Finance Test 5 Flashcards
Fund Capital
equity capital in a not for profit corp, typically obtained from contributions and grants and by retaining earnings; often called net assets on balance sheet
Preemptive Right
the right that gives current shareholders the opportunity to purchase any newly issued shares
How do common stock investors usually receive returns?
they are buying the right to a proportionate share of the residual earnings of the corporation. they get it from the net income
How do common stockholders exercise their right of control?
they have the right to elect a firm’s board of directors, who will in turn manage the business
What is the purpose of preemptive right?
it protects the present stockholders’ position of control and it protects the stockholders against dilution of value should new shares by issues at less than the current market price.
Classified Stock
the term used to distinguish between stock classes when a business uses more than one type of common stock
Give one reason for using classified stock
obtain funds from outside sources
rights offering
the mechanism by which new common stock is offered to existing shareholders
public offering
the sale of newly issued securities to the general public through an investment banker
What is a private placement and what are its primary advantages over a public offering?
securities are sold to one or a few investors, most common with bonds, but they also occur with stock. Advantages of priv place are lower admin costs and greater speed because the shares do not have to go through the securities and exchange commission
what are the employee stock purchase plans?
companies have plans that allow employees to purchase stock of the employing firm on favorable terms
Dividend Reinvestment Plan (DRIP)
a plan under which the dividends paid to a stockholder are automatically reinvested in the company’s common stock.
What is a direct purchase plan?
allow stockholders to purchase additional stock directly from the company. grew out of DRIP
What are the sources of equity available to not for profit firms?
they raise equity capital through govt grants and charitable contributions
Are not for profit corps at a disadvantage when it comes to raising equity capital?
their initial start up have decreases over the years making not for profit corps to rely more on profits and outside contributions
Dividend Yield
the annual dividend divided by current stock price
What are three approaches to valuing common stocks and when do each apply?
Start up business, young business, mature business
Does the holding period matter when using the dividend valuation model?
expect to hold the stock for a finite period and then sell it.
What are some assumptions of the constant growth model?
the expected dividend growth rate is constant for all years
What are the key features of constant growth regarding dividend yield and capital gains yield?
expected dividend yield is a constant and the expected capital gains yield is also constant
security market equilibrium
value exceeds its current price
what securities are most likely to be in equilibrium?
bonds of the US treasury and the bonds and stocks of major corporations are generally in equilibrium
Efficient markets hypothesis
the theory that stocks are always in equilibrium and it is impossible for investors to consistently earn excess returns (beat the market)
What two conditions must hold for markets to be efficient?
all info relevant to the values of the securities traded can be obtained easily and at low cost
the market contains many buyers and sellers who act rationally on the info
What are the implications of the EMH for investors and managers?
has important implications both for securities investment decisions and for business financing decisions
What is meant by beat the market?
in short term, you must realize a return that is higher then the average return on similar portfolios of stocks
in long term, means a return in excess of what is commensurate with the risk undertaken
capital structure
the structure of a business’s financing mix as shown on the balance sheet often expressed as the percentage of debt financing
what are some questions relevant to the capital structure decisions?
Is there an optimal mix of debt and equity? is there an optimal capital structure? do hospitals have different optimal structures than home health agencies or ambulatory surgery centers?
optimal capital structure
the mix of debt and equity financing the management believes is most appropriate for the business
Return on equity
new income divided by the book value of equity, measures the dollars of earnings per dollar of equity investment
financial leverage
the use of fixed cost financing, typically debt financing for healthcare providers
What is the impact of debt financing on owners rate of return?
increases the expected rate of return on equity to the owners
What is the impact of debt financing on owners’ risk?
as increase in returns goes up, the use of debt financing also increases owners risks
What is the basis for choosing the optimal level of debt financing?
the ultimate decision is not so clear. risk return trade off. higher returns can be obtained only by assuming greater risk
trade off model
a capital structure model that hypothesizes that a business’s optimal capital structure balances the costs and benefits associated with debt financing
How is the optimal capital structure defined?
the point at which a business’s overall (average) cost of capital is minimized
why is the optimal capital structure often called the target capital structure?
the optimal capital structure becomes the target for future financing
is it critical that the precise structure be identified and followed?
its not easy in practice to identify this structure for any given business. variations in debt usage do not have a significant impact on capital costs
target capital structure
the capital structure (mix of debt and equity) that a business strives to achieve and maintain over time
business risk
the risk inherent in the operations of business assuming it uses zero debt financing
reserve borrowing capacity
the practice of businesses to use less than the theoretical optimal amount of debt to ensure easy access to new debt at reasonable interest rates regardless of circumstances
debt capacity
the amount of debt considered optimal for the business (the target capital structure)
financial risk
the risk added when debt financing is used
what unique problems do managers of not for profit businesses face regarding capital structure decisions?
they cannot go to the capital markets to raise equity capital
why is capital structure important to the managers of not for profit businesses?
they do not have the same degree of flexibility in capital investments or capital structure decisions
How does a business’s target capital structure influence its financing decisions?
uses it to define the weights used in the corporate cost of capital estimate. used to guide financing decisions
Why is it best to specify the target capital structure as a range rather than a single value?
not unusual for a business’s actual capital structure to stray from the target structure. it is best to use a range rather than an single point value
Corporate cost of capital
the weighted average of a business’s capital (financing) costs; also the discount rate that reflects the overall risk of the entire business
What financing sources are typically included in a firm’s cost of capital estimate?
cost of debt and cost of equity
Should the component costs be estimated on a before tax or after tax basis?
after tax
Should the component costs reflect historical or marginal costs?
marginal costs due to planning period
