06 Aug Please do a well-parapharsed work
CH 5
1-
Common stocks are more risky than U.S. government bonds. Risk-averse investors demand higher returns on common stocks than government bonds as compensation for the added risk. If returns on government bonds were, on average, as high as those on common stocks, prices of government bonds would rise and prices of common stocks would fall as investors fled to the safer but equally promising bonds. This would result in lower expected returns on bonds for new investors and higher expected returns on stocks until the tradeoff of risk for return reappeared.
2-
The fact that government bonds earned a higher rate of return than common stocks in one year is not evidence that investors are suddenly willing to settle for lower returns on stocks than bonds. It means that investors’ expectations were not met, or said differently, that investors were surprised. To take on additional risk, risk-averse investors require additional expected return. But expected returns are not the same as realized returns. Because stocks and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in some years. But the expected returns on common stocks will always be higher than the expected returns on government bonds.
3-
The percentage of the company owned is most important to the investor. This determines the size of her claims on company cash flows and, hence, the value of her investment. A company’s share price, and the number of shares outstanding, can be arbitrarily changed by splitting the shares. Share price and number of shares owned are of interest only to the extent that they help the investor calculate more meaningful dollar or percentage ownership numbers.
4- Yields on callable bonds will be higher, investor takes risk by taking the callable bonds beacuse issuer will call the bond if interest rate declines. So issuer has to compensate the investor for taking the risk by investing in callable bonds.
7-
a-
Stock Price – 8% Underpricing = Issue price
$75.00 – 6.00 = 69.00
Issue price- 7% Spread = Net to company
69.00 – 4.83 = $64.17
Number of shares = $500 million / $64.17 = 7.79 million
b- Investment bankers’ revenue = $4.83 x 7.79 million = $37.63 million
c- Underpricing is not a cash flow. It is, however, an opportunity cost to current owners because it means that more shares must be sold to raise $500 million and each existing share will represent a smaller ownership interest in the company. P.S. Opportunity costs are just as real as cash flow costs.
CH 6
2. Operating leverage is the substitution of fixed- for variable-cost methods of production. Like financial leverage, sales must increase to cover the higher fixed costs, but once covered, profits rise more rapidly. Financial leverage requires higher cash flows to cover the higher interest payments, but once covered, profits accruing to shareholders grow more quickly with additional sales. One would not expect to find both high operating leverage and high financial leverage at the same firm, as both types of leverage magnify the risks borne by equity
3. Because all firms face business risk, company EBIT varies over time. Debt is a fixed income security, meaning interest expense does not vary with EBIT. As a result, all of the variability in EBIT is borne by equity investors, who hold a residual income security. As leverage increases, the same variability in EBIT is borne by a smaller equity investment, causing variability per dollar invested to rise. This results in increased volatility in shareholder returns or increased risk. Also, as evident from the range of earnings chart, leverage increases the slope of line relating EBIT to EPS or ROE, and the steeper the slope, the greater the variability in EPS, and ROE, for any given variability in EBIT.
4. Companies can incur significant costs of financial distress without going bankrupt. In fact, these costs are often much larger than the cost of bankruptcy itself. Costs include lost profit opportunities due to cut backs in investment, R&D, and marketing to conserve cash. They also include lost sales as potential buyers worry about the ability of the business to service its products and increased costs as suppliers become less willing to enter into long run contracts and to provide trade credit. In knowledge-based companies, top producers may depart as the company’s stock-based compensation becomes less attractive. Detrimental conflicts of interest among owners, creditors, and managers can also arise when a company gets into financial difficulty, even in the absence of formal bankruptcy.
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