Financial Markets and Capital Budgeting: Concepts and Calculations, Prove d'esame di Finanza

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DOMANDE ESAME FINANCIAL MARKETS FOR CORPORATE - If there is an arbitrage opportunity: we can make profit without taking any risk or making any investment - For businesses: financial intermediaries are the most important source of external funds - A call provision in bonds: allows the issuer to repurchase the bonds before the maturity - In capital budgeting decisions: interest expense is typically not included - The enterprise value is equal to the market value of equity + debt – cash - The free cash flow of a project is: the incremental cash generated by the project - The aggregate funding risk in loan commitments: Stems from the difficulty of meeting all of the loan commitments during a credit crunch - In indirect finance: A financial institution stands between the lenders and the borrowers - According to the law of one price: equivalent investment opportunities must trade for the same price if markets are competitive - Money markets are: markets where short-term debt securities are traded - Moral hazard problems: debt contracts reduce moral hazard - Mortality rate models: estimate the PD from past data on defaults - Net present value of a project: is the difference between the present value of benefits and the present value of costs - The true picture of networth: should consider the contingent value of equity (=contingent assets -contingent liabilities) - Primary markets: Are where a corporation itself issues new shares of stock - The profitability index is: ratio between the NVP of the project and the resources that are need - In RAROC models: if risk increases, the RAROC decreases - Secondary markets: are markets where securities can be resold - Value stocks are stocks with a low market-to-book ratio - In wholesale credit decisions: both quantity and pricing adjustments are used when making a loan - Present and explain briefly the 3 potential pitfalls in using the IRR rule (as compared to the NPV rule) the IRR rule and NPV rule may be in conflict in these situation. 1. Delayed Investments (The IRR is greater than the cost of capital so the IRR rule indicates you should accept the deal but the NPV is negative, so you should reject the deal), 2. Multiple IRRs (Because there is more than one IRR, the IRR rule cannot be applied, so you calculate only the NPV), 3. Nonexistent IRR (No IRR exists because the NPV is positive for all values of the discount rate. there is no discount rate that makes NPV equal to zero. Thus the IRR rule cannot be used). While the IRR rule has shortcomings for making investment decisions, the IRR itself remains useful. IRR measures the average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital. - CAPITAL BUDGETING Explain the difference between opportunity cost, project externalities and sunk costs. Provide an example for each of them. - Opportunity Cost: the value a resource could have provided in its best alternative use. So it’s is the value of what you will lose or miss out on when choosing one possibility over another. For example, the opportunity cost of taking a vacation instead of spending the money on a new car is not getting a new car. - PE is when the profits of other business activities of a firm are affected because of some indirect effects. Cannibalization is when sales of a new product displaces sales of an existing product. - Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken. Past Research and Development Expenditures are an example of money that has already been spent. - Investment decision rules: explain the payback rule and its pittfalls The payback period is amount of time it takes to recover or pay back the initial investment. If the payback period is less than a pre-specified length of time, you accept the project. Otherwise, you reject the project. The payback rule is used by many companies because of its simplicity. Pitfalls 1. Ignores the project’s cost of capital and time value of money. 2. Ignores cash flows after the payback period. 3. Relies on an ad hoc decision criterion. - Describe what linear discriminant models are and their problems 2) the expected ROA if the probability of repayment is 95% - An FI wants to evaluate the credit risk of a €3.5 million loan with a duration of 3.2 years to a AAA borrower. There are currently 270 publicly traded bonds in that class (i.e., bonds issued by firms with a AAA rating). The current average level of rates (R) on AAA bonds is 6.2%. The largest increase in credit risk premiums on AAA loans, the 99 percent worst scenario, over the last year was equal to 1.4%. The projected one year spread on the loans is 0.25% and the FI charges 0.3% of the face value of the loan in fees. Calculate the capital at risk (i.e., loan risk) and the RAROC on this loan. (Report all calculations) - An Fl wants to evaluate the credit risk of a € 4 million loan with a duration of 4.1 years to a BBB+ borrower. There are currently 300 publicly traded bonds in that class (i.e. bonds issued by firms with a BBB+ rating). The current average level of rates (R) on BBB+ bonds is 7.3%. The largest increase in credit risk premiums on BBB+ loans, the 99 percent worst scenario, over the last year was equal to 2.6%. The projected one year spread on the loans is 0.30% and the FI charges 0.4% of the face value of the loan in fees. Calculate the capital at risk (i.e., loan risk) and the RAROC on this loan. - An FI wants to evaluate the credit risk of a €4.3 million loan with a duration of 4.1 years to a AAA borrower. There are currently 310 publicly traded bonds in that class (i.e., bonds issued by firms with a AAA rating). The current average level of rates (R) on AAA bonds is 5.7%. The largest increase in credit risk premiums on AA loans, the 99 percent worst scenario, over the last year was equal to 2.1%. The projected one year spread on the loans is 0.40% and the Fl charges 0.15% of the face value of the loan in fees. Calculate the capital at risk (i.e., loan risk) and the RAROC on this loan. (Report all calculations) - You want to set up a retail company in Germany. There are 4 possible businesses that might be successful in the local market. Select the best business on the base of the NPV rule. How much is the IRR of each project? Project Initial investment (€) First-year cash flow Growth rate Cost of capital Italian food 125000 25000 3% 5% Second-hand clothes 80000 15000 5% 6% Electronics 220000 40000 2% 5% Co-working 195000 30000 4% 5.5% - You want to set up an import-export company of food products in a foreign country. There are 4 possible products that might be successful in the local market. Select the best product on the base of the NPV rule. How much is the IRR of each project? (Report all calculations) Project Initial investment (€) First-year cash flow Growth rate Cost of capital Parmesan cheese 800000 40000 3% 5.5% Processed porkmeat 650000 30000 2% 6% Gluten-free pasta 570000 25000 4% 5.5% Extra virgin olive oil 750000 35000 3% 5% - You want to open a shop in your town. Alter on in-depth market research, you have come up with 4 possible types of business that might be successful. Choose the business on the base of the NPV rule. report all the calculations in the box below. Project Initial investment First-year cash flow Growth rate Cost of capital Baker 175 30 5% 6% Fast food 400 85 4% 7% Book store 350 75 3% 7% Nail saloon 200 65 6% 8% - NPV decision rule and profitability index A car producer has a total staff of 95 engineers. According to the strategic plan, the enterprise will be starting the production of 3 new models. However, the limited number of engineers will probably allow to actually implement the production of 1 or 2 models. By using the methodology of the profitability index, which projects will the enterprise be able to start? (REPORT BELOW THE STEPS IN THE CALCULATION). Select in the list below all projects that can be implemented (can tick more than one) Model Initial investment (€) First-year cash flow Growth rate Cost of capital Engineering headcount Supercar 200 30 2.5% 6% 60 Minivan 250 40 2% 6.5% 50 Electric car 100 15 3% 5% 40