Final Exam Flashcards
Finance is…
The science or study of the management of funds
What is the goal of the firm?
The goal of the firm is to create value for the firm’s shareholders.
How is the goal of the firm achieved?
By maximizing the price of the existing common stock.\
Good finance decisions will help increase stock price and poor financial decisions will lead to a decline in stock price.
What is the role of management?
Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives
Contractual claims
Creditors, managers, employees and customers have contractual claim against the company
Residual claim
shareholders have residual claim against the company (meaning left over)
What is the role of finance in business?
There are three basic issued addressed by finance?
- What long-term investments should the firm undertake (capital budgeting decision)
- How should the firm raise money to fund these investments? (capital structure decision)
- How to manage cash flows arising from day-to-day operations (operating decisions)
What is the function of financial manager?
1 a) Raising funds 1 b) Obligations (stocks, debt securities) 2. Investment 3. Cash from Operational activities 4. Reinvesting 5.Dividends or interest payments
Finance function- managing cashflow
Principle 1 of Finance: Cash flow is what matters
Accounting profits are not equal to cash flows
- Cash flow drive the value of a business
- We must determine additional cash flows when making financial decisions
Principle 2 of Finance: Money has a time value
1$ received today is worth more than a dollar received in the future
- we can earn interest on money we received today, it is better to receive money sooner than later
- inflation
Computation of present value
an investment can be viewed in two ways-its future value or its present value (check slide 11 of lec 6)
Present Value
P= Fn/(1+r)^n
The net present value method
To determine net present value we
- Calculate the present value of cash inflows
- Calculate the present value of cash outflows
- subtract the present value of the outflows from the present value of the inflows
Positive Net present value
the project is acceptable since it promises a return greater than the required rate of return
Zero Net Present value
the project is acceptable, since it promises a return equal to the required rate of return
Negative Net Present value
Project is not acceptable since it promises a return less than the required rate of return
What are some typical outflows?
Initial investment (cash need to be purchases asset), Incremental operating costs repairs and maintenance of new equipment, additional investment in inventory
What are some typical inflows?
Incremental revenues, reduction of operating costs , salvage value
Cost of capital
average rate of return the company must pay to its long term creditors and stockholders for the use of their funds (Q: No short-term then?)
Choosing a discount rate?
The firm’s cost of capital is usually regarded as the minimum required rate of return.
Principle 3 of Finance: Risk requires a reward
Risk is the uncertainty about the outcome or payoff of an investment in the future
Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk
Diversification of investments
all investment is not the same
- some risk can be removed or diversified by investing in several different securities
- firm specific (unsystematic)
- market (systematic)
Principle 4 of Finance: Market prices are generally right
A financial market is “information efficient” if at any point in time the prices of securities reflect all information available to the public.
When new info. becomes available, prices quickly change to reflect that information.
Information efficient markets provide liquidity and fair prices
However, there are inefficiencies in the market that distort the market prices from value of assets (caused by behavioural biases)
Principle 5 of Finance: Conflicts of interest cause agency problem
The separation of management and the ownership of the firm creates an agency problem
owners or equity investors want to maximize the returns on their investments
Principal-Agent problem
Managers may make decisions that are not in the best interest of the shareholder.
Managers may seek to emphasize the size of the firm, sales, assets, or other perks
Oversight
Board of directors to oversee management
Managerial
to run the company
Compliance
Laws, regulations and standards
Internal audit
assurance and consulting acitivities
legal and advisory
advice
External audit
lend credibility
Monitoring
elect or remove directors and management
Principle 6 of Finance: Ethics and Trust in Business
Ethical behaviour is doing the right thing
- Sound ethical standards are important for business and personal success
- unethical decisions can destroy shareholder wealth
Real Asset
Tangible things owned by persons and businesses
- residential structures and property
- major appliances and automobiles
- office towers, factories and mines
- machinery and equipment
Financial Asset
What one individual has lent to another
- consumer credit
- loans
- mortgages
Function 1 of Money: Medium of Exchange
How transactions are conducted:
Something that is generally acceptable in exchange for goods and services.
In this function, money removes the need for double coincidence of wants by separating sellers from buyers
Function 2 of Money: Standard of Value
How the value of goods and services are denominated:
Something that circulates and provides a standardized means of evaluating the relative prices of goods and services
Function 3 of Money: Store of Value
How the value of goods and services are maintained in a monetary terms:
-the ability of money to command purchasing power in the future
Financial intermediaries
is an institution or individual that serves as a conduit for parties in a financial transaction.
-Act as a bridge between government, business,non-residents and households
Market Intermediaries
refers to resellers, physical distribution firms, marketing services agencies, and financial intermediaries.
Examples of Financial system (Financial intermediaries)
- Banks and other deposit-taking institutions
- insurance companies
- pension funds
- mutual funds
Direct claims
A payment made that is not backed up by a purchase order.
Indirect claims
A claim made by a shareholder seeking compensation for damages resulting from an action directed solely against the rights of the company in which it holds shares. The assertion is that the shareholder’s rights were indirectly affected by the actions against the rights of the company.
Intermediation
Brokerage function which brings together seekers and providers of goods, information, money, etc. Need for intermediation occurs due to the imperfect nature of markets and everyday situations where the complete (‘perfect’) knowledge about providers and seekers (and about what they seek) is not available to everyone.
Financial market
Markets for sale and purchase of stocks (shares), bonds, bills of exchange, commodities, futures and options, foreign currency, etc., which work as exchanges for capital and credit.
Primary Market
- Market in which buyers and sellers negotiate and transact business directly, without any intermediary such as resellers.
- Financial market in which newly issued securities are offered to the public.
Secondary market
- Customers other than those to whom a product was originally offered. For example, tools designed and priced for professionals may also be bought by serious hobbyists.
- Financial market where previously issued securities (such bonds, notes, shares) and financial instruments (such as bills of exchange and certificates of deposit) are bought and sold. All commodity and stock exchanges, and over-the-counter markets, serve as secondary markets which (by providing an avenue for resale) help in reducing the risk of investment and in maintaining liquidity in the financial system.
Money Market
Network of banks, discount houses, institutional investors, and money dealers who borrow and lend among themselves for the short-term (typically 90 days). Money markets also trade in highly liquid financial instruments with maturities less than 90 days to one year (such as bankers’ acceptance, certificates of deposit, and commercial paper), and government securities with maturities less than three years (such as treasury bills), foreign exchange, and bullion. Unlike organized markets (such as stock exchanges) money markets are largely unregulated and informal where most transactions are conducted over phone, fax, or online.
Capital market
A financial market that works as a conduit for demand and supply of debt and equity capital. It channels the money provided by savers and depository institutions (banks, credit unions, insurance companies, etc.) to borrowers and investees through a variety of financial instruments (bonds, notes, shares) called securities.
A capital market is not a compact unit, but a highly decentralized system made up of three major parts: (1) stock market, (2) bond market, and (3) money market. It also works as an exchange for trading existing claims on capital in the form of shares.
Organized exchanges
A securities marketplace where purchasers and sellers regularly gather to trade securities according to the formal rules adopted by the exchange.
Over-the counter
Describing a security or trade that does not occur on an exchange. Very often, the OTC market includes securities that are very small and do not trade on an exchange because they do not meet market capitalization requirements. OTC securities may theoretically be traded informally (one may stand on a street corner and sell his/her stocks), but the term usually refers to securities traded through a dealer network.
Corporate bonds: Debentures
Unsecured debt, backed only by the general assets of the issuing corporation
Corporate bonds: Secured debt (a.ka. mortgage)
Secured by specific assets
Corporate bonds: Subordinate debt
In default, holders get payments only after other debtholders get their full payment
Corporate bonds: Senior debt
In default holders get payment before other debtholders get
Corporate bonds: Zero coupon
pay face value at maturity only, sold at discount
Corporate bonds: Junk bonds
bonds with below investing grade rating
Retractable bond
A bond that features an option for the holder to force the issuer to redeem the bond before maturity at par value. An investor may choose to shorten the maturity on a bond because of market conditions or if he or she requires the principal sooner than expected.
Convertible bond
bond that can be converted into a predetermined amount of the company’s equity at certain times during its life, usually at the discretion of the bondholder.
Extendable bond
A long-term debt security that includes an option to lengthen its maturity period. Depending on the specific terms of the extendable bond, the bond holder and/or bond issuer may have one or more opportunities to defer the repayment of the bond’s principal, during which time interest payments continue to be paid. Additionally, the bond holder or issuer may have the option to exchange the bond for one with a longer maturity, at an equal or higher rate of interest. Because these bonds contain an option to extend the maturity period, a feature that adds value to the bond, extendable bonds sell at a higher price than non-extendable bonds.
Callable (Redeemable) bond
A callable bond is a bond that can be redeemed by the issuer prior to its maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at a lower rate of interest. In this case, the company calls its current bonds and reissues them at a lower rate of interest.
Equity instrument issued by corporations: common stocks
The common stockholders are the owners of the corporation’s equity
- voting rights
- no specific maturity date and the firm is not obliged to pay dividends to shareholders
- returns come from dividends and capital gains
Equity instrument issued by corporations:Preferred stock
Have face value, predetermined periodical (dividend) payments with priority over common stockholders
-No voting right but if dividend payment is not paid, preferred stockholders may get voting rights
Cumulative preferred stock
type of preferred stock with a provision that stipulates that if any dividends have been omitted in the past, they must be paid out to preferred shareholders first, before common shareholders can receive dividends.
Non-cumulative preferred stock
refers to the preferred stock shares which usually have dividends starting all over in every year. In case the company fails to pay dividends in one year, the dividends will not accumulate in arrears. The company is only expected to pay the dividends for the current year before the remaining amount is paid to the common shareholders.
Participating preferred stock
Type of preferred stock that gives the holder the right to receive dividends equal to the normally specified rate that preferred dividends receive as well as an additional dividend based on some predetermined condition.
Non-participating preferred stock
is a preferred share in a corporation with a feature that limits the dividends that can be issued per year. This maximum limit is usually written or stated on the face of the stock certificate as a percentage of the par value. It can also be stated in real dollars.The reason why non-participating preferred stockholders have maximum dividend limit each year is because preferred shareholders receive their dividends before any common shareholders. This secures that if the corporation declares dividends, the preferred shareholders will get paid no matter what. After the preferred dividends are paid off, the common stock shareholders will get whatever is left.
Derivative securities
Securities whose value is derived from the value of some underlying asset- most important derivatives are options and futures
Stock options
A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain period of time
-Not a tool of fundraising, but a method of compensation
How are prices of financial instruments determined?
In equilibrium by demand and supply forces
-reflect market expectations regarding the future as inferred from currently available information
Bootstrapping
The process by which many entrepreneurs raise “seed” or start-up money and obtain other resources necessary to start their businesses
- Initial seed money from the entrepreneur or other founders
- Other cash may be from personal savings, sale of personal assets, loans from family and friends, use of credit cards
- seed money spend on developing a prototype of the product or service and a business plan
- 1-2 years
Venture capital
v. capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing
- individual v. capitalist or angel investors are typically wealthy individuals who invest their own money in emerging businesses at very early stages in small deals
Three Reasons why traditional sources of funding do not work for new or emerging businesses
- The high degree of risk
- Types of productive assets
- information asymmetry problems
What do Venture capitalists’ investment give them?
- equity interest in the company often in a form of preferred stock that is convertible into common stock at the discretion of the venture capitalist
What do Venture capitalists provide?
involvement depends on the experience of the management team
-because of their industry and general knowledge about what it takes for a business to succeed, they provide counsel for entrepreneurs when a business is being started and during early stage of operation
How doe Venture Capitalists reduced their risks?
Some tactics to reduce risk are:
- funding the ventures in stages
- requiring entrepreneurs to make personal investments
- syndicating investments
- in-depth knowledge about the industry
Syndication
Occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalist
How does syndication reduce risk?
- It increases the diversification of the originating venture capitalist’s investment portfolio
- willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision
The exit
Venture capitalists are not long-term investors in the companies, but usually exit over a period of three to seven years
-Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process: timing, the method of exit, and what price is acceptable
What are the principal ways in which venture capital firms exit venture-backed companies?
- sell to a strategic buyer in the private market
- sell to financial buyer in the private market
- initial public offering: selling common stock in an initial public offering
