an overvalued stocks.
* Industry shocks: Corporate restructuring tends to have industry-specific waves (ex: an industry has many mergers).
## Footnote
* Data shows that transactions in a weak economy create more value.
148
Types of investment transactions:
* Equity investment: Can be done to establish a strategic partnership between firms, take an initial step towards an eventual acquisition, or just because it's a good investment.
* Joint venture: commonly used to enter a new (often foreign) market
* Acquisition
149
Types of divestment transactions:
* Sale of division: The sale can be to another company and the proceeds can either be returned to the shareholders or otherwise reallocated to better use.
* Spin-off: Separating part of a firm into a new, independent company. This does not generate any proceeds.
150
Types of restructuring transactions:
Recall, these restructurings DO NOT change the size or scope of the firm.
* Cost restructuring: Typically done because of underperformance in order to pursue increased operational efficiency.
* B/S restructuring: Changing the mix of assets, the capital structure, or both.
* Reorganization: May be mandated by a court in the event of insolvency.
## Footnote
* Mgmt's restructuring plan must be approved by the court, if it's not approved, the company may be liquidated.
151
True or false: Both a cash dividend and a share repurchase for cash leave shareholder wealth unchanged?
True
152
True or false: An optimal pice range for stocks does not exist?
False, there is a widespread belief in financial circles that an optimal price range exists for stocks. There is little empirical evidence to support this theory, however.
153
True or false: Empirical studies suggest that corporate transactions taken during stronger economic times tend to create more value?
False, corporate transactions taken during weaker economic times tend to create more value.
154
The steps involved in analyzing an announced corporate action include:
1. Initial evaluation
2. Preliminary valuation
3. Modeling valuation
4. Update investment thesis
155
True or false: Weights of debt and equity are calculated using most recent book values, and include any financing raised or additional equity issued?
False, weights of debt and equity are calculated using most recent market values, and include any financing raised or additional equity issued.
156
True or false: If interest rates were to increase, it would make retained earnings a more attractive way of financing new investment; as a result, the payout ratio would be more likely to decline?
True
157
Best way for companies to distribute excess cash
Since most shareholders prefer stable regular dividends, companies should use stock buybacks or special dividends. Stock buybacks are better if mgmt. wants to preserve flexibility.
CFA
flashcards
Decks in class (12)
# Cards
-
CFA L2 Quant196
-
CFA L2 Econ157
-
CFA L2 FSA Part (1/2)155
-
CFA L2 FSA (Part 2/2)162
-
CFA L2 Corporate Issuers157
-
CFA L2 Equity Valuation (Part 1)115
-
CFA L2 Equity Valuation (Part 2)144
-
CFA L2 Fixed Income213
-
CFA L2 Derivatives131
-
CFA L2 Alternative Investments152
-
CFA L2 Portfolio Management199
-
CFA L2 Ethics86
