Financial Markets and Financing Flashcards
money markets trade debt securities with maturities of more than 1 year. True or false?
False
they trade securities with maturities of less than 1 year
examples of money market securities
what doe capital markets trade?
long-term debt and equity securities
an example is the New York Stock Exchange
primary markets vs. secondary markets
what does the efficient markets hypothesis state?
that current stock prices immediately and fully reflect all relevant information.
the market is continuously adjusting to new information and acting to correct pricing errors
securities ratings
based upon the probability of default and the protection for investors in case of default
a firm must pay to have its debt rated
factors involved in the analysis used for rating
- the ability of the issuer to service its debt with its cash flow
- the amount of debt it has already issued
- the type of debt issued
- the firm’s cash flow stability
How does a rating effect the cost of capital
-higher ratings reduce interest costs
-lower ratings incur higher rates of return
rate of return
(amount received - amount invested) / amount invested
investment risk
credit risk
the risk that the issuer of a debt security will default
foreign exchange risk
the risk that a foreign currency transaction will be affected by fluctuations in exchange rates
interest rate risk
the risk that an investment security will fluctuate in value due to changes in interest rates
liquidity risk
the risk that a security cannot be sold on short notice for its market value
financial risk
the risk of an adverse outcome based on a change in the financial markets, such as changes in interest rates or changes in investors’ desired rates of return.
purchasing-power risk
the risk that a general rise in the price level will reduce the quantity of goods that can be purchased with a fixed sum of money
usable funds
invoice amount x (1-discount %)
annualized cost of not taking a discount can be calculated with the following formula
discount % / (100%-discount percentage) x days in year / (total payment period - discount period)
term loan
a loan that must be repaid by a certain date
line of credit
an informal borrowing arrangement.
It allows the debtor to reborrow amounts up to a maximum, as long as certain minimum payments are made each month.
revolving line of credit
allows the borrower to continuously pay off and reborrow from the line of credit.
There may be a commitment fee on the unused portion
effective interest rate
net interest expense / usable funds
effective rate on discounted loan
stated rate / (1.0 - stated rate)
simple interest loan
a loan in which the interest is paid at the end of the loan term.
Interest expense = loan amount x stated rate
discounted loan
requires the interest to be paid at the beginning of the loan term
loan amount = usable funds / (1.0 - stated rate)
loans with compensating balances
rather than charge interest, banks sometimes require borrowers to maintain a compensating balance during the term.
loan amount = usable funds / (1.0 - compensating balnce %)
effective interest with compensating balance (no dollars)
stated rate / (1.0 - Compensating balance %)
a firm has received an invoice for $120,000 with terms of 2/10, net 30. The firm’s bank will lend it the necessary amount for 30 days at a nominal annual rate of 6% with a compensating balance of 10%. What is the loan amount
$130,667
=usable funds / (1.0 - Compensating balance %)
= ($120,000 x 98%) / (100% - 10%)
= $117,600 / 90%
effective rate formula for a loan offered on a discounted basis with a compensating balance requirement
stated rate / (1.0 - stated rate - compensating balance %)
annualized rate of commercial paper
[(face value - net proceeds) / net proceeds] x number of terms per year
Management should select the financing option that results in the lowest present value of ____
after-tax cash outflows
Return on investment formula
capital turnover (sales / investment) x profit margin (income/sales)
A manufacturer with seasonal sales would be most likely to obtain _________________ from a commercial bank to finance the need for a fixed amount of additional capital during the busy season.
unsecured short-term loan
An unsecured short-term loan is often used to finance a firm’s need for fluctuating (e.g., seasonal) current assets. This practice is consistent with the maturity-matching (self-liquidating) approach to financing current assets.
The prime lending rate of commercial banks is an announced rate and is often understated from the viewpoint of even the most credit-worthy firms. Which one of the following requirements always results in a higher effective interest rate?
The imposition of a compensating balance with an absolute minimum that cannot be met by current transaction balances.
When a firm borrows money from the bank, it is often required to keep a certain percentage of the funds in the bank at all times. These compensating balances effectively increase the rate of interest on the money borrowed from the bank.
The strong form of the efficient markets hypothesis (EMH) states that current market prices of securities reflect
All information whether it is public or private.
The EMH states that stock prices reflect all relevant information, so the market is continuously adjusting to new information. Stock prices are in equilibrium, so investors cannot earn abnormal returns. The strong form of the EMH states that all public and private information is instantaneously reflected in current market prices of securities. Thus, investors cannot earn abnormal returns.
According to COSO, a risk profile is a view of the relationship between
risk and performance
A risk profile is a composite view of (1) the types, severity, and interdependencies of risks related to a specific strategy or business objective and (2) their effect on performance.
Systematic risk explains why
stock values tend to move in the same direction
Systematic risk, also called market risk, is the risk faced by all firms
Compared with another bond with the same risk and maturity but without a conversion feature, a convertible bond has a
Lower coupon rate because they offer investors a chance for capital gains
