finance revision Flashcards
investments
financial assets like stocks and bonds
price and risk
financial institutions
financial matters
banks and insurance
international finance
specialisation of assets and financial matters
capital budgeting
managing a long term investment
capital structure
mixture of debt and equity to finance operations
working capital
short term assets and liabilities
sole proprietorship
owned by one person
unlimited liability
all income taxed as personal
partnership
general - share gains and losses, unlimited liability
limited - liability limited to shares in business, not active in decisions
disadvantages of sole propietorship and partnership
unlimited liability for debts
limited life of business
difficult to transfer ownership
corporation
distinct legal entity
formed from articles of incorporation and bylaws
advantages of corporation
ownership easily transferred
life not limited
stockholders have limited liability
disadvantages of corporation
double taxation - corporation pays tax and stockholders pay income tax
more expensive/difficult to form
goal of financial management
maximise shareholders equity
profit maximisation is too vague
managers make decisions for shareholders, act in their best interest by increasing value
agency relationship
relationship between management and shareholders
agency problem
conflict of interest between managers and shareholders
why should managers act in shareholders interest
managerial compensation - job performance tied to rewards to increase share value
management control - threat of management replacement and takeover
primary market
original sale of securities occurs
public offerings or private placements
secondary market
owner sells to another, corporation not involved
dealer markets - dealers buy and sell at their own risk
auction market - brokers and agents match buyers and sellers
two lessons from market history
risky assets on average earn a risk premium as reward for bearing risk
greater the risk, the greater the potential reward
total dollar return
dividend income + capital gain/loss
return on investment
gain or loss from investment
income component - cash you receive from investment
capital gain/loss - change in value of asset
dividend yield
Dt+1 / Pt
capital gains yield
(Pt+1 - Pt)/Pt
risk-free return
return on gov bonds
risk premium
difference between stock returns and treasury bills
reward for bearing risk
arithmetic return
(R1 + R2 + … + Rt)/t
arithmetic vs geometric return
geometric < arithmetic if returns are not equal
arithmetic for short periods
geometric for long periods
efficiency
prices adjust quickly and correctly to new info
efficient capital market
market prices fully reflect all info, and adjust accordingly
inefficient market
overreaction or delayed reaction to events, gives investors the opportunity to make profit on announcements
efficient market response
the price instantaneously adjusts to fully reflects new info, there is no tendency for subsequent increase and decrease
slow response
the price adjusts slowly to the new info, 30 days elapse before price reflects new info
overreaction
the price over adjusts to the new info, there is a bubble in the price sequence
efficient market hypothesis
argues that actual capital markets are efficient
all investments in an efficient market are zero NPV investments
strong form efficient
all information of every kind is reflected in stock prices, there exist no such thing as inside info
semi strong efficient
all public info is reflected in the stock price
weak for efficient
at a minimum, the current price of a stock reflects its own past prices
future value
amount of money an investment will grow over some period of time at some given interest rate
compound interest
interest on interest
simple interest
interest only earned on principal amount
present value
current value of future cash flow discounted at appropriate rate
what do the letters represent in PV and FV equations
r - discount rate
t - life of investment
ordinary annuity
stream of cash flows for a fixed period of time
annuity due
a variation on ordinary annuity, an annuity for which cash flows occur at the beginning of each period
perpetuity
stream of cash flows continues forever
C - cash flow
r - discount rate
quoted rate vs effective annual rate
quoted rate - interest rate implied by advertising
EAR - interest you will actually earn
annual percentage rate vs EAR
APR is not EAR as it is equal to interest rate per period multiplied by the number of periods per year
pure-discount loan
borrower receives money today and repays a single lump sum some time in the future
usually short period of time
interest-only loan
borrower pays interest each period and repay entire principal at some point in the future
amortised loan
lender requires borrower to repay parts of the loan over time
paying it off called amortisation
the total payment declines each year because the beginning balance reduces
bond coupons
regular interest payments on a bond
securities
traded in financial markets
distributed subject to some legal requirements
financial market
a market where securities are traded
enable the exchange of previously issued securities
facilitate capital raising
common stock
securities represent an ownership stake in a firm
share of common stock gives right to put a vote at the firms annual meeting
stock market index
performance measure of a group of stocks in the market
preferred stocks
have several important differences to common stocks
priority in dividend payments
firms pay dividends firstly to the holders of PS before paying the holders of CS
no voting rights
PS do not convey the right to vote at the firms annual meetings
initial public offering
a companys first equity issue made available to the public
IPOs occurs when a privately held compnay decides to go public for the first time
secondary equity offering
an already publicly traded company issues additional equity
seasoned offerings may involve shares sold by existing shareholders, new shares or both
secured bonds
supported by collateral in the event of bankruptcy
unsecured bonds
no collateral
callable bonds
gives the issuing firm the right to repurchase at a set price
convertible bonds
investor can convert bonds into a set amount of equity shares
face value or par value
the amount of money repaid at the end of the loan
yield to maturity
total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principle
total bond value
present value of single cash flow + present value of annuity
discount bond
when market interest rate is higher than the coupon rate, the bond sells for less than face value
premium bond
if market interest rate is lower than the coupon rate on the bond
interest rate risk
risk from fluctuating interest rates, sensitivity of a bond to this risk depends on time to maturity and coupon rate
longer time to maturity, greater the risk
lower coupon rate, greater the risk
debt
repaid by the debtor/borrower to the creditor/lender
debt vs equity
debt is not an ownership of the firm
payment of interest is tax deductible, dividends are not
unpaid debt is a liability, if not paid creditors can claim assets of the firm
unfunded debt
short term debt security
maturity is less than a year
debentures
long term debt security
maturity is more than a year
indenture
written agreement between the corporation and creditors, also called a deed of trust
bond agreement
features of indentures
- basic terms of bond
- total amounts of bonds issued
- description of property used as security
- repayment arrangement
- call provisions
- details of protective covenants
basic terms of bonds (indentures)
registration of the principal value
registered form - registrar who records bond ownership
bearer form - certificate is evidence of ownership and corporation will pay the bearer, bonds are difficult to recover if paper is lost or stolen
colleteral
term for securities pledged as a payment of debt
seniority
order in which repayment to lenders occurs in bankruptcy
sinking fund
account managed by a bond trustee for the purpose of repaying bonds
call provisions
allows companies to repurchase or call some or all of the bonds at stated prices over a specific period
can have deferred call provision - not active at beginning of bonds life, making the bond call protected
protective covenant
limits certain actions a company may take during the term of the loan
negative covenants - prohibiting actions
positive covenants - obligate actions
bond ratings
concerned with the possibility of default, made from info supplied by corporation
debt rated by either Moody’s, standard and poor or fitch
treasury notes and bonds
gov issued bonds, usually ordinary coupon bonds
no default risk and are exempt from state income taxes
zero coupon bond
pays no coupons at all and is usually offered at a price much lower than its stated value
deduct interest every year for tax purposes even though no interest is paid
floating rate bond
coupon payments are adjustable
adjustments tied to an interest rate
usually the holder can redeem the note on coupon payment date after a specified amount of time
coupon rate has a floor and a ceiling
inflation-linked bond
coupons adjust to the rate of inflation
income bonds
coupon payments depend on company income
convertible bonds
bonds can be swapped for a fixed number of shares anytime before maturity
put bonds
allow the holder to force the issuer to buy bonds back at a stated price
over the counter
most bonds are traded over the counter rather than in bond markets
lacks transparency and ability to see trading price and volume
bid price
price a dealer is willing to pay for a security
bid-ask spread
dealers profit
clean price
price of a bond not including accrued interest payments
dirty price
price including accrued interest payments
also called full/invoice price
nominal interest rate
percentage change in the number of dollars you have
real interest rate
percentage change in how much you can buy with your dollar, the percentage change in buying power
fisher effect
relationship between nominal and real interest rates and inflation
1+R=(1+r)(1+h)
R - nominal rate
r - real rate
h - inflation rate
approximation formula - R = r+h
term structure of interest rates
relationship between short and long term interest rates
long term > short term, term structure is upward sloping
short term > long term, downward sloping
determinants of term structure curve
real rate of interest rate - real rate is high, interest rate is high
inflation - prospect of future inflation makes investors demand compensation for their loss in return which is inflation premium
interest rate risk - long term bongs have greater risk of loss from changing interest rates, compensation as interest rate risk premium
treasury yield curve
yield on treasury bonds relative to their maturity
the shape of the curve is a reflection of the term structure of interest rates
taxability premium
extra yield demanded as a result of the unfavourable tax treatment
liquidity premium
result of illiquidity of many corporate bonds
zero growth rate
P0 = D/R
growth is constant
D1= D0(1+g)
growing perpetuity
asset that shows constant growth rate forever
common stock
equity without priority for dividends or in bankruptcy
cumulative voting
total number of votes that each shareholder may cast is determined first, usually number of share owners x number of directors elected
1/(N+1)
straight voting
directors are elected one at a time, each shareholder can cast all of his votes for each member of board, free out minority shareholders
staggered elections
are applied, only a fraction of the directorships are up for election at a particular time
proxy
grant authority by a shareholder to someone else to vote the shareholders shares
proxy fight
management tries to get as many proxies transferred as possible but sometimes an outside group can try to obtain votes via proxy
rights of directors
right to share proportionally in dividends paid
right to share proportionally in assets remaining after liabilities have been paid in liquidation
right to vote on stockholder matters of great importance such as a merger
pre-emptive right
the right to share proportionally in any new stock sold
dividend characteristics
unless declared by the board of directors, dividends are no liability, a company cannot default on a undeclared dividend
the payment of dividends is not a business expense, it is paid out of the corporations after tax profits
dividends received by shareholders are taxable
dividend
cash paid out of earnings, if payment is made from sources other than retained earnings it is called distribution
declaration date
the date the board passes a resolution to pay dividend
ex-dividend date
two days before the date of records, establishing those individuals entitled to a dividend
if you buy on or after this date the previous owner receives the dividend
date of record
the holder of records are identified, those who are entitled to receive the dividends
date of payment
the date that the dividend checks are mailed
share repurchases
- open market - firm does not reveal themselves to buyer
- tender offer - firm announces all of its stockholders that it is willing to buy a fixed number of shares at a specific price
- targeted repurchase - firm may repurchase shares from specific individual stockholders
net present value
difference between the market value of an asset or project and its cost
how much value is added by undertaking an investment
discounted cash flow valuation
determine value of investment by prospecting and discounting future cash flow to todays value
we can estimate the NPV by comparing this to cost of the investment
net present value rule
states that an investment should be accepted if the net present value is positive and rejected if it is negative
challenge process of discounting but coming up with the cash flows
resulting NPV is only an estimate, reality can be higher or lower
payback period
the amount of time required for an investment to generate cash flows sufficient to cover its initial cost
disadvantages of payback
ignores the time value of money as it is calculated by adding up future cash flows
need the right cut off, may reject long term projects if you ignore cash flows beyond cut off
advantages of average accounting return
easy to calculate
needed info will usually be available
disadvantages of average accounting return
not a true rate of return, time value of money is ignored
uses a benchmark cut-off rate
based on accounting net income and book values, not cash flows and market values
internal rate of return
closely related to NPV and specifies the discount rate that makes NPV of an investment 0
investment is acceptable if IRR > required return
