Principles of Finance Review
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- 1-1: rational investors prefer (2)
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1. higher returns
2. lower risk - 1-2: A cash flow received sooner is worth ____ than a cash flow received later
- more
- 1-4: 3 interrelated areas of finance
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1. financial markerts and institutions
2. investments
3. managerial (corporate) finance - 1-5: Name the 4 main financial institutions and explain them.
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1.COMMERCIAL BANK
-depository: business loans, trust operat., brokerage, insurance
2. SAVINGS AND LOANS
(THRIFTS)
-depository: real estate loans
3. CREDIT UNIONS
depository: consumer loans
4. INSURANCE COMPANIES - 1-6: name the 4 types of investment companies
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1. stock brokerage
2.banks
3. investment companies
4. insurance companies - 1-7 explain the 4 types of managerial finance
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1. MANAGEMENT
-strategic planning, acquisitions, employee incentives
2. MARKETING
-product introductions, advertising, capital budgeting
3. ACCOUNTING
-provides data for financial decisions
4. INFORMATION SYSTEMS
- provides data for financial decisions - 1-8 Descibe the history of financial markets beginning from 1900's.
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-early 1900's- full service banks
-loss of confidence during depression (6000 banks
failed): market decrsd > 80%
- 1970's= deregulation (during high inflation & intrst rates) - 1-8 What is the Glass-Steagall Act of 1933?
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- separated commercial and investment banking
- authorized deposit insurance - what is the SARBANES-OXLEY ACT of 2002?
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-est. accountability & responsibility for financial information
-outside directors & independent auditors
-CEO & CFO certify finan. statements. - 1-13 Globalization of business allows for...
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-better transportation and communication
-lowered trade barriers
-cost of production increased: need new markets
-multinational firms can shift production to w.e. costs the lowest - 1-15: what is the job of a financial manager? (2)
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1. max value of the firm
2. value= present, or current, value of cash flows an asset is expected to generate in the future -
2-1 what is a real asset?
what is a financial asset? -
- r.a.= physical, observable, or touchable item
- f.a.= INTANGIBLE asset that represents a promise to distrib cash flows some time in the future - What are the major types of financial instruments? (3)
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1. money market instuments
2. capital market instruments
3. derivatives market instruments - what are money market instruments?
- t-bill, CD's, eurodollar deposit, money market mutual fund
- what are capital market instruments?
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Equity (Stock)
-Common Stock
-Preferred Stock
Debt (Bonds)
-Maturity
-Sector/Issuer
-Structure - What are derivatives market instruments?
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- options
- futures
- swaps - why do firms issue financial instruments?
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...so it can purchase the tangible assets necessary to produce income;
-Common Stock
-Preferred Stock
-Debt
-Hybrid (convertible) - What is included in the equity part of the balance sheet?
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1.Common equity
-Stockholder’s total investment in the firm
2.Par value
-Nominal or face value of a stock or bond
3.Retained earnings
-Earnings the firm has not paid out as dividends throughout its history
4.Additional paid-in capital
-Difference between the value of newly issued stock and its par value - What is debt?
- a loan given to an individual, company, or government
- Explain the features of debt.
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-Priority to assets and earnings
-Principal value = Face value = Par value
-Interest Rate
-Maturity date (The time a note or bill of exchange becomes due)
-Cash flow structure
-No control of the firm (no voting rights)
**Restrictive covenants protect bondholder rights - Short Term Debt. What does it include? order of risk: high to low
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1. Treasury Bill (T-bill) – Discount UST obligation
2. Commercial Paper – Discount corporate debt
3. Repurchase Agreement
Sale and repurchase (collateralized loan)
4.Certificate of Deposit – Time deposit at Bank
5.Eurodollar Deposit
Time deposit in non-US bank (denominated in US $)
__________________________
6. Money Market Mutual Fund
Pooled, managed investments in short-term debt
7.Banker’s Acceptance – Discount bank guarantee
8. Federal Funds – Deposits at Federal Reserve Banks
--Overnight loans between banks to manage reserves
--Loans made at Federal Funds Rate (daily market rate) - What is long term debt?
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Term Loans
Private contract between borrower and lender
Advantages:
Speed, flexibility, and low issuance cost
Bonds
Long-term contract
Borrower agrees to pay bondholders:
Scheduled principal and interest payments - List the bond sectors and explain them (8).
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Treasury
Agency
Corporate
Foreign
Yankee - Foreign debt issued in US
Municipal bonds – State/local governments
Revenue bonds (project revenues)
General obligation bonds (general tax authority)
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Asset-Backed
Mortgage-Backed
Structured – CDO, CMO - What are the two bond features?
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1. Credit/quality features
2. Cash flow features - List what is included in the credit quality features (6).
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-Structured
-Mortgage bonds
-Debenture
-Subordinated debenture
-Income bond
-Junk bond - List what is uncluded in the cash flow features (7).
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-Structured
-Zero coupon bond
-Floating rate bond
-Inflation indexed bond
-Putable bond
-Callable bond
-Sinking fund - What are the two main bond contract features and their qualities?
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1. Bond Indenture (legal document)
-Trustee represents bondholders
-Restrictive covenants (dividends, debt ratios)
2. Cash flow provisions
-Interest rate: Fixed or floating
-Maturity
-Sinking fund – Early retirement of principal
--Call for redemption by annual lottery
--Buy bonds on the open market
-Options: Call, put, sinking fund
-Convertible into shares of common stock - What are the two main bond rating services?
- Moody's and S&P
- What is the difference b/w investment grade bonds and junk bonds?
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->Investment grade bonds: AAA, AA, A, or BBB
->Junk Bonds: Below BBB (BB, B, CCC, etc.) - What is preferred stock?
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Priority over common stock in distribution of dividends and assets
Dividend payments are a fixed % of par value
Can be omitted if not earned – without bankruptcy risk - What are the main features of preferred stock?
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-Cumulative dividends (Typical)
-Conversion into common stock (Typical)
-Voting rights (Only when dividends not paid)
-Sinking funds (Typical for new issues) - What is common stock (equity 2)?
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-Represents ownership in a corporation
-Residual claim on assets and earnings of firm
-Common stockholders vote for:
--> Board of directors, mergers, changes in charter - What are equity instruments in international markets (2)?
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1. Euro stock: Stock traded in countries other than the “home†country of the company, not including the United States
2. Yankee stock: Stock issued for foreign companies that is traded in the United States - what are american depository receipts (ADR's) in international markets?
- Represent ownership in stocks of foreign countries that are held in trust by a bank located in the country the stock is traded
- What is foreign debt?
- Sold by a foreign borrower but denominated in the currency of the country in which it is sold
- What is eurodebt?
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Debt sold in a country other than the one in whose currency the debt is denominated
ex: euronotes and eurobonds - what is a derivative?
- value depends on underlying asset
- what is a future?
- arrangement for delivery of an item at a set future date at a set price
- what is the derivative Swap?
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an arrangement to exchange cash flows
-ex: interest rate swaps - Name the embedded options on preferred stocks and bonds.
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-Call Option: Issuer option to repurchase
-Put option: Investor option to sell
-Sinking fund option: Investor option to repurchase
-Convertible – Investor option to exchange for common stock
-->Conversion ratio: Number of shares of common stock the holder receives upon conversion - From the issuers perspective, what is the benefit of debt?
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-Interest Tax Deductible
-Lowest cost of financing
-No voting rights
-No dilution of ownership - What is the disadvantage of issuing debt?
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-Inflexible legal obligation
-Increases leverage
-Covenants may limit flexibility - From the investors perspective, what are the advantages and disadvantages of debt?
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ADVANTAGES
-Priority claim on earnings
-Priority claim on assets
-Predictable cash flows
-Low risk
DISADVANTAGES
-Low return (limited upside)
-No ownership or control - From the issuers perspective what are the advantages and disadvantages of preferred stock?
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Advantages
-No voting rights
-No dilution of ownership
Disadvantages
-Higher cost than debt
-Increases leverage
-Covenants may limit flexibility - From the investor's perspective what are the advantages and disadvantages of preferred stock?
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Advantages
-Senior to common stock
-Predictable cash flows
Relatively low risk
-70% Corporate dividend exclusion
Disadvantages
-Low return (limited upside)
-No ownership or control - From the issuer's perspective what are the advantages and disadvantages of commmon stock?
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Advantages
-No dividend obligation
-No maturity or repayment
Disadvantages
-High cost
-Dilutes ownership
-Dilutes control - From the investor's perspective what are the advantages and disadvantages of commmon stock?
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Advantages
-Highest expected return
-Ownership and control
Disadvantages
-High risk