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ACTEX 2015 SOA Exam: CFE, U.S.

TABLE OF CONTENTS

VOLUME I

Section A – CORPORATE FINANCE

Berk, Chapter 8, Fundamentals of Capital budgeting A-1 to A-8 Berk, Chapter 18, Capital Budgeting and Valuation with Leverage A-9 to A-18 Berk, Chapter 22, Real Options A-19 to A-26 Berk, Chapter 23, Raising Equity Capital A-27 to A-32 Berk, Chapter 24, Debt Financing A-33 to A-40 F-113-14, Securitization, Insurance and Reinsurance A-41 to A-54 F-119-15, Capital Management, Banking’s New Imperative, McKinsey A-55 to A-62 F-120-15, Creating Value Through Best In Class Allocation, JP Morgan, October 2009 A-63 to A-68 F-121-15, Is the Company Using Its Capital Wisely? KPMG A-69 to A-70 F-123-15, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance, Vol 15, #1 A-71 to A-80 F-124-15, The Modigliani-Miller Theorems: A Cornerstone of Finance, Centre for Studies in Economics and Finance, May 2005 A-81 to A-84 Section B –DECISION MAKING

Berk, Chapter 1, The Corporation B-1 to B-4 Berk, Chapter 2, Introduction to Financial Statement Analysis B-5 to B-12 Berk, Chapter 3, Financial Decision Making and the Law of One Price B-13 to B-16 Berk, Chapter 17, Payout Policy B-17 to B-28 Berk, Chapter 25, Leasing B-29 to B-38 Berk, Chapter 26, Working Capital Management B-39 to B-46 Berk, Chapter 27, Short Term Financial Planning B-47 to B-54 Berk, Chapter 28, Mergers and Acquisitions B-55 to B-64 Berk, Chapter 29, Corporate Governance B-65 to B-76 Berk, Chapter 30, Risk Management B-77 to B-88

iv


F-120-15, Creating Value Through Best In Class Allocation, JP Morgan, October 2009 A-63 to A-68 F-123-15, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance, Vol 15, #1 A-71 to A-80 F-124-15, The Modigliani-Miller Theorems: A Cornerstone of Finance, Centre for Studies in Economics and Finance, May 2005 A-81 to A-84 F-126-15, An International Comparison of Capital Structure and Debt Maturity Choices, National Bureau of Economic Research B-89 to B-96 F-129-15, The Modigliani-Miller Theorem, The New Palgrave Dictionary of Economics B-97 to B-100 Section C – STOCHASTIC MODELING

Kemp, Chapter 1 C-1 to C-2 Hubbard, Chapter 5 D-21 to D-26 Layering your own view into a Stochastic Simulation by Tony Dardis SOA Risks and Rewards August 2013 C-3 to C-4 Section D – ADVANCED RISK ASSESSMENT TECHNIQUES

Hubbard, Chapter 1, (background) D-1 to D-4 Hubbard, Chapter 2, (background) D-5 to D-6 Hubbard, Chapter 3, (background) D-7 to D-14 Hubbard, Chapter 4 D-15 to D-20 Hubbard, Chapter 5 D-21 to D-26 Hubbard, Chapter 6 D-27 to D-32 Hubbard, Chapter 7 D-33 to D-42 Hubbard, Chapter 8 D-43 to D-48 Hubbard, Chapter 9 D-49 to D-58 Hubbard, Chapter 10 D-59 to D-66 F-107-13, A Market Cost of Capital Approach to Market Value Margins D-67 to D-74 F-130-15, Yield Curve Extrapolation: Work in Progress, Moody’s Analytics D-75 to D-80 A Risk Management tool for Long Liabilities: The Static Control Model, 2009 Enterprise Risk Management Monograph D-81 to D-88

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SECTION E – FINANCIAL RISK MANAGEMENT

Hubbard, Chapter 7 D-33 to D-42 Dowd, Chapter 10, Estimating Options Risk Measures E- 1 to E- 8 Dowd, Chapter 12, Mapping Positions to Risk Factors E- 9 to E-14 Dowd, Chapter 13, Stress Testing E-15 to E-22 Dowd, Chapter 15, Backtesting Market Risk Models E-23 to E-34 Dowd, Chapter 16, Model Risk E-35 to E-40

SECTION Q – REVIEW QUESTIONS Q-1 to Q-10

SECTION S – SOLUTIONS TO REVIEW QUESTIONS S-1 to S-12

Corporate Finance, Chapter 8


A-1

CORPORATE FINANCE, CHAPTER 8, FUNDAMENTALS OF CAPITAL BUDGETING

I. Introduction A. An important responsibility of corporate financial manager is determining which

project or investments a firm should undertake

B. Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept

C. The NPV rule allocate the firm’s resources to maximize its value

1. To implement the NPV rule, compute the NPV of each project and

accept those in which the NPV is positive 2. NPV depends on cash flows and these are uncertain

II. Forecasting Earnings

A. A capital budget lists the projects and investments that a company plans to

undertake during the coming year

B. Capital budgeting analyzes alternative projects and decides which to accept 1. Earnings are not cash flows 2. First determine incremental earnings which is the amount a firm’s

earnings are expected to change as a result of the investment decision

C. Incremental earnings forecast

1. Capital expenditures and depreciation

a. Investments in plant, equipment and property are cash expenses, they are not expense when calculating earnings

b. A firm deducts a fraction of these costs through depreciation i. Straight line depreciation is the simplest method

ii. An assets cost less salvage value are divided equally over its estimated useful life

c. Capital expenditures are a key reason why earnings are not an accurate representation of cash flows

2. Interest expenses

a. To get net income, subtract interest expenses form EBIT b. Capital budgeting does not include interest expense c. Unlevered net income of a project excludes interest expense

associated with debt

A-2 Corporate Finance, Chapter 8


3. Taxes a. Use the firm’s marginal corporate tax rate which it’s the rate the

firm will pay on an incremental dollar of pretax income b. Income tax = EBIT c where c is the marginal corporate tax

rate

4. Unlevered net income calculation

Unlevered net income = EBIT (1 - c) = (revenues – costs – depreciation) (1 - c)

D. Indirect effects on earnings

When computing incremental earnings of an investment, include all changes between the firm’s earnings with and without the project

1. 2. Opportunity cost of using a resource

a. Is the value it would have provided in tis best alternative use b. Since this value is lost when the resource is used by another

project, include opportunity cost as an incremental cost of the project

c. A common mistake is to assume an idle asset has no opportunity cost; however the asset could be sold or leased

3. Project externalities

a. Indirect effects of a project that may increase or decrease the profits of other business activities of the firm

b. When sales of a new product displaces sales of another product is referred to as cannibalism

E. Sunk costs and incremental earnings

1. A sunk cost is an unrecoverable cost that the firm has incurred

a. Sunk costs are paid regardless whether the project is proceeds or not

b. They are not incremental to the current decision so they are exclude

c. If our decision does not affect cash flow then it should not affect our decision

2. Fixed overhead expenses

a. Overhead expenses are associated with activities that are not directly attributable to any business activity affect many areas of the corporation

i. To the extent these costs are fixed, they are not incremental to the project

ii. Only include additional overhead expenses that rise because of the decision to take on the project



A-3

3. Past research and development expenditures

a. When a firm has spent significant resources to develop a product, there is a tendency to continue investing tin the product even f market conditions have changed and the product is unlikely to be viable

b. Any money already sent is a sunk cost and is irrelevant c. The decision to continue or abandon a project should be based

solely on the incremental costs going forward

4. Unavoidable competitive effects—if sales are likely to decline in any case as a result of anew products introduced by competitors then the lost sales are a sunk cost and not included in the projections

5. Sunk cost fallacy—the tendency of people to be influenced by the sunk costs and to throw good money after bad

F. Real world complexities

1. Estimates of revenues and or costs are much more complicated 2. A new product has low sales initially as customers become aware of a

product 3. Then sales accelerate, plateau and ultimately decline due to

competition or obsolescence

III. Determine cash flow and NPV A. Earnings are an accounting measure of a firm’s performance and do not represent

real profits

B. To evaluate a capital budgeting decision, determine the incremental effect of a project on a firm’s free cash flow

C. Calculating free cash flow form earnings

1. Earnings include non-cash charges such as depreciation and exclude capital investment

2. Capital expenditure and depreciation

a. Depreciation is a method for allocating the original purchase cost of an asset over its life

b. Depreciation is not included the cash flow forecast c. However, the actual cash cost of the asset is included when it is

purchased

3. Net working capital (NWC) a. Is the difference between current assets sand current liabilities

Net working capital = current assets – current liabilities = cash + inventories + receivables – payables



b. Trade credit

i. Firms must maintain a minimum cash balance to meet unexpected expenditures and inventories of raw materials

ii. Firms do not receive cash until customers pay iii. Receivables measure the amount of credit a firm has

extended to its customers iv. The difference between receivables and payables is trade

credit

c. The increase in working capital in year t is

d. NWCt = NWCt - NWCt-1

4. Free cash flow can be lower than unlevered net income in the early years if there is an upfront investment in equipment

D. Calculating free cash flow directly

Free cash flow = (revenues – costs – depreciation) (1 - c) + depreciation - capital expense - NWC

1. First deduct depreciation when computing the project’s incremental

earnings and then add it back when computing free cash flow

2. An equivalent formula is

Free cash flow = (revenues – cost) (1 - c) - capital expense - NWC + c depreciation

3. The term c depreciation is the depreciation tax shield; it is the tax savings that results from a positive impact on free cash flow

E. Calculating the NPV

1. The cost of capital is the expected return an investor can earn on their best alternative investment with similar risk and maturity

2. Compute the value of each free cash flow (FCF) in the future and compute a present value

PV(FCFt) = FCFt / (1 + r)t where 1/(1 + r)t is the discount factor



A-5

F. Using Excel

1. Capital budgeting is easily performed in a spreadsheet

2. Tips for using excel a. Create a project dashboard—identify and centralize all

assumptions b. Color code for clarity c. Maintain flexibility—state all assumptions on an annual basis

even if expected to be constant d. Never hardcode—even though the same answer is produced, it

becomes difficult to update the model if a variable changes

IV. Choosing among alternatives A. Compare mutually exclusive alternatives then choose the alternative with the

highest NPV

B. When comparing alternatives, only compare those cash flows that are different; ignore cash flows that are the same

V. Further adjustments to free cash flow A. Other non-cash items should not be included in a project’s free cash flow

B. Timing of cash flows—cash flows will be spread out over the year; can model

more frequently than annual

C. Accelerated depreciation

1. Because deprecation contribute positively to cash flow through the deprecation tax shield, the firm should use the most accelerated method of deprecation allowable

2. The modified accelerated cost recovery system (MACRS) depreciation categorizes assets according ot its recovery period

3. Based on that period, MACRS depreciation assigns a fraction of the purchase price a firm can recover each year

D. Liquidation or salvage value

1. Assets that are no longer needed have a resale value or a salvage value if parts can be sold for scrap

2. In free cash flow, include the liquidation value of any assets that are no longer needed and may be disposed

3. Since the gain on sale is taxed, calculate the gain as the difference

between the sale price and the book value of the asset

Gain on sale = sale price – book value



4. Book value is equal to the asset’s original cost less the amount depreciated for tax purposes

Book value = purchase price – deprecation

5. The project’s free ash flow is adjusted to account of the after-tax cash flow from the asset sale After tax cash flow form asset sale = sale price – (c gain on sale)

6. If the sale price is less than the original purchase price of the asset, the gain on sale is treated as a recapture of the depreciation and taxed as ordinary income; if the sale price exceeds this rice then this portion of the gain on sale is considered a capital gain

E. Terminal or continuation value

1. Sometimes a firm will forecast free cash flow over a period shorter less

than the full horizon of the project 2. The remaining free cash flow beyond the forecast horizon is included

as a one-time, market value cash flow at the end of the forecast period called the terminal or continuation value of the project

F. Tax carryforwards

1. The firms marginal tax rate is based on the overall level of pretax income

2. Tax loss carryforwards and carrybacks allow corporation to take losses in a current year and offset them against gains in nearby years

3. Firms can carry back 2 years and carry forward 20 year

a. When losses are carried back, the firm receives a refund in the current year for back taxes; otherwise the loss is carried forward

b. When a firm has tax carryforwards in excess of pretax income, additional income it earns today will not increase the taxes it owes until it exhausts the carryforwards

c. This delay reduces the present value of the tax liability

G. Global financial crisis—tax changes to help businesses

1. Bonus depreciation allowing additional first year depreciation of 50% of the cost of the asset , increasing the present value of tax shields associated with new capital expenditures

2. Allowed small and medium sized firms to deduct the full purchase price of capital equipment rather than deduct it over time

3. Extended loss carryback for small businesses 5 years allowing

struggling businesses to receive refunds of taxes already paid



A-7

VI. Analyzing the project

A. The most difficult part of capital budgeting is deciding how to estimate the cash

flows and cost of capital

B. Break even analysis

1. When uncertain f a capital budgeting decision, it is useful to determine the breakeven level

2. The breakeven level is the level for which the NPV has a value of zero

C. Sensitivity analysis

1. Breaks the NPV calculation into its comment assumptions and shows how the NPV varies as the underlying assumptions change

2. Allows exploration of the effects of errors in the NPV estimates and learn which variables are most important

D. Scenario analysis

1. Certain factors may affect more than one parameter 2. Scenario analysis considers the effect on the NPV of changing

multiple project parameters

E. David Holland interview

1. Cash flows are a fact and earnings are an option a. Earnings use an accounting framework b. Economics of cash flows are clear

2. Investment decisions are based on cash flows because

a. They take project risk into account and b. Show the impact on value creation to owners

3. Key metrics

a. Primarily rely on net present value for investment decisions

i. It identifies key drivers that effect project success and ii. Demonstrates the interplay of factors that affect cash

flow b. The business unit manager learns to control the model to

alleviate risk or accelerate upside potential

c. NPV vs IRR i. An attraction of IRR is the ease of comparing percentage

returns, but hides the scope of a project ii. NPV captures the size of the return in dollars and shows

a project’s impact on share price iii. NPV also creates an ownership framework for

employees with stock compensation



4. Deal with uncertainty around metrics with extensive modeling

a. The business lead is responsible to

i. Understand het assumptions in the model and ii. To check the model’s results against alternative

assumptions

b. Scenario, sensitivity analysis and game theory control risk by adjusting strategy

c. Also look at qualitative aspects such as show t fits into customer base

5. To stay completive, must deal with some level of risk, even in down

markets

a. Apply the same discount rate to all products to avoid distorting the true value of the company

b. To assess a projects unique risks, model the upside or downside of the cash flows

c. Analyze sensitivity to 1% change in operating costs or revenue growth

d. Discuss results with business lead

F. Using excel spreadsheets

1. Goal seek for break-even analysis—excel will determine the breakeven point for key assumptions in the model

2. Data tables allow computation of the sensitivity of NPV to any other input variable in the financial model

3. Build multiple scenario’s by adding additional rows with alternative assumptions and then use the index function



A-9

CORPORTE FINANCE, CHAPTER 18 CAPITAL BUDGETING AND VALUTAION WITH LEVERAGE

I. Capital budgeting

a. Determine NPV

i. Estimate the incremental free cash flows generated by the project ii. Discount the project’s free cash flow based on the cost of capital

b. Three methods for capital budgeting with leverage and market imperfections

i. Weighted average cost of capital method

ii. Adjusted present value method iii. Flow to equity method

II. Overview of key concepts

A. Debt financing creates a valuable interest tax shield for the firm because interest

payments are tax deductible as an expense

1. The WACC method discounts the unlevered free cash flows using the weighted average cost of capital using the effective after tax interest rate which incorporates the tax benefit of debt

2. The adjusted present value method discounts a project’s cash flows without leverage suing the unlevered cost of capital and then separately estimates and adds the present value of the interest rate shield

3. The flow to equity method values equity bed on the total payouts to

shareholders

B. Simplifying assumptions

1. The project has average risk 2. The firm’s debt to equity ratio is constant 3. Risk of the firm’s debt and equity and the weighted average cost of

capital will not change 4. Corporate taxes are the only imperfection

C. Simplifying assumptions are restrictive, but typical of many projects and firms

1. First assumption is typical for investments concentrated in a single

industry 2. Second assumption reflects the fact that firms increase debt as they

grow 3. Third assumption is typical of firms without high levels of debt where

the interest tax shield is likely to be the most important market imperfection the capital budgeting decision

Hubbard, Chapter 4


D-15

HOW TOMEASURE ANYTHING, CHAPTER 4, CLARIFYING THE MEASUREMENT PROBLEM

I. Introduction A. Prior to making a measurement, answer the following:

1. What decision will the measurement support? 2. What is the definition of the thing being measured in terms of

observable consequences and how does this thing matter to thedecision being asked?

3. How much do you know about it now? 4. How does uncertainty about the variable create risk for the decision? 5. What is the value of additional information?

B. Answers to these questions often completely change to just how organization

should measure something , but what they should measure

C. If a measurement maters at all, it is because it must have an effect on decisions and behavior

D. A measurement has no value if managers cannot identify a decision that could be

effected by a proposed measurement

II. The five steps

A. Define a decision problem and the relevant uncertainties

1. Describe your dilemma 2. Define all variables relevant to the dilemma

B. Determine what you know now

1. Describe uncertainties in terms of ranges and probabilities 2. This helps determine the risk involved 3. This is a teachable skill

C. Compute the value of additional information

1. The information value of a measurement allows us to both identify

what to measure as well as informing us how to measure it 2. If there are no variable with information values that justify the cost of

measurement, skip to step 5

Hubbard, Chapter 4


D-16

D. Apply the relevant measurement instruments to high value measurement

1. Basic measurement instruments are random sampling, controlled experiments

2. Methods that allow us to a. Use limited data to isolate the effect of one variable b. Quantify soft preferences c. Exploit new technologies for measurement

3. Repeat step 3

E. Make a decision and act on it

1. When an economically justifiable amount of uncertainty ahs been removed, decision makers face the risk versus return decision

2. To optimize the decisi0on, the risk aversion of the decision maker can be quantified

3. Quantify risk aversion and other preferences and attitudes of decision makers

4. Repeat step 1—tracking the results about a decision must made is always in the context of future decisions

III. Unexpected challenge of defining a decision A. Measurements start with defining a decision

1. Some managers believe they need to measure something but have a

hard time articulating a specific action the measurement would be for

a. It is only important to measure if the knowledge of the value could cause us to take different actions

b. An unidentified decision is not better than having no decision in mind

2. Sometimes the stated measurement implies a nonsensical decision

3. The failure of getting the purpose identified correctly first can lead to years of debate based on ambiguities

B. Decision oriented measurement

1. Impact pathway shows how one thing affects another 2. Aggregating different decision models into one model allows the

model to be reused on future decisions 3. It can be difficult for researchers to think about measurements in terms

of specific decisions their research would support and the specifics of alternatives interventions that they might recommend

4. Previously, researchers identified which variables should be measured to track progress towards achieving development goals without reference to any specific decision

Hubbard, Chapter 4


D-17

C. Getting to a real decision

1. To implement the first steps in a five step process, conduct workshops with key decision makers and selected subject matter experts (SMEs)

a. SMEs represent the most knowledgeable individuals in the organization on the topic being considered

b. This can take half a day c. For example, is the decision about implementing a technology at

all or simply a question as to how it should be implemented

2. Requirements for a decision

a. A decision must have two or more realistic alternatives

b. A decision has uncertainty i. Without uncertainty there is no dilemma

ii. A decision must have two or more choices and the best choice is not certain

c. A decision has potentially negative consequences if it turns out a wrong position was taken

i. Even if both outcomes are positive, one may be more profitable than another

ii. Called opportunity loss

d. A decision has a decision maker

e. If someone has a hard time to get a measurement problem to fit a specific decision, they may be making unnecessary presumptions about what constitutes a decision

3. Potential forms for a decision

a. A decision can be one big thing or many little things

b. Decisions do not have to be limited to one time choices; they could be a large number of small recurring decisions

c. A decision can be either a discrete or continuous choice

i. Decisions do not have to be binary, “either/or”

ii. Decisions can be choosing an optimal value over a wide continuum

d. Decisions can come with one or many stakeholders, including collaborative and competing parties

i. The SMEs and managers involved in modelling may not be making the actual decision

ii. But there is always an agent for the decision

Hubbard, Chapter 4


D-18

D. Do dashboards and decisions go together

1. The difficulty of connecting measurement to decisions starts at the

highest levels in an organization

2. Dashboards are meant to be “at a glance” summaries with charts and graphs

a. Data consists of a dozen or more variables that could be financial

or project status that managers feel they need to know on a regular basis

b. A dashboard can be a very powerful tool c. It is also routinely a wasted resource

3. The dashboard may not be selected with specific decisions in mind

based on specific conditions for action

4. It is only hoped that once the right conditions arose in the data, the manager would recognize a need to act and already know what acetoin is required so that they could react without delay

5. There is a risk that the need to act will be too subtle to be immediately

and consistently detected among dashboard variables

6. Another risk is that once a the need to act is correctly identified, the manager will waste time deciding what to do and design a specific response when the contingency could have been worked out in advance

IV. If you understand it, it can be modeled

A. A decision has to be defined well enough to be modelled quantitatively

1. The simple act of attempting to calculate forces a degree of clarity on

what decision is being addressed 2. The outcome of a model indicates some action

B. A simple decision model

1. Estimated costs of action X 2. Estimated benefits of action X 3. If benefits of action X exceed costs of action, execute action X

C. A simple cost benefit analysis could be decomposed further to show how

different costs and benefits create a cash flow over time

D. Cash flows are the basis for computing a net present value that takes into consideration the timing of the benefit

E. The monetary values for each benefit or cost by year can then be decomposed

further into more variables

Hubbard, Chapter 4


D-19

F. A more sophisticate statistical model based purely on historical data cold e a

decision model if the output represents a specific recommended action

G. When a decision is decomposed there are several insights 1. Several other important variable may pertain to the judgment which

may be the most important measurement 2. A simple decomposition of highly uncertain variables can reduce the

error factor by 10 – 100 times 3. Merely decomposing highly uncertain estimates provides a huge

improvement to estimates 4. Decomposition is worth the time to implement

H. Intuition models

1. Have a high degree of additional inconsistencies, logical inference errors and unstated assumptions that are not visible for others to inspect

2. Anything that can be modeled intuitively can be represented in a quantitative model that avoid some of the errors intuition

I. All models are wrong, but some are useful; some models can be measurably more useful than others

J. Risk and uncertainty are measurable and are key to understanding measurement

V. Uncertainty and risk A. Quantitative clarity is a strong foundation to advance any field

B. Decision makers require unambiguous and quantitatively sound definitions for

uncertainty and risk regardless of how others may use them

C. Fortunately, decision makers who make real world decisions with limited information and significant consequences do not need to be distracted by semantics

D. Uncertainty

1. The lack of complete certainty, that is the existence of more than one possibility

2. The true outcome is not known

E. Measurement of uncertainty—a set of probabilities assigned to asset of possibilities

F. Risk--a state of uncertainty where some of the possibilities involve loss, catastrophe or other undesirable outcome

G. Measurement of risk—a set of possibilities each with quantified probabilities and

quantified losses

H. These definitions are useful when discussing any type of measurement problem

Hubbard, Chapter 4


D-20

VI. IT security example

A. Different parties had a different detailed mental images of IT security. But no one

considered how those details could help define IT security B. Conclusion was that IT security means a reduction the frequency and severity of

a specific list of undesirable events C. Each proposed system to improve security can be represented by a combination

of costs D. Measurement facilitated by asking the question, “What is observed with

improved IT security?” E. Experts can be calibrated to assess uncertainty quantitatively F. An ambiguous term such as security can be decomposed into some relevant,

observable components G. Measurement dealing with sustainability, resilience, dependability, reliability etc.

are ultimately measure so frisk reduction H. Calibrated probability measurements is key to understanding your current level

of uncertainty

VII. Defining risk and uncertainty

A. The essential fact is that risk can mean 1. A quantity susceptible to measurement or 2. Something distinctly not of this category

B. Knight’s definition

1. If a probability cannot be assigned to an event, then the event is considered uncertain

2. If a probability can be assigned to an event, then it is considered risk without regard to whether the probability is for a potential loss

C. Definitions have never been universally accepted 1. Some contradict other sound definitions 2. Decision sciences call decisions under uncertainty where uncertainty is

defined with quantified probabilities 3. Journal of Economics defined risk as a change of damage or loss

D. Different professions use their own unique definitions of risk

1. In project management, risk incudes the positive outcomes 2. Actuaries use the term uncertainty that already encompasses outcomes

that are not necessarily losses

Review Questions Q-3


Source: Berk, Chapter 22, Real Options Question 1 (34 Points) Discuss the staging of mutually independent investments.

Review Questions


Q-4

Source: Berk, Chapter 23, Raising Equity Capital Question 2 (43 Points) Discuss the staging of mutually independent investments.

Review Questions Q-5


Source: Berk, Chapter 23, Raising Equity Capital Question 3 (48 Points) Describe the mechanics of an initial public offering in the US.

Review Solutions


S-2

Source: Berk, Chapter 22, Real Options Solution to Question 1 (34 Points) Statement Points Staging mutually dependent investments 1

Advantage is that it allows manager to postpone investment until new information is learned 4

Staging

In many applications, staging has a natural order (prototype before large scale development) 3 In some situations, the order can be chosen 3

Mutually dependent investments 1

The value of one project depends on the outcome of other projects 2 Need to determine the optimal order of investment that will minimize the cost of development 4

Beneficial to

Make the least costly investments first and delay more expensive investments until it is clear they are needed 3 Invest in riskier and lengthier project fist and delay future investments until the greatest amount of information can be learned 3

General rule

Rank each project from highest to lowest 2 by the ratio of (1 – (PV (success)) / PV(investment) 4 Where

PV(success) is the value at the start of the project of receiving $1 if the project succeeds 2 PV(investment) is the project’s required investment at the start of the project 2

TOTAL POINTS 34

Review Solutions


S-3

Source: Berk, Chapter 23, Raising Equity Capital Solution to Question 2 (43 Points) Statement Points A. Initial capital is provided by entrepreneur and family 2

B. Sources of funding

1. Angel investors 2

a. Individual investors who buy equity in small firms 3 b. Acquire a sizeable equity interest in exchange for their funds 2 c. Finding angels is difficult 1

2. Venture capital firms 2

a. Limited partnerships that specializes in raising money to invest

in private equity of small firms 4 b. Limited partner gets the benefits of diversification 2 c. General partners of the firm are venture capitalists d. General partners charge substantial fees to and take a share of the

positive returns generated by the fund (called carried interest) 4 e. Venture capitalists use their control to protect their interests 2

3. Private equity firms 2

a. Organized like a venture capital firm 1 b. Invests in equity of existing privately held firms; not start ups 3 c. Initiate investment by finding publicly traded firm and purchase

outstanding equity to take the company private (called a leveraged buyout) 4

4. Institutional investors 2

a. May invest directly in private firms or 2 b. Become limited partners in venture capital or private equity firms 2

5. Corporate investors—a corporation that invests in private companies

C. Outside investors 1

1. When a founder sells equity to outside investors for the first time, common

practice to issue preferred stock rather than common stock 2 TOTAL POINTS 43

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