Corporate Finance an der Technische Hochschule Nürnberg | Karteikarten & Zusammenfassungen

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TESTE DEIN WISSEN

Describe why negative NPV projects aren't invested in on the perfect capital market.

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TESTE DEIN WISSEN

Because on the perfect capital market, all participants have access to the same information. Therefore, investors are aware of the fact that the new project has a negative NPV. Investors won't let them do it. In fact, they'll sack management if it comes to it, as there's no transaction costs for doing this on the perfect capital market.

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TESTE DEIN WISSEN

What is a leveraged buy out? 

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TESTE DEIN WISSEN

When a former growth company matures and does not increase leverage, a smart investor may decide to purchase it, increase the debt and then sell, taking advantage of the higher company value thanks to the tax shield. 


If management themselves decide to do this, it is called a management buy out. 

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TESTE DEIN WISSEN

Which about the perfect capital market are true. 

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TESTE DEIN WISSEN

There's only one interest rate for borrowing and lending. Otherwise everyone would borrow low and invest high- everyone has same information. 

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TESTE DEIN WISSEN

What happens to free cash flow left after a company has invested in all positive NPV projects?

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TESTE DEIN WISSEN

1. Debt holders must be paid. This is compulsory. 

2. Decide how much of what's left will be poured out as dividends (dividend policy doesn't effect company value)

3. Use what's retained to invest in 0 NPV projects.

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TESTE DEIN WISSEN

What are the general assumptions of a perfect capital market?

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TESTE DEIN WISSEN

1. Atomistic market structure. Every participant is small and cannot change prices themselves. Changes occur only if "atoms" move together.


2. Assumption of complete information. All information available as of today is known by everyone. No one has an information advantage. 


3. No transaction costs. It is costless to monitor management's behaviour.

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TESTE DEIN WISSEN

Describe a possible NPV 0 project for a stock listed company to participate in.

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TESTE DEIN WISSEN

Share buybacks. Company buys back their own shares because on the perfect capital market they're always fairly valued (same information). No influence on company value or share price because they're fairly valued.


However if for whatever reason, the shares are worth more (too cheap on capital market) this is now a positive NPV project and company value will increase. Not relevant on perfect capital market.


Share buybacks are generally a good sign on the market. It means that shares are too cheap and people generally believe management about the true value. If share prices do not increase, then management will lose credibility and they cannot do this again. But this is all not relevant on the perfect capital market.

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TESTE DEIN WISSEN

Describe why on the perfect capital market, an unlevered company will be worth the same amount as a levered company with the exact same cash flows.

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TESTE DEIN WISSEN

Because you could ensure a safe profit today and pay 0 in the future. This works by shorting the equity of which ever company is worth more and buying the equity of the other company. 


If you're buying the equity of the unlevered company, you borrow the debt value on the capital market. (Value unlevered - equity levered - debt < 0)


if you're buying the equity of the levered company, you invest the debt amount of the levered company on the capital market. (Equity levered + debt - value unlevered > 0)

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TESTE DEIN WISSEN

Describe some risks of the tax shield 

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TESTE DEIN WISSEN

- The taxable base must be high enough so that all interests can be deducted. 

- Financial authorities may not accept some payments to be interest fees. 

- Tax rate or regime could change.

- Risk of bankruptcy 

- Risk of debt volume changing due to changes in financial policy.

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TESTE DEIN WISSEN

True or false. The tax shield is poured out to the investors of the company. Therefore, the tax shield increases the cash flow to equity holders and therefore the value of equity. 

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TESTE DEIN WISSEN

True 

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TESTE DEIN WISSEN

True or false. The equity value of the leveraged company is lower than that of the unleveraged company if the value of debt is higher than the value of the tax shield (value of tax shield lower than value of debt)

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TESTE DEIN WISSEN

True

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TESTE DEIN WISSEN

Describe why ALL projects with a positive NPV are realised.

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TESTE DEIN WISSEN

An increase of wealth always leads to higher utility and if someone were not maximising utility, they'd be irrational. This violates the general assumptions in economics so we ignore this irrational behaviour. 

Also because on a perfect capital market, everyone has the same information and if shareholders were aware of management not taking opportunities, they would sack them (no cost for this on perfect capital market).

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TESTE DEIN WISSEN

Describe the free cash flow and how to find it. 

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TESTE DEIN WISSEN

FCF is the cash flow that goes to shareholders after all NPV positive projects have been invested in. CF operating - CF investing

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Q:

Describe why negative NPV projects aren't invested in on the perfect capital market.

A:

Because on the perfect capital market, all participants have access to the same information. Therefore, investors are aware of the fact that the new project has a negative NPV. Investors won't let them do it. In fact, they'll sack management if it comes to it, as there's no transaction costs for doing this on the perfect capital market.

Q:

What is a leveraged buy out? 

A:

When a former growth company matures and does not increase leverage, a smart investor may decide to purchase it, increase the debt and then sell, taking advantage of the higher company value thanks to the tax shield. 


If management themselves decide to do this, it is called a management buy out. 

Q:

Which about the perfect capital market are true. 

A:

There's only one interest rate for borrowing and lending. Otherwise everyone would borrow low and invest high- everyone has same information. 

Q:

What happens to free cash flow left after a company has invested in all positive NPV projects?

A:

1. Debt holders must be paid. This is compulsory. 

2. Decide how much of what's left will be poured out as dividends (dividend policy doesn't effect company value)

3. Use what's retained to invest in 0 NPV projects.

Q:

What are the general assumptions of a perfect capital market?

A:

1. Atomistic market structure. Every participant is small and cannot change prices themselves. Changes occur only if "atoms" move together.


2. Assumption of complete information. All information available as of today is known by everyone. No one has an information advantage. 


3. No transaction costs. It is costless to monitor management's behaviour.

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Q:

Describe a possible NPV 0 project for a stock listed company to participate in.

A:

Share buybacks. Company buys back their own shares because on the perfect capital market they're always fairly valued (same information). No influence on company value or share price because they're fairly valued.


However if for whatever reason, the shares are worth more (too cheap on capital market) this is now a positive NPV project and company value will increase. Not relevant on perfect capital market.


Share buybacks are generally a good sign on the market. It means that shares are too cheap and people generally believe management about the true value. If share prices do not increase, then management will lose credibility and they cannot do this again. But this is all not relevant on the perfect capital market.

Q:

Describe why on the perfect capital market, an unlevered company will be worth the same amount as a levered company with the exact same cash flows.

A:

Because you could ensure a safe profit today and pay 0 in the future. This works by shorting the equity of which ever company is worth more and buying the equity of the other company. 


If you're buying the equity of the unlevered company, you borrow the debt value on the capital market. (Value unlevered - equity levered - debt < 0)


if you're buying the equity of the levered company, you invest the debt amount of the levered company on the capital market. (Equity levered + debt - value unlevered > 0)

Q:

Describe some risks of the tax shield 

A:

- The taxable base must be high enough so that all interests can be deducted. 

- Financial authorities may not accept some payments to be interest fees. 

- Tax rate or regime could change.

- Risk of bankruptcy 

- Risk of debt volume changing due to changes in financial policy.

Q:

True or false. The tax shield is poured out to the investors of the company. Therefore, the tax shield increases the cash flow to equity holders and therefore the value of equity. 

A:

True 

Q:

True or false. The equity value of the leveraged company is lower than that of the unleveraged company if the value of debt is higher than the value of the tax shield (value of tax shield lower than value of debt)

A:

True

Q:

Describe why ALL projects with a positive NPV are realised.

A:

An increase of wealth always leads to higher utility and if someone were not maximising utility, they'd be irrational. This violates the general assumptions in economics so we ignore this irrational behaviour. 

Also because on a perfect capital market, everyone has the same information and if shareholders were aware of management not taking opportunities, they would sack them (no cost for this on perfect capital market).

Q:

Describe the free cash flow and how to find it. 

A:

FCF is the cash flow that goes to shareholders after all NPV positive projects have been invested in. CF operating - CF investing

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