Final Study Flashcards
When did the SEC get created?
1934
What is the primary objectives of the SEC?
To regulate all companies that have publicly traded securities.
What does the SEC publish on a periodic basis?
ASRs (Accounting Series Releases)
What organization has the SEC granted authority to monitor accounting standards?
FASB (Financial Accounting Standards Board)
Define: Accounting Periods
The rule that financial reports should be prepared periodically and cover periods of equal length. Companies may choose the time of year they desire their accounting periods to end.
Define: Matching
Firms should include all expenses incurred to realize the revenues that they report.
Define: Conservatism
Frims should report the lowest figure when uncertainty exists
Define: Understandibility
The information contained in reports should be written at a level that the reader with reasonable conprehension of business practices can understand.
Define: Relevance
Reports should contain information that is relevant to the decisions at hand.
Define: Reliability
Information provided should be complete and verifiable.
Define: Consistency
Firms should strive to use consistent accounting methods so their statements can be compared over time.
What are the 5 requirements that all firms must report?
The financial position at a period’s end, the cash flows of a period, the earnings for a period, the comprehensive income for the period, and the investments and distributions to owners for the period.
Define: Balance Sheet
the report that records a firm’s assets, liabilites, and owner’s equity at a point in time.
Does the balance sheet report over a period or at a point in time?
At a point in time.
What is the formula for Assets, Liabilities, and Owner’s Equity?
Assets = Liabilities + Owner’s Equity
When do firms normally end their fiscal years?
Firms will end their fiscal year when they are in their most favorable financial position .
What is a comparative balance sheet?
A balance sheet that shows multiple years.
What are the other names for an Income Statement?
Statement of Earnings or Profit and Loss statement
Define: Income Statement
The report that records a firm’s earnings for a period and shows factors that influenced those earnings.
Does the income statement report over a period or at a point in time?
Over a period
What is the intent of an income statement?
To match a companies expenses with its revenues for an entire reporting period
Define: Net Income
The difference between the firm’s revenues and expenses.
What are some other names for Net Income?
Net Profit, Net Earnings, Profit after Tax
Are companys’ Net Income and Cash flow the same thing?
No, they are rarely the same number and they are not synonymous.
What are two noncash expenses?
Depreciation and amortization
Do noncash expenses reduce net income or a firm’s cash position?
They reduce a firm’s net income because they are expenses but do not require a transfer of cash.
Are all cash outlays represented as expenses?
No, purchases of inventory or property, plant and equipment are not expenses,
Define: Operating Income
The firm’s income after operating expenses from the main line of business before the inclusion of income from investments but before interest or taxes have been deducted.
Define: Earnings Before Interest and Taxes
The firm’s total income from all sources before interest and taxes have been deducted.
Define: Earnings before Tax
The Firms EBIT, less interest charges
Define: Gross Margin
Net Income minus the cost of goods sold or the cost of sales
What is another name for Gross Margin?
Gross Profit
Define: Gross Profit
Net Income minus the cost of goods sold or the cost of sales
Define: Statement of Owner’s Equity
Report that describes all changes in the owners’ equity account.
Define: Treasury Stock
Outstanding shares that have purchased by the company but not retired
Does the statement of Owners’ Equity report over a period or at a point in time?
Over a period.
Define: Statement of Cash Flows
Report that the inflow and outflow of cash for a firm.
What are the three major headings for the Statement of Cash Flows
Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities
What does Cash Flow from Operating Activities Show?
Net Income plus noncash expenses with other adjustments
What does the Cash Flow from Investing Activities Show?
The cash flow from investing activities and presents cash flows related to purchase and sale of property, plant, and equipment and other non-current investments.
What does the Cash Flow from Financing Activities Show?
The effects of financing activities such as issuance and repayment of debt, stock and payment of dividends.
Are Dividends a use or source of cash?
Use.
What are the three types of ratios that analysts use?
Operating Performance Ratios, Liquidity Ratios, Financial Strength Ratios
What do Operating Performance Ratios show?
They measure a firm’s profitability and asset usage.
What do Liquidity Ratios show?
They measure a firm’s ability to meet short term financial obligations and its skill in managing working capital.
What do Financial Strength Ratios show?
They measure a firm’s risk that is associated with the way a company has packaged its debt and equity trhat it uses to finance its assets.
Define: Profit Margin
Indicates a firm’s ability to convert its sales into earnings. Also called Return on Sales
Define Return on Sales
Indicates a firm’s ability to convert its sales into earnings. Also called Profit Margin
Profit Margin Formula
Net Income / Net Sales
Return on Sales Formula
Net Income / Net Sales
What kind of ratio is Profit Margin?
Operating Performance Ratio
What kind of ratio is Return on Sales?
Operating Performance Ratio
Define: Gross Margin Ratio
The average percentage by which a sales price of a company’s goods or services exceeds the cost of those goods or services
Gross Margin Ratio
Net Sales (Costs of goods Sold) / Gross Margin
What kind of ratio is the Gross Margin Ratio?
Operating Performance Ratio
Define: Asset Turnover
The firm’s ability to generate sales through its assets
What kind of ratio is Asset Turnover?
Operating Performance Ratio
Define: Return on Assets (ROA)
The best indicator of a firm’s asset usage. Also called ROI (Return on Investment)
ROA (Return on Assets) Formula
Profit Margin * Asset Turnover
What kind of ratio is ROA (Return on Assets)
Operating Performance Ratio
What kind of ratio is ROI (Return on Investment)
Operating Performance Ratio
Are analysts more interested in points of time or periods of time?
Normally analysts are interested in periods of time for comparison sake. It is best to use years worth of data for comparison.
What are qualifications for companies to be compared?
They must be of similar size, with similar accounting methods, in the same kind of business, and the strategies of the company must be known.
Define: Horizontal Percentage Changes
Differences from year to yhear in discrete components of financial statements.
Define: Vertical Percentage changes
A benchmark is chosen (normally sales) and other components are expressed against that benchmark
Is it better to use Horizontal Percentage Changes, Vertical Percentage changes, or both?
Both, because it gives insight into the company.
Define: DuPont Formula
Represents a snapshot of every key ingredient of a firm’s financial position
DuPont Formula
(Net Income/Sales) * (Sales/Assets) * (Assets/Equity)
What does the duPont Formula (methodology) allow you to isolate?
The factors that are responsible for the ROE.
Define: Sustainable Rate of Growth
the extent a company can grow without having to obtain outside financing.
Sustainable Rate of Growth Formula
(Sales/Total Assets) * (Net Income/Sales) * (Total Assets/Total Debt) * (1- Payout Ratio)
Define: ROE (Return on Equity)
The return on investment for the firm’s shareholders
ROE (Return on Equity) Formula
(Net Income Available to Shareholders)/(Average Owner’s Equity)
What is Net Income Available to Shareholders?
Net Income - Interest - Taxes - Dividends paid to preferred stockholders
Define: P/E (Price/Earnings) Ratio
The market price of a company’s stock divided by the EPS
Define: EPS (Earnings Per Share)
The Company’s net income divided by the average number of common stock outstanding during the year.
EPS (Earnings Per Share) Formula
(Net Income Available to Shareholders)/(Average Common Shares Outstanding)
P/E (Price/Earnings) Ratio Formula
Stock Price/EPS
Define: Payout Ratio
The percentage of earnings per share that a company distributes in the form of dividends.
Payout Ratio Formula
Dividends/Net Income
Define: Times Interest Earned
How many times over a firm’s earnings could pay for the interest obligations of a firm.
Times Interest Earned Formula
EBIT (Earnings before Interest & Taxes) / Interest Obligations
What kind of ratio is ROE (Return on Equity)?
Operating Performance Ratio
What kind of ratio is Payout Ratio?
Operating Performance Ratio
What kind of ratio is P/E (Price/Earnings) Ratio?
Operating Performance Ratio
What kind of ratio is EPS?
Operating Performance Ratio
What kind of ratio is Times Interest Earned?
Operating Performance Ratio
Define: Current Ratio
The company’s ability to meet short term obligations and unforeseen needs.
Current Ratio Formula
Current Assets/Current Liabilities
What kind of Ratio is the Current Ratio?
Liquidity Ratio
Define: Quick Ratio
A variation of the current ratio that only uses assets that are readily converted into cash.
Quick Ratio Formula
(Cash + Marketable Securities + Accounts Receivable)/Current Liabilities
What kind of ratio is the Quick Ratio?
Liquidity Ratio
Define: Receivables Turnover
How quickly a company ordinarily converts accounts receivables into cash.
Define: Days Sales Outstanding
Converts the recievalbes turnover figure into the number of days
Receivables Turnover Formula
Net Sales/Average Accounts Receivables
DSO (Days Sales Outstanding) Formula
Number of Days in a Period(Normally 365)/Receivables Turnover
What kind of ratio is Receivables Turnover?
Liquidity Ratio
What kind of Ratio is DSO (Days Sales Outstanding)?
Liquidity Ratio
Define: Inventory Turnover
How well a company is managing its working capital account. OR how long it takes for a company to buy inventory and turn it into a finished good.
Inventory Turnover Formula
Cost of Goods Sold/Average Inventory
What kind of ratio is Inventory Turnover?
Liquidity Ratio
Define: Days Inventory
Turns the Inventory turnover into number of days
Days Inventory Formula
Number of Days in a Period(Normally 365)/Inventory Turnover
Define: Operating Cycle
Estimates how long it takes a business to complete the purchase of inventory, the conversion of inventory to finished goods, the sale of finished goods, and collection of accounts receivable.
What kind of ratio is Days Inventory?
Liquidity Ratio
What kind of ratio is Operating Cycle?
Liquidity Ratio
Operating Cycle Formula
DSO+ Days Inventory
Define: Accounts Payable Turnover
How far a company is stretching its payable obligations
Accounts Payable Turnover Formula
Purchases/Average Accounts Payable
Why is it difficult to get the Accounts Payable Turnover?
Not all companies provide data about their purchases. Instead analysts will use the cost of goods sold plus the changes in inventory
What kind of formula is Accounts Payable Turnover?
Liquidity Ratio
Define: Days Payable
The approximate number of days that it takes for the accounts payable turnover.
Define: Debt to Total Assets
Calculates the percentage of a company’s assets that are being provided by creditors
Debt to Total Assets Formula
Total Liabilities/Total Assets
What kind of ratio is Debt to Total Assets
Financial Strength Ratio
Define: Debt to Capitalization
Shows the long term debt in terms of all equity and debt
Debt to Capitalization Formula
Long Term Debt/(Total Equity + Long Term Debt)
What kind of ratio is Debt to Capitalization?
Financial Strength Ratio
Define: Debt to Equity
The proportion of borrowing to equity in the capital structure.
Debt to Equity Formula
Total Liabilities/Total Equity
What kind of ratio is Debt to equity?
Financial Strength Ratio
Define: Forecasting
Making observations from the surrounding world and making projections.
Define: Pro Forma Financial Statements
Financial statements based on projections in order to plan for future endeavors.
Are Pro Forma Statements accurate?
Pro Forma statements are only as accurate as the assumptions they are built on. These should be tested when possible
When Pro Forma Statements are created, do analysts use single assumptions, a few assumptions or many assumptions?
Analysts try to make many assumptions that are as confident and accurate as possible
What are the three steps to creating Pro Forma Statements?
Qualitative Step (identifies key assumptions), Quantitative Step (Comparative techniques), and testing the assumptions
Where is the best place to start for the Qualitative Analysis step?
Assess factors that may impact the industry as a whole and test them.
What are the Industry Qualitative Factors?
Industry Definition, Sales Influence, and Cost Structure
What are the Company Qualitative Factors?
Company Definition, Sales Influence, and Cost Structure
What is the the best way to define critical variables that influence a firm’s future performance?
Consider a firm’s management, strategies, facilities, size, product line, and cost structure.
Define: Time Horizons
A point in the future where projections might lose credibility.
Is it easy or difficult to establish a projections horizon?
Difficult because accuracy diminishes with the length of time, and different projections may have different horizons and the horizons will have to be the same.
What are the two mathmatical objectives of Quantitative Analysis?
Determine how a company has performed in the past, and to use that as a foundation with assumptions to project the future.
What are some companys that publish industry surveys?
Robert Morris Associates, Standards & Poor’s, and Value Line (and others)
What do Industry surveys show?
the key ratios for an industry
What should you obtain at minimum to assist with Historical Evaluations?
A industry’s historical sales growth, asset usage skill, profitability, return on equity, dividend policy, liquidity, and capital structure.
What purpose(s) the Industry Survey information serve?
Analysts can test assumptions they made during the qualitative analysis, and they can quantify the industry’s record
After obtaining the industry information, what should an analyst collect?
The company’s analysis with the same information.
Should an analyst get vertical or horizontal methods for a company?
Both if possible.
Once an analyst has the Industry Survey information and the company’s analysis, what is the next step?
To compare the two to see if there are similarities or differences.
What is a caveat to projecting statements?
Large assumptions must be made and tested, and not all the results may be of great accuracy.
What is normally decided first when projecting statements?
Sales growth records
What is developed after the Sales Growth records?
Income statements using the desired vertical percentages.
What Cash Flow portion is Net Income a part of?
Cash Flow from Operating Expenses
What statement fulfills a firm’s requirement to disclose its earnings for a period?
Income Statement
What ratios measure a firm’s profitability and asset usage?
Operating Performance Ratios, Liquidity Ratios, Financial Strength Ratios
What ratio shows the average percentage by which sales price exceeds the cost of goods sold?
Gross Margin
What Cash Flow portion is Depreciation a part of?
Cash from from Operating Activities
What does a working capital position measure?
The current assets less the current liabilities at any given time.
What benefits do a company get when they reduce investments in inventory?
Less dependence on short term credit (paying it back), and improving cash flow
What hazards can arise if a company reduces its investment in inventory?
They can lose sales if they overly restrict the amount of inventory.
What ratio is the best indicator of a firm’s ability to manage its assets?
ROA (Return on Assets)
What does Sustainable Growth Calculation Measure?
How quickly a company can expand without taking external capital
Surveys produced by Robert Morris Associates are used during which phase of Analysis?
Quantitiative Analysis
When considering a major company decision, what are the two vantage points?
How the decision will iompact the firm and the resulting stockholder reaction.
Define: Value
Value is added to a firm when earnings are enchances, operation or financial risks are reduced, or when efficiencies result as the consequence of a decision.
When should management reinvest capital into the business?
As long as returns being generated by the business exceed those whicch shareholders could realize by investing their capital elsewhere.
How does Management obtain capital for investment?
Debt, retained earnings (withheld dividends), and new equity issues.
What is management’s return on investment on assets measured in?
Earnings or cash flows
How do investors receive their returns on investment?
Interest payments (lenders/debt holders), dividends or rising stock values (shareholders)
How is value being added to a firm’s owner?
When the rate of return exceeds the cost of capital they have invested.
If Managers cannot find good investment opportunities, what is their duty?
To return shareholders capital so they can invest their funds elsewhere.
Define: Capital Structure
The combination of debt and equity which balance’s a firm’s assets. Also called capitalization.
What is another name for Capital Structure?
Capitalization
Define: Capitalization
The combination of debt and equity which balance’s a firm’s assets. Also called Capital Structure.
What is another name for Capitalization?
Capital Structure
What is an important consequence or result of asset acquisition?
New Net income, cash flow, or efficiency that outweighs the cost of the acquisition.
How are dividends taxed?
At a corporate level and at the personal level of the stakeholder.
What are some internal considerations that need to take place when looking for new funding?
The amount of funding, The structure of the company’s existing capitalization, the company’s future needs
What are some external factors that may influence managers?
High or low interest rates and the market price of shares.
Define: Financial Risk
The uncertainty associated with a company’s ability to convert operating income to a given level of earnings per share.
What are the most commonly used indicators for financial risk?
The capitalization ratios
Why does a capital market prefer a certain level of debt?
Earnings are higher per share in a capital structure where some debt is present.
Define: Dilution
The process by which a given level of earnings is spread of a greater number of shares.
Which sides of the balance sheet can managers use to add value?
Both sides of the balance sheet.
When creating value, are both sides considered at the same time or separately?
They should be considered separately in order to determine the merits from each side.
What is the pattern that an investment/capitalization issue typically follows?
Choose an proposal to invest in, a capitalization package for financing the package is created, and then they are both considered together.
Define: Present Value
the value in the present of a sum of money, in contrast to some future value it will have when it has been invested at compound interest.
What are some variables common to all investments?
Size, duration, return and timing of the return.
Why are investments that provide cash flow sooner preferred?
Because they allow for the reinvestment sooner and money has a different value over time
Define: Accumulated Value
The sum of the payments received up to a future time. Also called Future Value
Define: Future Value
The sum of the payments received up to a future time. Also called Accumulated Value
Future Value Formula
(1+Periodic Interest Rate)^number of periods * Initial Investment
Define: Discount Factor
the rate that an investor believes he can enjoy whether or not an investment is chosen.
Present Value Formula
FV / (1+Interest Rate)^Number of periods in the future
What is the rule of 72?
The rule that bankers used to determine (in approximate terms) what combination of interest rate and years would cause an investment to double.
If an investment pays out over multiple years, how is that calculated?
The years must be calculated seperately then added up in order to get the present value
Is the present value equation a rearrangement of the future value equation?
Yes
True/False: A major tenet of finance is to match short-term assets with short-term borrowings and long-term assets with long-term borrowings.
TRUE
If the financial risk of a firm decreases, what will happen to the stock price?
It will rise
Define: Capital Investments
Investments that provide returns for a period greater than one year
What are some examples of Capital Investments?
Property, plant or equipment; marketing campaigns; research and development, or permanent additions to working capital
What is the most popular way to evaluate capital investments?
Capital Budgeting
What are the 4 steps of capital budgeting?
generation of investment ideas, evaluation and ranking of alternatives, selection of investments, and continuing appraisal of previous investment performance.
Are generating alternative investing ideas more or less important than scrutinizing the current ideas?
They are more important because creative companies will be more successful.
Define: Relevant Cash Flows
Costs and benefits which only exist if an investment is implemented. Also called Incremental Cash Flows
Define: Incrimental Cash Flows
Costs and benefits which only exist if an investment is implemented. Also called Relevant Cash Flows
Define: Sunk Cost
A cost a company will have to bear even if the investment is not understaken or fails. This flow should not be considered an incremental cost during analysis
Define: Acquisition Costs
Cash payments that are required for ownership and any subseqient expenditures required to extend the life of the asset.
What can purchase price be offset by?
Discounts, trade ins, or other means.
What can purchase price be increased by?
Installation charges or freight charges
Define: Operating Costs
The peridodic (usually annual) cost of using the asset. These are normal reoccuring costs.
Is an overhaul an operating cost or an acquisition cost?
It is an acquisition cost because it is not a periodic cost of using the asset.
The benefits of investments are thought of as?
Sources of cash. These may be operating cost savings, additional revenues, tax savings, cash proceeds from the sale of an asset, or the predicated salvage value of the new asset.
Can taxes provide costs of benefits?
They can provide either. The sale of an asset will be subject to taxes if the asset is sold for any price other than book value. If sales price exceeds book value, then it is considered income and taxed. If the sales price is less than book value, it is considfered a loss and taxed at an appropriate rate.
Net Book Value of an Asset Formula
Purchase price + Improvements - Depreciation
When are tax complications avoided?
When a firm retains the old asset and a new asset is bought.
Define: Investment Tax Credits
A credit equal to a certyain percentage of the cost of the investment. This was enacted by congress to stimulate the economy.
Define: Differential Analysis
A technique widely used to identify incrimental benefits and costs.
How is the differential analysis generally displayed?
A table showing the potential areas impacted (revenues, operating expense, utilities, maintenance, salaries, insurance, depreciation)
When performing differential analysis what is important?
To choose a reference point for comparasins. Normally the reference point is the company as it is before any investments take place.
What is the most important practice when capital budgeting?
Consistency.
Tax consequences of the capital gain on the sale of the old asset is
A cost
Is depreciation added or subtracted from Net Income to determine cash flow?
Added
Define: Useful Life
The estimated economic life of an asset.
How are time horizons normally chosen?
Arbitrarily but later they must conform to the period of time an analsyst can be confident in the predicted figures.
Define: Depreciable Life
The number of years that a company will depreciate the new asset.
When a new asset is compared to an old one, how is the time horizon changed?
The time horizon must be shortened to match the older assets.
What is done after a time horizon is compared for new assets and old assets?
The residual cash flows for the new asset must be estimated.
What is year zero defined as on Investment charts?
The moment the investment is implemented
Define: Salvage Costg
The cost of the new value at the end of its useful life
Is salvage cost shown as a cash inflow or a cash outflow?
Inflow
How can investments be ranked?
They are numerically ranked through the comparisons of their retursan. Most are based on Present Value
Define: Payback
The number of years that will pass before returns equal the original investment. Also called Break-even analysis.
What is another name for payback analysis?
Break-even analysis
What is another name for break-even analysis?
Payback analysis
Payback Formula
Investment/Annual Cash Inflows
If the investment does not return regular equal installments, how can you find the payback?
Adding each years return successively until a figure is obtained that equals the original investment.
What is the advantage of the payback calculation?
It tells a firm when they can predict when the cost of investment will be recovered so that funds can be employeed elsewhere
What is a drawback of Payback and break-even analysis?
It does not recognize the magnitude of returns past the payback date
Define Benefit/Cost Ratio
The ratio of incremental cash flows to the acquisition costs
What is the drawback of Benefit/Cost ratio?
It fails to compensate for the time value of money
What are discount factors varied to compensate for?
Risk
Define: Hurdle Rates
Discount factors that firms employ.
What is the most commonly used hurdle rate?
The approximate risk to the firm itself.
Do firms normally rely on a single or multiple hurdle rates?
Single hurdle rate and rely on managers opinions of present values to select investments.
If an investment is perceived as less or more risky, how will the hurdle rate change?
More risk = higher hurdle, lower risk = lower hurdle
Define : Present Value Payback
Same as payback but uses Present Value in the denomiator
Present Value Payback Formula
Initial Investment/PV of Annual Cash Flows
What is a drawback of Present Value Payback?
It does not recognize the magnitude of returns past the payback date
Is it better to use a singular or multiple methods when ranking investments?
It is better to use multiple methods, but Present Value based methods are superior to others.
What does an investment with positive NPV create?
Value
What qualitative assesments must take place when determining investments.
The impact on personnel, the community, the environment, and the law.
Define: Present Value Index
Identical to Benefit/Cost Ratio but uses Total Present Value in the numerator
Present Value Index Formula
Total PV of Annual Cash Flows/Initial Investment
Define: Net Present Value
the present value of a company’s future cash flows minus the initial investment
Net Present Value Formula
Present Value of Annual Cash Flows - Initial Investment
Define: Internal Rate of Return
the discount factor necessary to make an investment’s NPV equal 0
How is Internal Rate of Return normally calculated?
Through Trial and Error manually or through computers and financial calculators
Why are IRR calculations popular?
they describe an investment’s returns in a way that can be compared to the firm’s hurdle rate.
What calculations are Hurdle Rates used in?
Present Value Calculataions or benchmarks that are used to judge internal rates of return
Why aren’t hurdle rates static?
Hurdle rates are normally varied to compensate for risk.
Define: Opportunity Cost
Average hurdle rate. Also called Cost of Capital
Define: Cost of Capital
Average hurdle rate. Also called Opportunity Cost
Define: Operational Risk
The risk associated with a companys ability to produce and market its products
Define: Risk of Illiquidity
An investors lack of access to funds will prevent participation in a better investment
What does the capital market set prices based on?
The markets perception of how a company is doing.
Define: Efficient Market
At any given moment, the prices of securities reflect all that is or can be known about a company’s future.
Why does the Efficient market theory exist?
Because at any time there are hundreds of analysts attempting to find value to exploit.
How do Debt Markets price their funds?
Based on the risk they perceive a firm has.They will set their return requirements based on a firm’s operational risk, financial risk, and the terms of the loan.
Do long term loans or short term loans have a greater probility that a better opportunity will come along for investors?
Long Term Loans
Cost of Capital Formula
(%Debt * Cost of Debt) + (%Equity * Cost of Equity)
Where do you get the data for the Cost of Capital Formula
The balance sheet to get the percentages of debt and equit.
What is a more accurate figure than Cost of Capital?
Target Cost of Capital
Define: Target Cost of Capital
Same as cost of capital but it reflects the future percentages that the company is going to maintain.
Define: Marginal Cost of Capital
same as cost of capital but is based on the prices that are reflected in the current capital structure. (paid in the past) This means it is based on the prices that a company will have to pay to recreate the target structure
What are the two dominant forms of debt?
Loans and Bonds
Is cost of debt calculated before or after taxes?
After Taxes. Interest payments are tax deducitible.
Define: Bonds
Long term securities that a firm issues to investors in return for capital.
What is the most common unit of issued bond?
$1000 bond
Define: Coupon Rate
The interest on a bond.
To calculate the yield to maturity of a bond, you are using which of the following capital budgeting techniques?
IRR
The call price of a bond is also referred to as
Strike Price
How can firms generate equity?
Earnings, issuance of stock
What is the YTM calculated from?
The investor’s perspective.
Define: Yield to Maturity (YTM)
The return that is earned on a bond
If a bond is valued at part, what is its YTM equal to?>
Coupon Rate
If the market falls, will the market discount or mark up bonds with high interest rate?
Mark up
How does the market impact bonds?
As the market rises above the rate, the bonds will lose value and be discounted. As the market falls below the rate, the bonds will gain value and will inflate in price.
The Capital Asset Pricing Model relates historical returns of a company to?
The market as a whole
Cost of Equity Formula
Projected EPS/Stock Price
What is the fundamental assumption underlying dividend discount models?
The maximum price that investors are willing to pay for a stock is the present value of the future dividends they will receive.
What are the two methods for quantifying the returns that investors expect?
Dividend Discounts and Risk Premium Assessments
True/False: Changing YTMs does not change the value of a bond.
True! Market changes the value and that in turn changes YTM.
Define: Call Provision
Permits a firm to repurchase bonds at their market value or par value (if the market value reaches a certain point)
What is the call price also called?
Strike Price
Cost of Debt Formula
(1-Tax Rate) * Interest Rate
Growth Rate Formula
(1-Payout%) * ROE
Define: Risk Premiums
Returns that investors require in excess of the returns that are available in risk-free assessments
What are some “risk free” investments
US Government securities: Treasury Bills and Bonds
Total Required Return Formula
Risk Free Rate + Risk Premium
What is the best way to define a risk premium to use?
Guess!
What does the Capital Asset Pricing Model quantify?
A company’s risk premium by relating the historical returns of that company or the industry that it competes, to the performance of the market as a whole.
Define: Beta
a variable that measures the magnitude of covariance in stock performance and the total stock market
CAPM Formula
Risk Free Rate + Beta*(Market Return-Risk Free Rate)
What does a Beta of 1 mean?
The company has risk equal to the average stock market so it will move in the same direction as the market at the same rate
What does a Beta of less than 1 mean?
The stock value will move in the same direction as the market, but not move as far
What does a Beta of greather than 1 mean?
The stock value will move in the same direction as the market, but move farther
Is Risk increased or decreased as a beta rises?
Greater
What are the two solutions to finding a market return proxy?
An estimate could be made or the historical performance of the market can be used.
Define: Preferred Stock
Provide the holder with ownership in a firm, without exposure to risks that common shareholders have.
Why are Preferred stocks attractive to investors?
They provide a relatively safe and predictable return
What does preferred stocks not provide?
They do not have voting rights, and they do not benefitr from high returns of a profitable year
Cost of Preferred Formula
Preferred Dividends/Preferred Equity of Capital Structure
Define: Convertibles
instruments that can be converted to common stock. This may occur with our without the investor’s approval.
When are call provisions enacted?
When the par value of bonds increase to a certain value (also known as strike price)
Cost of New Equity Formula:
Next Year’s Dividend/StockPrice*(1-Fee%) + Growth Rate
Cost of New Debt Formula:
(Interest on Coupon Payment/Proceeds Debt Issue) * (1-Tax Rate)
