"investment Valuation, Exam 3" Brett Olsen, Bus 409

Front 1

Covered interest arbitrage

Back 1

finding arbitrage in interest rates between countries

Front 2

Interest rate parity

Back 2

the arbitrage-induced relationship between interest rates and exchange rates

Front 3

Pros of hedging (buyer)

Back 3

-decreases volatility by reducing downside risk
-decreased volatility "smooths" earnings, allowing more accurate forecasts
-smoother earnings reduces stock price volatility, which leads to a decrease in cost of equity (by reducing beta)
-reduced stock price volatility leads to a reduced cost of debt via improved credit rating
-reduced costs of debt and equity translate to a reduced overall cost of capital

Front 4

Cons of hedging (buyer)

Back 4

-requires extra premium
-limits upside potential

Front 5

Valuation method advantages & disadvantages:
Book Value

Back 5

Advantages:
-Simple
-"Authoritative"

Disadvantages:
-Ignores some assets and liabilities
-Historical costs: backward-looking
-Subject to accounting manipulation

Front 6

Valuation method advantages & disadvantages:
Liquidation Value

Back 6

Advantages:
-Conservative

Disadvantages:
-Ignores "going concern" value
-(Dis)orderly sale?

Front 7

Valuation method advantages & disadvantages:
Replacement Value

Back 7

Advantages:
-"Current"

Disadvantages:
-Replace what?
-Subjective estimates

Front 8

Valuation method advantages & disadvantages:
Relative Valuation

Back 8

Advantages:
-Simple
-Widely used

Disadvantages:
-"Earnings" subject to accounting manipulation
-"Snapshot" estimate: may ignore cyclical, secular changes
-Depends on comparable firms: ultimately just a measure of relative, not absolute value

Front 9

Valuation method advantages & disadvantages:
Discounted Cash Flow

Back 9

Advantages:
-Theoretically based
-Rigorous
-Affords many analytical insights
-Cash focus
-Multiperiod
-Reflects time value of money

Disadvantages:
-Time-consuming
-Risks "analysis paralysis"
-Easy to abuse, misuse
-Tough to explain to novices

Front 10

What are the different valuation methods?

Back 10

-Book value
-Liquidation value
-Replacement value
-Relative valuation
-Discounted cash flow

Front 11

How are growth rates and free cash flow interdependent?

Back 11

As growth projection increases, CFs should increase and vice versa. You cannot change one without changing the other (e.g. you need cash to grow, and you need to grow to make more cash).

Front 12

What is terminal value?

Back 12

An estimate of the value of all future cash flows to a firm at a stable growth rate.

Front 13

What is the principle-agent relationship of firms?

Back 13

The agent takes care of the principles of the firm (not his own). Agents are owners (shareholders) who act as managers.

Front 14

What is an agency conflict?

Back 14

Owners want managers to run the firm in the owner's best interest, but managers tend to have some conflicting self-interests.

Front 15

How do you solve an agency conflict?

Back 15

Corporate governance - monitors for management
-board of directors
-auditors
-analysts
-takeover market
-market