Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

How To Be An Investment Banker > Chapter 3 - Finance Overview > Flashcards

Chapter 3 - Finance Overview Flashcards

1
Q
  1. What is the primary role of the financial system?
A

The primary role of the financial system is to efficiently and optimally
allocate savings to investments.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q
  1. Who are some of the key players in the financial system?
A

Some of the key players in the financial system are savers such as individuals,
borrowers such as individuals, companies and governments,
and the financial institutions that are supposed to bring them together.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q
  1. What is the primary role of financial institutions?
A

The primary role of financial institutions is to efficiently match savers
and borrowers, specifically by providing information gathering and
distribution, risk sharing, and liquidity.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q
  1. What are some examples of institutional investors?
A

Some examples of institutional investors include pension funds, insurance
companies, and endowments.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q
  1. What are some examples of alternative investments?
A

Some examples of alternative investments include private equity, venture
capital, and hedge funds.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q
  1. Why is money today worth more than money tomorrow?
A

Money today is worth more than money tomorrow for at least three
reasons. First, there is risk associated with receiving and being able to
use the money the longer out in the future you go. Second, in an inflationary
environment, money has less purchasing power in the future.
Third, money today could be invested and earn some return.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q
  1. What is a discount rate?
A

A discount rate, also referred to as an investor’s opportunity cost of
capital, is the return required by investors to invest in a project of a
specified level of risk for a specified time period. The discount rate is
also the rate used to present value cash flows.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q
  1. Conceptually, how do you estimate a discount rate?
A

Conceptually, you can estimate a discount rate by taking the riskfree
rate for the appropriate time period and adding the expected inflation
rate and an appropriate risk premium for an investment at that
level of risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q
  1. What is the basic present value formula?
A

The basic present value formula is: Cash flow in a certain time period
divided by one plus the discount rate raised to the appropriate time
period.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q
  1. How do you value a perpetuity?
A

You can value a perpetuity by taking the perpetual cash flow and
dividing by the appropriate discount rate.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q
  1. How do you value a perpetuity with constant growth?
A

You can value a perpetuity with constant growth by taking the next
period’s cash flow and dividing by the discount rate less the constant
growth rate.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q
  1. How do you calculate the future value of an amount of money?
A

You can calculate the future value of an amount of money by taking
the present value and multiplying by one plus the discount rate raised
to the number or periods.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q
  1. How should companies decide whether or not to invest in a project?
A

In theory at least, companies should decide whether or not to invest
in a project if the project’s internal rate of return (IRR) is greater than
the project’s discount rate or hurdle rate, or if the net present value
(NPV) of the project is greater than zero.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q
  1. How do you calculate net present value?
A

You calculate net present value by summing each period’s cash flow
divided by one plus the discount rate raised to each time period.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q
  1. How do you calculate the internal rate of return?
A

You calculate the internal rate of return by solving for the discount
rate in an equation where zero equals the sum of each period’s cash flow
divided by one plus the discount rate raised to each time period.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q
  1. What kinds of things should companies include in cash flow when analyzing
    NPV or IRR?
A

When analyzing NPV or NRR, cash flow should include all of the
cash flows that directly relate to the project, including the initial investment
as well as ongoing costs and capital expenditures, working capital
requirements, and revenues and profits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q
  1. What kinds of things should companies not include in cash flow when
    analyzing NPV or IRR?
A

When analyzing NPV or NRR, companies should not include sunk

costs or any allocation of expenses that would need to be spent regardless.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q
  1. Under what circumstances will the net present value equal zero?
A

Net present value will equal zero when a project’s IRR is exactly
equal to the discount rate used in the NPV formula.

19
Q
  1. What is capital structure?
A

Capital structure reflects a company’s choice of funding, and specifically
its makeup of debt and equity.`

20
Q
  1. Which is more expensive, debt or equity, and why?
A

Equity is more expensive because it is riskier than debt, has less certain
cash flows, is subordinate to debt in a bankruptcy or liquidation,
and because dividends, unlike interest, are not tax deductible.

21
Q
  1. Why does adding more debt to the capital structure raise the cost of debt?
A

Adding more debt to a company’s capital structure raises the cost of
debt because it raises the risk of distress and bankruptcy, which results
in a significant loss of value, and therefore makes all of the company’s
debt riskier.

22
Q
  1. Why does adding more debt to the capital structure raise the cost of
    equity?
A

Adding more debt to a company’s capital structure raises the cost of
equity because debt raises the risk of distress and bankruptcy, which results
in a significant loss of value to the company and usually a complete
loss of value to equity holders. Moreover, more debt requires higher
levels of interest, which reduces the flexibility of management.

23
Q
  1. Why is the cost of capital U‐shaped?
A

The cost of capital is U‐shaped because debt is less expensive than
equity but also because adding debt raises the cost of both debt and
equity due to bankruptcy costs, agency costs, and the potential loss of
tax deductions if interest expense exceeds operating income.

24
Q
  1. What are some advantages and disadvantages to issuing debt?
A

Some advantages to issuing debt include a lower cost of capital than
equity, given it is less risky to investors and because interest is tax deductible.
Some disadvantages to issuing debt include an increased risk
of financial distress or bankruptcy; mandatory payment of interest
expense, which reduces the flexibility of management; and covenants,
which may restrict the company’s ability to issue more debt and penalize
the company if it does not maintain certain operating performance
and/or leverage.

25
Q
  1. What are some advantages and disadvantages to issuing stock?
A

Some advantages to issuing stock include no mandatory dividend
payments, the least risk‐adverse investor class, and currency that can be
used for acquisitions. Some disadvantages to issuing stock include the
highest cost of capital of any type of funds, the highest transaction costs
to raise the funds, and vulnerability from activist investors.

26
Q
  1. What is the difference between secured debt and unsecured debt?
A

Secured debt is debt that is secured or collateralized by specific assets.
Unsecured debt is not secured by specific assets.

27
Q
  1. What has a higher cost: secured debt or unsecured debt? Why?
A

Unsecured debt has a higher cost of capital because the debt is not
collateralized by specific assets.

28
Q
  1. What is preferred stock?
A

Preferred stock, while technically a form of equity, is a hybrid security
that has features of both debt and equity. It is a mandatory dividend obligation,
like interest, though the dividend can be deferred. It has a cost
of capital in between that of debt and common stock.

29
Q
  1. What are some different ways in which a company can return money to
    investors?
A

A company can return money to investors by paying back or retiring its
debt, by issuing dividends to stockholders, and by buying back its stock.

30
Q
  1. What are the pros and cons of dividends versus stock buybacks?
A

Some investors, such as widows and orphans and non‐taxable investors,
prefer dividends, while taxable investors and investors who do
not need income generally prefer stock buybacks. Moreover, most of
the time, capital gains tax rates are lower than taxes paid on dividend
payments. Also, companies generally have more flexibility with stock
buybacks than they do with dividends since cutting dividends sends a
negative signal to the market.

31
Q
  1. How do you value a bond?
A

You can value a bond by computing a bond’s net present value by
summing each period’s cash flow (coupon payments and principle payment)
divided by one plus the appropriate market interest rate raised to
the cash flow’s time period.

32
Q
  1. What is yield to maturity, and how do you calculate it?
A

Yield to maturity represents an investor’s average return earned on
a bond that is held to maturity. You can calculate yield to maturity
by using the IRR formula. Specifically, set the bond’s price equal to
the sum of each period’s cash flow (coupons and principle payment)
divided by one plus the YTM to appropriate time period and solve for
the YTM.

33
Q
  1. What is yield to call, and how do you calculate it?
A

Yield to call represents an investor’s average return earned on a
bond that is called at the first possible call date. You can calculate
yield to call the same way as yield to maturity, except substitute the
call price for the par value and use the first call date instead of the
maturity date.

34
Q
  1. What is yield to worst, and how do you calculate it?
A

Yield to worst represents an investor’s lowest possible average return
earned on a bond that is either called or held until maturity. If there is
only one call date, the yield to worst is calculated as the lesser of the
yield to call and the yield to maturity. If there are multiple call dates, it
is calculated as the lesser of the lowest yield to call rate (given each call
date) and the yield to maturity.

35
Q
  1. What is a bond’s current yield, and how do you calculate it?
A

A bond’s current yield reflects the bond’s annual coupon divided by
the bond price.

36
Q
  1. If interest rates rise, what will happen to the price of a bond?
A

If interest rates rise, the price of a bond will fall.

37
Q
  1. What is duration and why is it important?
A

Duration reflects the average maturity of a bond or, equivalently, the
average amount of time to each cash flow (the coupon payments and
the principal payment). Duration is important because it helps measure
a bond’s sensitivity to interest rate changes and helps institutional investors
match their investment income with their expected liabilities.

38
Q
  1. What are the key assumptions of the Black‐Scholes formula for pricing
    options?
A

The key assumptions of the Black‐Scholes formula used for pricing
options are the risk free interest rate, the underlying stock price, the exercise
price, the stock’s expected volatility, and the time until maturity.

39
Q
  1. What are the differences between an option and a warrant?
A

An option does not result in new shares being issued and therefore
does not cause dilution to existing shareholders, whereas warrants are
issued by the company and result in new shares being issued.

40
Q
  1. How would a change in the level of the risk‐free interest rate affect the
    value of a call? A put?
A

An increase in the level of the risk‐free interest rate will raise the value
of a call and lower the value of a put.

41
Q
  1. How would a change in the underlying stock price affect the value of a
    call? A put?
A

An increase in the stock’s underlying price will raise the value of a call
and lower the value of a put.

42
Q
  1. How would a change in the exercise price affect the value of a call? A put?
A

An increase in the exercise price will lower the value of a call and
raise the value of a put.

43
Q
  1. How would a change in a stock’s expected volatility affect the value of
    a call? A put?
A

An increase in the stock’s expected volatility will raise the value of a
call and raise the value of a put.

44
Q
  1. How would a change in the time until expiration affect the value of a
    call? A put?
A

An increase in the time until expiration will raise the value of a call
and raise the value of a put.

How To Be An Investment Banker (7 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions