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Accounting managerial > Finance Exam > Flashcards

Finance Exam Flashcards

1
Q

What is Finance

A

the study of how and under what term saving (money are allocated between lenders and borrows

consists of financial systems (public, private and government spaces, and the study of finance and financial instruments)

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2
Q

What is corporate finance

A

the area of finance that deals with the sources of funding and the capital structure of corporations, and the actions taken to increase the value of firm to shareholders

primary goal is to maximize/increase shareholder value

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3
Q

Corporate Finance decisions

A

Capital budeting

Capital structure

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4
Q

What is Capital Budgeting

A

the process of making and managing expenditures on long-lived assets (“what investments should the firm undertake?”)

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5
Q

What is Capital Structure

A

the mixture of debt and equity capital maintained by the firm and used to finance its investment activities (“how should the firm make this investment?”

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6
Q

Absence of Arbitrage Opportunities

A

arbitrage involves exploiting price differences to earn diskless profit

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7
Q

Time Value of Money

A

a dollar today is worth more than receiving a dollar in the future

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8
Q

Risk-Return trade off

A

expected return rises when an increase in risk

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9
Q

Financial Markets

A

Money Markets: markers for short term instruments
Capital Markets: markets for long term debt and equity securities
Primary Markets: when corp issues new securities (cash flows from investors to the firm
Seconday Markets: involve the purchase & sale of “used” securities from one investor to another

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10
Q

Financial Institutions (intermediaries)

A

facilitate flows of funds from savers to borrows (banks,, Pension funds, etc.). Most efficient manner (direct or indirect (intermediation) finance)

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11
Q

Two major categories of financial securities

A

Debt instruments: commercial paper, treasury bills and notes, mortgage loans, bonds
Equity instruments: common stick, preferred stock

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12
Q

Marketable securities

A

can trade between or among investors after their original issue in public markets and before they mature or expire (publicly-listed stocks, corporate bonds)

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13
Q

non-marketable securities

A

cannot be traded or amount investors (savings accounts, term deposits)

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14
Q

Separation of Ownership and Control

A

Agency Relationship
Agency Problem
Agency Costs

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15
Q

Agency relationship

A

principals hire agents to represent their interests (shareholders hire managers)

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16
Q

Agency Problem

A

when their are conflicts of interest between principle and agents. Agents incentives might be misaligned

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17
Q

Agency Costs

A

the costs of resolving conflicts of interest (agency problem)

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18
Q

Financial Markets Fisher Model:

A

motivates the existence of capital markets, individuals can borrow or lend fund in financial markets to alter their consumption and increase utility

motivates the “positive NVP rule”, accept projects > NPV

Consumption vs. Investment decisions (can be made independently of each other)

basic principle of investment decision making is: “investments must be at least as desirable as opportunities available in the finance markets

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19
Q

Key conceptual issues with fisher separation

A
  • says that all investors will want to accept or reject the same investment project using NPV rule, regardless of personal consumption preferences
  • shareholders will be united in their preference for the firm to undertake profit NPV decisions, regardless of their personal consumption prefrences
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20
Q

Shareholder Wealth Maximization

A

considered the most appropriate goal
genuine economic profit
reflects the value of these economic profits both now and into the future

Can only be one equilibrium interest rate (otherwise arbitrage opportunities would arise

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21
Q

Perfectly competitive & frictionless markets

A

trading is costless (no taxes)
info about borrowing and lending opportunities is available to all agents
there are many traders (all price takers, not setters).

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22
Q

The one period case

A

PV and FV (lump sum cash flows)

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23
Q

The multi-period case

A

PV (multiple cash flows)

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24
Q

APR

A

Annual Percentage Rate, or “quoted” rate
IGNORES COMPOUNDING effects
APR = EAR when there is annual compounding and payments are made annually
just “r” in formula

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25
Q

EAR

A

Effective annual rate
ACCOUNTS for compounding effects
gives the TRUE rate states in annualized terms

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26
Q

Simplifications to reduce calculations

A

Annuities and Perpetuities

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27
Q

“m” in EAR formula

A

compound periods

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28
Q

NPV

A

If the project’s NPV is positive, the project should be accepted
Cash flows/(1+r) - the initial Investment

  • represents the expected change in firm value from undertaking the project. the positive NVP’s creative value, and negative destroy value
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29
Q

Strengths of NPV measure

A

uses cash flows rather than accounting numbers
analyzes all of the projects cash flows
correctly discounts these cash flows accounting for the TVM
is conceptually attractive and relatively easy to interpret

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30
Q

Payback Period

A

= PBP represents the time a project requires to recover the initial cost. A project is accepted if its payback period is less than a specified benchmark
accepted: PBP < specified benchmark

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31
Q

Weaknesses of PBP

A
  • Cash flows occurring after PBP is achieved are ignored
  • Cash flows are not discounted. PBP thus ignore the TMV
  • the choice of policy benchmark is arbitrary
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32
Q

Strengths of PBP

A
  • simple to compute & easy to understand making it useful for small day-to-day decisions
  • may be useful for firms with limited access to capital due to its emphasis on speedy cash recovery
  • may not be as limited in practice as its theory. significant cash flows beyond the cutoff may be ignored
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33
Q

IRR

A

discount rate applied to a projects cash flows such that the project has a net present value of zero (BREAK EVEN DISCOUNT RATE)
most important alternative approach to NPV
no algebraic formula that can be used when more than 2 non-zero cash flows (FINANCIAL CALC)

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34
Q

IRR decision rule

A

IRR > project’s discount rate —-> Accept project (NPV>O)

IRR < projects discount rate ——> REJECT project (NPV<0)

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35
Q

Issues with IRR approach

A

independent and mutually exclusive projects

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36
Q

independent projects

A

independent is its acceptance/reject has no impact on the acceptance of other projects

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37
Q

mutually exclusive projects

A

mutually exclusive when accepting one project dictates the rejection of all others (amount of land - open a nightclub, parking lot or shop?)

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38
Q

Multiple Rates of Return

A

Future cash flow is negative.
ex: open, profit, close and renovate
2 feasible MULTIPLE IRR’s (2 multiple signs

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39
Q

Issue’s facing mutually exclusive projects

A

Scale Problem:
- IRR is states as percentage that doesn’t account for the size of the iniacial investment
- could use the NPV approach instead
- Incremental IRR
Timing Problem:
- projects that have larger cash flows earlier will tend to have higher IRR’s

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40
Q

Scale problem : Incremental IRR

A

select larger project and forgo smaller one

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41
Q

Timing problem solve

A
  • compare projects NPV’s
42
Q

Profitablilty Index

A

A profitability index thats > 1 signifies that a project has a positive NPV

  1. indefendent projects
  2. mutually exclusive projects
  3. caption rationing
43
Q

Profitabiliy index : Independent Projects

A

accept all projects with PI’s greater than 1 (positive NPV)

44
Q

Profitabiliy index : Mutually exclusive projects

A

PI measure suffers from the scale problem as the IRR measure (doesn’t account for the size of mutually exclusivee projects )
Use NPV approach instead

45
Q

Profitabiliy index : Capital rationing

A

may not have sufficient funds available to pursue all of its positive NPV projects - lead to incorrect decision based on NPV criterion
rank in order of PI (lowest to highest) - which provides most value per dollar invested

46
Q

Capital budgeting problems using NPV rule steps

A
  1. identify incremental cash flows
  2. dress the tax implications
  3. TVM (discount back to PV)
47
Q

Step 1. identify incremental cash flows

A

depreciation expense is NOT a cash flow
any cash flow must be incremental - (does rallying this cash flow depend directly on acceptance or rejection of project?

Opportunity costs (incremental)
Erosion (incremental cash flow) - cash flow you will loose from existing flow if you open another one
Synergy (opposite of erosion)

Note: SUNK costs are NOT INCREMENTAL

48
Q

Step 2. Address the tax implications

A

Revenue (after tax). = revenue (pretax) x (1-tax rate)

Capital Cost Allowance Tax Sheild - PV CCATS
= the easiest way to determine the present value of these tax savings is to apply the formula

49
Q

Step 3. Time Value of Money (discount all future cash flows to their time zero PV

A

ensure all after tax cash flows are discounted back to time zero - PV CATTS already does this (PV)

50
Q

Inflation and Discount Rates

A

real cash flows - real discount rates
nominal cash flows - nominal discount rates

convert interest rates from real to nominal, we can use the famous Fisher Equation

51
Q

Operate Cash flows

A

OCF is the cash flow thats started on after tax basis

52
Q

Top Down approach (OCF)

A

OCF = Sales - costs - taxes

53
Q

Tax shield Approach

A

on formula sheet

54
Q

Bottom up approach (OCF )

A

OCF = Net income + depreciation

55
Q

Investments with unequal lives

A

inadequate when different expected durations
longer = more time to generate positive cash flows
find the C in pV annuity formula

find NPV of each project under analysis and find the equivalent annual cash flow by computing annuity payment associated with NPV

56
Q

Risk and Capital Budgeting

A

Sensitivity Analysis
focuses on evaluating how susceptible a projects NPV is to a change in one of the inputs. one input is varied while others are assumed to meet their expected values

Scenario Analysis
is a variation on sensitivity analysis where a number of differently likely scenarios are evaluated and each scenario involves multiple factors varying
ex :if management is ineffective, variable costs, FC’s and initial costs might all rise above their expected values

Break-even analysis
shows the level of sales that are needed to achieve a zero NPV. BEP determine the sales level such that PV inflows equals PV outflows

57
Q

Bond Valuation

A

Bonds = debt securities (fancy IOU)

58
Q

Zero-coupon bond (pure discount)

A

funds are borrowed at t=0 and FV is repaid upon maturity. PV lump sum formula
ex: Canadian Treasury Bills

59
Q

Coupon bonds

A

funds are borrowed at t=0
make coupon payments to repay the FV at maturity
PV annuit and PV lump sum formula an adding the two results together

60
Q

YTM

A

discount rate

Coupon bond = conceptually equivalent to capital budgeting project IRR

61
Q

Coupon rates

A

not the same as the bonds YTM. refers to the bonds coupon payments

CR = Annual coupons / FV

62
Q

Bonds concepts

A

when the discount rate increases, future cash flows willl have a lower PV today

63
Q

Bond price > FV

A

Premium bonds

64
Q

Bond Price = Face Value

A

PAR bonds

65
Q

Bond Price < Face Value

A

Discount bonds

66
Q

Coupon rate > YTM

A

premium bond

67
Q

Coupon rate < YTM

A

Discount bond

68
Q

Bonds with lower CR

A

are more sensitive to yield changes

69
Q

Bonds with longer maturities

A

are more sensitive to yeild changes

70
Q

Spot rates

A

actual price in the moment

71
Q

forward spot rates

A

expectation of what the rate will be

72
Q

Measuring historical return, two components to stock return

A

: dividend yield and capital gains yield

r1 = D1/P0 + (P1 - P0 / PO) = total return

73
Q

Historical returns

A

“historical” - looking back
Higher risk asset classes have earned higher returns over the long run
expect common stock have a higher return than bonds, which have a higher reuturn than Treasury bills

74
Q

Risk Premium

A

The return generated by risky assets over and above the risk =-free rate is called a risk-premium

75
Q

standard deviation and historical returns

A

higher the risk, higher the standard deviation, higher the return

76
Q

annual returns calculations

A

ex :

(2016 share price - 2015 share price) + dividends / 2015 share price

77
Q

means, variance, standard deviation for historical data

A

interested in calculating forward-looking paparementers esitmates
1. identify possible future states of the world with known probabilities

78
Q

Pairwise Assets

A
  • Expected covariance
  • Correlation

= measure how two random variables (future asset returns) move in relation to one another

if both asset returns tend to be positive/negative - their returns tend to move together and their corvariance/corellation will be positive

Leess than perfectly positive (pxy< 1) , DIVERSIFICATION BENEFITS

“the risk of the sum is less than the sum of the risks”

79
Q

Portfolios of Assets

A 
Expected return (formula given) 
Standard deviation (2 asset portfolio formula given)
        - formula expands as we add more assets to the portfolio.  each pair of assets will have its own covariance/correlatoin which must be considered in the portfolio standard deviation calculation
80
Q

risk

A

measured by standard deviation of portfolio return

increases with mean return

81
Q

Correlation coefficient meanings

A

P =1 max St. dev P
P=0 reduced st. dev P
P = -1 min st. dev P

82
Q

Diversification

A

can substantially reduce the variability of returns without an equivalent reduction in expected returns

83
Q

risk reduction arises when

A

“worse than expected” returns are offset by “better than expected” returns from another asset in the portfolio

84
Q

Unsystematic risk

A

aka: firm-specific risk, idiosyncratic risk, unique risk

can be diversified away

85
Q

Systematic risk

A

aka: market risk, non-diversifiable risk
cannot be eliminated through simple diversification

pervasive events that affect nearly all assets to some degree
ex: interest rate exposure, foreign exchange rates, exposure to oil prices

86
Q

Total risk

A

(variance of returns)
can be decomposed into systematic risk and unsystematic risk

refers to events that affect a single security or small group of securities
ex: labour unrest at a particular firm, inclement weather in particular region, unfortunate events like fires, thefts, etc.

87
Q

Asset Pricing Formula (CML)

A

Slope of the line connecting the risk-less asset w Portfolio T is the steepest line that can feasibly be drawn. Combing the diskless asset with portfolio T and investor can realize the most efficient trade-off between risk and return

88
Q

Price model assumptions

A
  • investors only hold efficient portfolios
  • markets are perfectly competitive
    all investors are price takers
    full information is simulatenosly available to all agents
    There are no “market frictions (taxes, regulatory constraints, transaction costs)
    Investors have Homogeneous beliefs regarding expected returns, variances & covariances of all tents

TANGENCY PORTFOLIO IS THE MARKET PORTFOLIO
———> all investors are holding the same portfolio of risky assets - sum of all investors portfolios is “the market”

89
Q

Measuring Market risk

A

diversified portfolios don’t need to be concerned about the unique risk of a stock

90
Q

Marginall contribution of portfolio risk

A

captured by the assets beta coefficient which measures

  • security’s contribution to the market portfolio’s total risk
  • securirties responsiveness to changes in the market portfolio
  • securitys market risk or systematic risk
91
Q

Security Market Line (SML)

A

relationship between an assets required return and its systematic risk
calculates the cost of common equity

key result of the capital asset pricing model (CAPM)

92
Q

Slope term in SML

A

market risk premium (E(rm) - rf)

93
Q

Implications of the CAPM

A

relationship between required return & beta is linear
all securities, if fairly priced, should lie on SML
investors rewarded only for exposure to systematic risk

94
Q

WACC

A

tells us the average after-tax cost a firm faces when raising new funds to pursue expansion projects

use as the projects discount rate if the new project has the same risk as the company’s existing operations

95
Q

Beta and Cyclicality

A

strong pro-cyclical stocks have higher beta’s
High debt = high risk = high beta
Beta = Cov/ Var

firms assets can be viewed as a portolfio of debt and equity A= D + A
Beta is just the weighted average of individual betas

96
Q

Estimating Beta

A

industry beta provides a better estimate of a firms beta IF the firms operations are similar to those of other firms in the industry

Can also be estimated by regressing the returns of an individual stock agains the returns of a “market” portfolio

97
Q

Efficient market

A 
info is readily available to investors
there forms of market efficiency 
- Weak form efficiency 
- semi-strong efficiency 
- strong form efficiency

hypothese conveys

  • since info is immediately reflected in prices, investors should not expect to earn abnormal returns
  • learning new info doesn’t help investors because prices adjust before investor can exploit info
  • firms should expect to receive “fair value” for any securities they issue
98
Q

weak form efficiency

A

all past stock price/return info is incorporated into current asset prices
- technical analysis cannot be used to generate abnormal returns

99
Q

semi strong form efficiency

A

then all publicly available information is incorporated into current asset prices
- fundamental analysis cannot be used to generate abnormal returns

100
Q

strong form efficiency

A

all pertinent information (public and private) is incorporated into current asset price
- insider trading cannot be used to general abnormal returns

101
Q

Foundation of market efficiency

A

rationality
- when new info becomes available all investors adjust their estimates to asset prices

independent deviations from reality
- small # of individuals may act less then rationally
pessimistic group will be offset by a optimistic investors who estimates of assets new price is too high (cancel each other out)

arbitrage
- arbitrage opportunity involves the simultaneous purchase and sale of different but similar assets to earn a riskless profit due to the misplacing of some asset. assume that savvy investors would take steps to correct misplacing by engaging in arbitrage trading

102
Q

Testing market efficiency

A

weak form efficiency:
- can be evaluated by testing the serial correlation of an assets returns

Semi-strong efficiency

  • often tested using the Event Study Metholofy
  • look for evidence under-reaction, over-reaction, early reaction or delayed reaction around the time of a significant event

Strong form efficiency

  • tests vernally revolve around instances of insider trading (using non-public info to earn abnormal returns)
  • illagilty of insider trading makes difficult

Accounting managerial (7 decks)

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