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Finance & Accounting

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Table of contents page

1. Introduction


2. Theory


A complete summary of the exam relevant theory 2.1 Finance 2.2 Accounting

3. Solutions to Tasks


Detailed solutions to all in-class tasks of the block. 2.1 Finance (Task 1 – 13) 2.2 Accounting (Task 14 – 25)

4. Article summaries


Summaries of the Finance articles, which are exam-relevant literature

5. Glossary


6. Trial Exams (incl. extensive solutions)

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1. Introduction was founded in September 2008 by two students from the University of Maastricht for students from the University of Maastricht, who influence the seminars with their own impressions and experience of the courses. cooperates with, which is the proven counterpart of at the University of St. Gallen Switzerland. As you, we had and wanted to pass the exams and from our own experience we know how difficult it can be to deal with problems like time pressure and organization of the study material. Finance and Accounting The Finance and Accounting exam you are facing will be a True / False exam. The seminar is separated into a Finance part and an (Financial) Accounting part. The exam consists of quantitative questions – calculations - as well as qualitative questions – definitions. The required readings for the exam are: For Finance - Berk and DeMarzo - Corporate Finance, Chapters 10-22, 23.1, 24 + Articles available on eleUM ( article summaries in script) For Accounting - Harrison and Horngren – Financial Accounting, Chapters 1-3, 5-8, 12, 13 (ch. 8: pp. 413-422) For Both: - Lectures

How to prepare the exam: To optimally prepare the exam we provided you with a folder. After the seminar you should first try to understand the whole theory of the seminar (with your notes) and the theory script. The tasks incl. solutions from the tutorials will help you to understand the theory ( task script). You should also lay a focus on definitions, which you can easily learn gain points in the exam with these. Just sit down together with a friend and ask each other the definitions (glossary). In the last days before the exam you should mainly focus on the trial exams, with the help of the formula sheet. A year’s exam always contains a decent amount of old year’s questions.

We hope that we could help you with our seminar wish you GOOD LUCK with your exams!!! Your team

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Theory & Formulas In the following part you will find explanations of all the relevant topics of the course. It contains all essential principles and formulas, as well as rules, you need to know. It is very important that you understand the theory in order to able to apply it later in the exam. Before doing practice exams you should work through this part.

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2. Theory 2.1 Finance 1. Capital Markets – Risk & Return The general principle underlying investments of each kind (stocks, bonds, options etc.) is that investors in general do not like risk and demand a risk premium to bear it.

1.1 Risk – Common vs. Independent Risk Over a given time period, the risk of holding a stock is that the dividends plus the final stock price will be higher or lower than expected, which makes the realized return risky. There are two types of risk: firm-specific risk – risk due to firm-specific news. Risk that does not affect the whole market, but only one firm or a small number of firms. Also called idiosyncratic, unsystematic, unique or diversifiable risk. systematic risk – risk due to market-wide news. Risk that affects all companies to some degree. Also called undiversifiable or market-risk. As the names already suggest, firm-specific risk can be diversified/averaged out in a (large) portfolio. Contrary systematic risk can not be diversified in a portfolio, since it affects all or most of the firms in the portfolio. Whereas investors are not compensated for holding firm-specific risk, they expect a risk premium for holding systematic risk. A portfolio that contains only systematic risk (where all unsystematic risk is diversified) is called an efficient portfolio. The systematic risk of such an portfolio can be measured by it’s beta – the expected percent change in the excess return of a security for a 1% change in the excess of the market portfolio.

1.2 Measuring Risk As mentioned a stock/portfolio contains two kinds of risk: - diversifiable risk and - undiversifiable risk

1.2.1 Variance / Standard Deviation (Volatility) Stocks: Variance and standard deviation both measure the variability of the returns. The standard deviation is also referred to as a stocks volatility. Variance: 5 – Finance & Accounting

The expected squared deviation from the mean. Standard Deviation: (Volatility) The square root of the variance.

Portfolios: By holding portfolios of stocks with more than two stocks, firm-specific risk can be diversified and therefore total risk can be reduced. In order to calculate the volatility of a portfolio we need the covariance. Covariance: (T = nr. of returns, R = return,

= expected return)

The expected product of the deviations of two returns from their means. Variance: ( = weight, amount of i held in the portfolio) The weighted average covariance of each stock with the portfolio Standard Deviation: (Volatility)

Each security contributes to the volatility of the portfolio according to its volatility, scaled by its correlation with the portfolio.


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1.3 CAPM – The capital pricing model The CAPM enables us to calculate the cost of capital for an investment. A firm’s cost of capital for an investment or project is the expected return that its investors could earn on other securities with the same risk and maturity. The underlying assumption of the CAPM is that the market portfolio is an efficient portfolio – there is no way to reduce risk without lowering its return. The cost of capital, r, for investing in a project with a beta, ß, is:

1.3.1 The Capital Market Line The capital market line, which is the line from the risk-free investment through the market portfolio, represents the highest expected return available for any level of volatility.

The CAPM assumes an efficient market portfolio. Since investors are only paid a risk premium for the market risk (since firm-specific risk is diversified away), the appropriate measure of risk to determine a security’s risk premium is it’s beta.

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1.3.2 The security market line The security market line (SML) shows the required return for each security as a function of its beta with the market.

See: Task 1

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2. Capital Structure The capital structure is the relative proportions of debt, equity and other securities in order to raise funds. The most common choices are financing through either equity alone or through a combination of debt and equity. - Equity in a firm with no debt is called unlevered equity. - Equity in a firm that also has debt outstanding is called levered equity.

2.1 Modigliani-Miller Modigliani and Miller introduced the concept of perfect capital markets.

2.1.1 Modigliani-Miller (without taxes) Assumptions: - No taxes - No transactions costs - Individuals and corporations borrow at same rate - A firm’s financing decision does not change the cash flows generated by its investments

MM Proposition I: In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Through homemade leverage, individuals can either duplicate or undo the effects of corporate leverage.

MM Proposition II: The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. Cost of Capital of Levered Equity:

The cost of equity rises with leverage, because the risk to equity rises with leverage (bondholders are paid first).

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2.1.2 Modigliani-Miller (with taxes)

Assumptions: - Corporations are taxes at the rate TC on earnings after interest - No transactions costs - Individuals and corporations borrow at same rate

MM Proposition I: The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.

Since corporations can deduct interest payments but not dividend payments, corporate leverage lowers tax payments.

MM Proposition II: The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. Cost of Capital of Levered Equity:

The cost of equity rises with leverage, because the risk to equity rises with leverage (bondholders are paid first).

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2.2 Personal Taxes The value of a firm is equal to the amount of money the firm can raise by issuing securities. The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive, after all taxes have been paid. Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm value. After-Tax Cash Flows To debt holders To equity holders = Tax on Interest Income = Corporate Tax = Tax on Equity Income It depends: =


Effective Tax Advantage of Debt

2.3 WACC The portfolio of a firm’s equity and debt replicates the returns we would earn if it were unlevered. As a consequence, the cost of capital of the firm’s assets can be calculated by computing the weighted average of the firm’s equity and debt cost of capital, which is the weighted average cost of capital (WACC): (without taxes)

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(with taxes)

The value of the firm can be found in a similar way in which the value of a project is found: As the present value of the discounted future cash flows. Now, the lower the WACC (=discount rate), the higher the firm value. Finding the lowest WACC leads to the optimal capital structure.

See: Task 5

2.4 Tradeoff Theory The tradeoff theory weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage.

The present value of financial distress costs is determined by two factors: - the probability of financial distress - the magnitude of the costs after a firm is in distress

2.4.1 Agency Costs

Agency Benefits of Leverage: - Concentration of Ownership (allows original managers of the firm to maintain their equity stake) - Reduction of Wasteful Investment - Commitment (tie managers’ hands because of the threat of financial threat)



Finance & Accounting Sample