Financial Mgmt - LT financing and on Flashcards
Define a net-net lease
Lessee (using party) assumes not only the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, and so on, but also the obligation for a residual value at the end of the lease.
What is a bond
Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
Indenture
the bond contract
What is the definition of a par/face value of a bond?
the principal that will be returned at maturity (most commonly $1,000 per bond)
what is the Coupon rate of interest of a bond
the annual interest rate printed on the bond and paid on par value
Debenture bonds
Unsecured; no specific asset is designated as collateral. These bonds are considered to have more risk and, therefore, must provide a greater return than secured bonds.
Secured bonds
bonds that have specific assets designated as collateral
mortgage bonds
secured by a lien on real property
Callable bonds
bonds that can be redeemed by the issuer prior to maturity
Convertible bonds
Convertible bonds provide that the bond holder has the option of converting the bonds into a specified number of shares of equity (stock) of the issuing company. Investors in convertible bonds will exercise the option to convert if the market price of the stock increases.
Zero Coupon bond
bond that does not pay interest during its life. (there are no coupons to submit for interest payments)
Floating rate bond
Bond that pays a rate of interest that fluctuates over the life of the instrument
Eurobonds
Bond payable in the borrowers currency but sold outside the borrowers country
Formula for cost of debt
cost of debt = interest rate x (1 - marginal tax rate)
Current yield of bond, equation
current yield = annual coupon interest / current market price
Yield to maturity (expected rate of return)
the rate of return required by investors as implied by the current market price of the bonds is the yield to maturity
How is the selling price of a bond determined?
As the sum of the PV of future cash flows from:
Periodic interest × PV of an annuity
Maturity face value × PV of $1
Both discounted using market rate of interest.
Preferred Stock
A class of ownership in a corporation that has a priority claim on its assets and earnings before common stock, generally with a dividend that must be paid out before dividends to common shareholders are paid.
Value of a share of preferred stock
PSV = Annual Dividend / Required Rate of Return
Preferred stock rate of return
PSER = Annual Dividend / Market Price
Common Stock Valuation
CSV = first year dividend / (required rate of return - growth rate)
Common Stock Expected Rate of Return formula
(first year dividend / market price) + growth rate
Formula for degree of operating leverage (DOL)
% change in operating income / % change in unit volume
Operating leverage
measures the degree to which a fir incurs fixed costs in its operations
Financial leverage
measures the extent to which a firm uses debt financing
Degree of financial leverage
% change in EPS / % change in EBIT
Define the hedging principle of financing (also called the principle of self-liquidating debt).
Principle that focuses on matching cash flows from assets with the cash requirements needed to satisfy the related financing. Thus, long-term assets should be financed with long-term sources of capital, and short-term assets should be financed with short-term sources of financing.
What is the objective of optimum capital structure?
To minimize a firm’s aggregate cost of capital financing by using an optimum mix of debt and equity components; to achieve the lowest possible weighted average cost of capital
Business risk constraint
Firms with a higher level of business risk have an increased chance that operating results may cause default on fixed obligations and, therefore, should use less debt financing than a firm with steady operating results.
Tax rate benefit effect
Therefore, the higher the tax rate faced by a firm, the greater the amount of tax saved from the use of debt financing compared to using equity financing.
A hedging approach
The strategy of matching asset and liability maturities. The strategy helps ensure that funds are generated from the assets when the related liabilities are due.
Working capital
current assets - current liabilities
Concentration banking
accelerates the flow of funds from multiple local banks to a firms primary bank by regular, usually automatic, transfers of funds
What is the coeffiecient of variation and how is it computed for investment analysis?
The coefficient of variation is a measure of the relative variation around an average value.
For investment analysis it is computed as: Standard deviation of investment return/Average return of investment
What is the Sharpe Ratio and how is it computed?
The Sharpe Ratio is a measure of return per unit of risk. It is computed as: (Average rate of return earned – Risk free rate) / Standard deviation of investment return
Commercial paper
Short-term unsecured promissory notes issued by large, established firms with high credit ratings as a form of short-term financing (i.e., 270 days or less)
what are US treasury bills?
Debt investment instruments that are the direct obligation of the U.S. government. They are considered to be virtually risk-free and are commonly used as the basis for the risk-free rate of return in many financial analyses.
Define “repurchase agreement” (also called a repo).
A debt investment instrument with a commitment by the buyer to resell the instrument to the seller at a specified price, which includes the original principal plus an interest or fee factor, at a specified time. Repurchase agreements can be used as investment instruments for as short a period as one day. provides for the seller to repurchase the instrument with no loss in value.
Credit Criteria
the policies used to decide whether a customer should be extended credit.
A call option (contract) grants the owner the right (but not the obligation) to (BUY or SELL) some underlying asset?
Buy
A put option (contract) grants the owner the right (but not the obligation) to (BUY or SELL) some underlying asset?
Sell
Describe financial risk.
Risk to common shareholders that derives from a firm’s use of debt financing, which requires interest payment regardless of the firm’s operating results, and its use of preferred stock, which requires payment of dividends before common shareholders receive dividends.
Describe liquidation risk (also called marketability risk).
The risk associated with the possibility that an asset cannot be readily sold for cash equal to its fair value.
Describe nondiversifiable risk (also called systematic risk or market-related risk).
Elements of risk that cannot be eliminated through diversification of investments; usually derive from general economic and political factors (e.g., general level of interest rate, new taxes, inflation/deflation, etc.)
Describe diversifiable risk (also called unsystematic risk, firm-specific risk, or company-unique risk).
Elements of business risk that can be eliminated through diversification of investments; for example, diversification of projects or securities investments
Describe default risk.
The risk associated with the possibility that the issuer of a security will not be able to make future interest payments and/or principal repayment.
Describe currency exchange risk.
Risk that derives from changes in exchange rates between currencies; may affect foreign currency transactions, foreign currency investments and/or future foreign currency economic activity.
Describe interest rate risk.
Risk to investors associated with the effects of changes in the market rate of interest on outstanding fixed-rate debt instruments. If the market rate of interest increases, the market value of already outstanding fixed-rate debt instruments will decrease.
Describe inflation risk (also called purchasing power risk).
The risk that a rise in the general price level (inflation) will result in reduced purchasing power of a fixed sum of money
Business risk is measured as
the expected variability in earnings before interest and taxes-EBIT.
who is financial risk borne by?
the COmmon shareholders of the firm
what are diversifiable risks also known as?
firm-specific risks
the greater the use of ___ financing by a firm, the higher the financial risk for the firm
debt
Non diversifiable risks are also called,
systematic risks
what is basis risk?
the risk of loss from ineffective hedging activities
a company is concerned that the market price of its stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by
purchasing a put option on that stock. It will allow the purchaser the option to sell the stock at the specified price in the future. Thus, if the price of the stock declines, the value of the put option will increase by an equivalent amount
