Final Exam Flashcards
What are the two types of financial markets?
Public financial markets
» markets for the creation, sale, and trade of liquid securities having standardized features
Private financial markets
» markets for the creation, sale, and trade of liquid securities having les standardized negotiated features.
What are the different types of risk?
Default risk
» risk that a borrower will not pay the interest and/or principal on a loan
Interest rate risk
Market risk
What is nominal interest rate ?
Observed or stated interest rate
What is the real interest rate (RR)?
Interest one would face in the absence of inflation, risk, illiquidity, and any other factors to determine the interest rate.
R debt (Rd) = RR + IP +DRP +LP + MP
What is risk-free interest rate?
Interest rate on debt that is virtually free of all default risk.
What is inflation?
Rising prices not offset by increasing quality of the goods or services being purchased.
What is inflation premium (IP)?
Average expected inflation rate over the life of a risk-free loan.
Risk-free rate (Rf) = RR +IP
What is default risk premium (DRP)?
Additional interest rate premium required to compensate the lender for the probability that a borrower will default on a loan.
What is prime rate?
Interest rate charged by banks to their highest-quality (lowest default risk) business customers.
What are bond ratings?
> > An assessment that reflects the default risk of a firm’s bonds as judged by a bond-rating agency
Ex. Standard&poor’s or moody’s
***for larger mature corps, differences in DRPs are often captured by bond ratings
***Liquidity and maturity horizon may influence the nominal interest rate on a ventures’ bond
What are the two different types of premiums?
Liquidity premium (LP) >> Premium charged when a debt instrument cannot be converted to cash quickly as its’ existing value
Maturity Premium (MP) >>premium that reflects increased uncertainty associated with long-term debt
What is the term structure of interest rates?
Relationship between nominal interest rates and time to maturity when default risk is held constant.
Also known as YIELD CURVE
» Graph of the term structure of interest rates
Describe debt.
Debt issues may be SECURED or UNSECURED.
Senior debt: debt secured by a venture’s assets
Subordinated debt: Debt with inferior claim (relative to senior debt) to venture’s assets
There is an investment risk of loss:
» chance or probability of financial loss from a venture investment
Describe rate of return
Probability -weighted average of all possible rates of return
%Rate of return = (cash flow+(ending value-beginning value))/(beginning balue)*100
Standard deviation.
Coefficient of variation
Measure of a the dispersion of possible outcomes and the expected return of an investment
Measure of the dispersion risk per unit of expected rate of return
What are the different type of investors?
Private equity investors
»owners of proprietorships, partners in partnerships, and owners in closely held corporations
Closely held corporations
»corporations whose stock is not publicly traded
Publicly traded stock investors
»equity investors of firms whose stocks trade in public markets such as the over-the-counter market or an organized securities exchange
What are two different type of markets?
Over-the-counter (OTC)
»network of brokers and dealers that interact electronically without having a formal location
Organized securities exchange
»a formally organized exchanged typically having a physical location with a trading floor where trades take place under rules set by the exchange
What is market capitalization (aka CAP)?
A firm’s current stock price multiplied by the number of shares that are outstanding
What is the investment risk premium (IRP)?
Additional return that investors can expect to earn when investing in a risky publicly traded common stock
Market risk premium (MRP)
Excess average annual return of common stocks over long-term government bonds
Venture Hubris
Optimism expressed in business plan projections that ignore the possibility of failure or underperformance
Weighted average cost of capital (WACC)
Weighted average of the cost of the individual components of interest bearing debt and common equity capital
***most early stage financing is equity capital
Business planning.
***Business plan must allow the time and money necessary to secure proper legal advice from attorneys who specialize in tracking, interpreting, and apply the every-changing securities law
***during the development and startup stages, entrepreneur is likely to focus on identifying, developing, and bringing to market a product, service, or process
Business angels
Investors who typically invest in the equity of an LLV or a nonpublic (subchapter S or C) corporation
Venture capitalists
Investors who prefer equity investments in nonpublic corporations with the contractual agreements (spelled out in “term sheets”)
Heart of securities law
- Prospective investors should have all relevant information necessary to make informed investment decisions
- Investors in securities available to the general public should not be permitted to benefit from nonpublic or inside information
- Deceived investors should receive relief in the event of securities fraud
Securities act of 1933
> > main body of the federal law governing the creation and sale of securities
Securities exchange act of 1934
> > federal law that deals with the mechanisms and standards for public security trading
Securities crowd funding
JOBS act title III’s small offering registration exemption form SEC registration requirements involving crowdfunding for the sale of securities
Blue-sky laws
State laws designed to protect individuals from investing in fraudulent security offerings
offer — every attempt or offer to dispose of or solicitation
Sale — offer to buy
Expected value
Weighted average of a set of scenarios or possible outcomes
Internally generated funds
Net income or profits (after taxes) earned over an accounting period
— to calculate:
»sustainable sales growth rate:
Rate at which a firm can grow sales based on the retention of profits in the business
Financial capital needed (FCN)
Funds needed to acquire assets necessary to support a firm’s sales growth
Spontaneously generated funds
Increases in accounts payables and accruals (wages and taxes) that accompany sale increases
Additional funds needed (AFN)
Gap remaining between the financial capital needed and that funded by spontaneously generated funds and retained earnings
AFN = required increase in assets - spontaneously generated funds - increase in R/E
Percent of sales forecasting method
Forecasting method that makes projections based on the assumption that most expenses and balance sheet items can be expressed as a percentage of sales
Constant ration forecasting method
Variant of the percent-of-sales forecasting method that projects selected cost and balance sheet items at the same growth rate as sales
The financial forecasting method:
- Forecasted sales
- Project the income statement
- Project the balance sheet
- Project the statement of cash flow
Venture capitalists (VC’s)
- Having personal stakes and have raised funds
- Individuals who join in formal, organized firms to raise and distribute venture capital to new and fast-growing ventures
American research and development (ARD) —1946
1st investment : high voltage engineering corporation, a venture organized by MIT physicists and engineers
Small business administration (SBA) in 1953
- tax advantages
- borrow 4 x the SBIC equity base
Professional venture investing cycle
- Determine (next) fund objectives and policies
3 common
characteristics:
- industry
- stage and size of investment
- geographic area - Organize new fund (usually a partnership)
- Solicit investments in new fund
- Obtain commitment for series of capital calls
- Conduct due diligence and actively invest
- Arrange harvest or liquidation
- Distribute cash and securities proceeds (as available)
- Determine (next) fund objectives and policies
Business incubators
- organization that helps startup companies develop by providing management, operating, and financial services
- usually formed as a nonprofit
- length of time a co. Can stay in the program depends:
—complexity of the business model, predetermined revenue, or other benchmark targets
Seed Accelerator
Startup accelerator
- organization that usually provides both an equity investment and a mentoring and educational, fixed-term , cohort program to help startup co. succeed
Business incubators and seed accelerators offer mentoring, networking, and business educational skills to startup firms accepted into their programs. These benefits, along with obtaining loan funds by business incubators and the injection of seed equity by business accelerators, providing important assistance and support for entrepreneurs who are successful applicants.
Business crowd sourcing
- process of obtaining business ideas, development support, and operating services from a large network of non-employees
- lower development and opportunity costs at a faster speed
Crowd funding
- process of financing ideas, ventures, and projects by gathering funds from a large network of people
Reward-based crowdfunding
- involves soliciting non-equity funds to finance specific business products and services or to request donations form a specific purpose
- keep what is raised or all-or-nothing
Equity crowdfunding
- involves soliciting funds from a large number of small investors in exchange for an equity position in the venture requesting the funding.
The five C’s of credit analysis
Capacity - an indicator of future payment performance
Capital - personally invested
Collateral - “guarantees”
Conditions - purpose of loan
Character - general impression
Primary criterion
—- Firm’s ability to pay off loan + interest
Commercial loan restrictions
Maintenance of accurate records and financial statements
Limits on total debt
Restrictions on dividends or other payments to owners and/or investors
Restriction on additional capital expenditures
Restrictions on sale of fixed assets
Performance standards of financial ratios
Current tax and insurance payments
Small business administration programs
- provide contract assistance and counseling
- 7(a) loans
- 504 loans
- micro loans
- venture capital
Factoring
- selling receivables to a third party at a discount from their fv
- could be with recourse or without recourse
Receivables lending
Use of receivables as collateral for a loan
Venture leasing
Leasing contracts where one component of the return to the lessor is a type of ownership in the venture, usually through warrants
Direct public offerings
Security offering made directly to a large number of investors
Harvesting
Process of exiting the privately held business ventures to unlock the owner’s investment value.
- Through a systematic distribution of assets directly to the owners
- Through an outright sale of the going concern to others.
Unicorns
High-expected growth companies with valuations in excess of $1 billion
Systematic liquidation
> > a venture liquidated by distributing the venture’s assets to the owners
Advantages:
-the entrepreneur and other owners maintain control throughout the harvest period
- the harvesting of the investment value can be spread out over a number of years
- the time, effort, and cost of finding a buyer for the venture can be avoided
Disadvantages:
-The treatment and taxation of liquidation proceeds as ordinary income (rather than capital gains)
- the commitment of the entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more lucrative.
- the acceleration of the rates of decline in the going concerns’ value as other industry participants respond to the reduction in the investment
Outright sale
> > venture sold to others, including family members, managers, employees, or external buyers
Family members
Can transfer through
- heir
- selling
Managers
> > have limited personal resources for an outright buy
- leveraged buyout (LBO)
- Management buyout (MBO)
***LBO/MBO exit strategy requires a tight plan for streaming operations and cutting costs
Leveraged buyout (LBO)
> > Purchase price of a firm is financed largely with debt financial capital
~ existing investors equity is retired from an aggressive debt issue
Management buyout
> > special type of LBO where the firm’s top management continues to run the firm and has a substantial equity position in the reorganized firm
Employees
- employee stock ownership plans (ESOPS)
- available in leveraged (harvest all at once) and un-leveraged securities
Outside buyers
Valuation analysis for an acquisition
- control premium: “value of controlling the venture”
~related to the value
-illiquidity discount : “compensate for the resale of disadvantages”
Initial public offering (IPO)
- a venture’s first offering of SEC registered securities to the public
Primary shares offering: the sale of new shares (securities)
Secondary shares offering: the sale of used shares (securities)
Investment banking
> > an intermediary assisting in the creation, sale, and distribution of financial assets.
experts; initiate markets
Underwriting spread (typically 7 to 10 percent) -difference between what the investment bank gets from selling securities to public investors and what it pays to the issuing firms
Red herring disclaimer
Obligatory disclaimer disavowing any intent to act as an offer to sell, or solicit an offer to buy securities
Investment banking due diligence
The process of ascertaining, to the extent possible, an issuing firm’s financial condition and investment intent
Firm commitment
Type of agreement with investment bank involving the investment banks’ underwritten purchase and resale of securities
Best efforts
Type of agreement with investment bank involving only marketing and distribution efforts
Seasoned offering
A firm that has already had publicly traded shares
Unseasoned offering
When the issuer has not previously issued that type of security
Financial distress
When cash flow is insufficient to meet current debt obligations
Loan default
Occurs when there is a failure to meet interest or principal payments when due on a loan
Acceleration provision
Provides that all future interest and principal obligations on a loan become immediately due when default occurs
Cross-default provision
Provides that defaulting loan places all loans in default
Foreclosure
Legal process used by creditors to try to collect amounts owed on loans in default
Insolvent
> > when a venture has a negative book equity or net worth position and /or when its cash flow is insufficient to meet current debt obligations
A) balance sheet insolvency
B) cash flow insolvency
Balance sheet insolvency
- exists when a venture has negative book equity or net worth because total debt exceeds total assets
- common during early stages
Cash flow insolvency
Exists when a venture’s cash flow is insufficient to meet its current contractual debt obligations
Restructuring
> > turnaround a financially distressed venture
- operations restructuring
- asset restructuring
- financial restructuring
Operations restructuring
Involves growing revenues relative to costs and/or cutting costs relative to the venture’s revenues
Asset restructuring
Involves improving the working capital to sales relationships and/or selling off fixed assets
Financial restructuring
Involves changing the contractual terms of the existing debt obligations and/or the composition of the existing the venture
- debt payment extension
- debt composition change
Debt payments extension
Involves postponing due dates for interest and principal payments on credit purchases
Debt composition change
Occurs when creditors reduce their contractual claims against the venture
Federal bankruptcy reform act of 1978
Ch. 11 - business reorganizations
Ch.7 - procedures for liquidating a ventures assets
Bankrupt
When a petition for bankruptcy is filed with a federal bankruptcy court.
- voluntary bankruptcy petition
- involuntary bankruptcy petition
Bankruptcy reorganizations
- a successful reorganization and continuing of operations
- Merging the venture with another firm
- liquidating the venture under Ch. 7 of the bankruptcy law
Reasons for legal reorganizations
- Common Pool problem
- holdout problem
Common pool problem
When individual creditors have incentive to foreclose on the venture even though it is worth more as a going concern
Automatic Stay provision:
A restriction on the ability of an individual creditors to foreclose to try to recover their individual claims
Holdout problem
When one or more of the creditors refuses to agree tot eh reorganization term because of the potential for a larger individual recovery.
Cram-down procedure:
- Bankruptcy court accepts a reorganization plan for all creditors, including dissenting creditor classes
Debt-in-possession financing
-short-term financing, made all existing unsecured debt, to help meet liquidity needs during the reorganization process
Liquidations
- restrict management from fraudulently transferring the ventures assets.
- provides a court-decided “fair and equitable” basis for allocating the asset proceeds to all claimants
- Allows the entrepreneur and other shareholders to “walk away” from the venture with no further obligations
Liquidity order of claims
- administrative costs associated with the venture’s liquidation
- wages and other unpaid employee benefits (limited to amounts earned within the past three months with a maximum of $2,000 per employee)
- specific consumer claims ($900 maximum per claim)
- Tax claims (property and income taxes)
- Secured creditors (entitled to the proceeds from sale of plan and equipment pledged as security for mortgage loans or bonds )
- unfunded pension plan liabilities ( a portion may have prior claim over general creditors while the remainder has a claim equal to the general creditors)
- General (unsecured) creditor claims (includes holders of trade credit, unsecured loans including debenture loans, and unpaid portions of secured loans)
- preferred stock holder claims
- common stock holder claims (differential priorities might exist if different classes of common stock had been previously issued)
Two types of cost
- implicit
- explicit
Difference between accounting perspective and finance perspectives
- Cash flow is a new venture’s lifeblood.
- Finance perspective demands that, where possible, the cost of financial capital be explicitly incorporated in evaluations, projections, and strategy.
State securities regulations
- in addition to federal restrictions, issuers must also consider restrictions imposed by the various states
- state securities regulations are “blue sky” laws
- designed to protect individuals from investing in fraudulent security offerings
Role of federal securities law
- Federal laws frequently are predicated on some offending behavior’s affecting more than one state
- This focus is due to “state-rights” traditions and the notion that an infraction confined to one state is a state, not a federal, matter.
Securities fraud
- It is unlawful for a person in the offer or sale of securities:
- to employ any device, scheme, or artifice to defraud
- to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact
- to engage in any transaction, practice, or course of business which operates as fraud or deceit upon the purchaser
Projected financial statements
Financial forecasting process to project financial statements
- forecast sales
- project income statement
- project balance sheet
- project statement of cash flows
Carried interest
portion of profits paid tot eh professional venture capitalist as an incentive compensation
two and twenty shops
investment management firms having a contract that gives them a 2% of assets annual management fee and 20 percent carried interest
Capital call
when the venture fund calls upon the investors to deliver their investment funds
- it is common to require subsequent investments consistent with the levels of investors’ initial contributions
Deal flow
flow of business plans and term sheets involved in the venture capital investing process
due diligence (in venture investing context)
process of ascertaining the viability of a business plan
VC screening criteria
- venture capital firm requirements
- characteristics of the proposal
- Characteristics of the entrepreneur/team
- nature of the proposed industry
- strategy of the proposed business
Term sheet
Summary of the investment terms and conditions accompanying an investment
- valuation
- ongoing funding needs
- size and staging of financing
- preemptive rights on new issues
- commitments for future financing rounds and performance conditions
- form of security or investment
- redemption rights and responsibilities
Protective clauses in case of default
- acceleration provision: provides all future interest and principal obligations on loan become due immediately upon default
- cross-default provision: provides that defaulting on one loan places all others in default
Private workouts
voluntary agreement between a venture’s owners and its creditors that provides for a financial restructuring of the venture’s outstanding debt
Private liquidations
assignment: transfer of title to the ventures assets to a third-party assignee or trustee
