Midterm content (chapter 1-3) Flashcards
1
Q
when determining how much a financial asset is worth and wether you should buy it, what assumptions should you make?
A
assume that they wiil last forever and they will pay dividends forever
2
Q
what is a perpetuity?
A
A stream of cash flows that occur at regular intervals and last forever
3
Q
what is an annuity?
A
a stream of (n years) paid at regular intervals and ends after a fixed number of payments.
4
Q
What are bonds?
A
a form of loan (financial product) which pays interest and has a fixed date when it stops paying interest.
5
Q
Who provides bonds?
A
governments and companies
6
Q
And bond is typically issued and sold to a market agent such as a…
A
bank.
7
Q
Can the market agent (bank) sell the bond to someone else? What happens regarding the bond?
A
The agent can sell the bond to someone else, and the seller gets money from the sale, and the buyer gains the right to receive the bond’s future cashflows (interest payments)
8
Q
what is the difference between a bond and a loan?
A
A bond is tradable sold to multiple investors and can be traded, bought and sold to others, while a loan is a direct agreement between borrower and lender and is not tradable.
9
Q
What is the face value of a bond?
A
the par value, or the principal amount of a bond that is repaid at the end of the term (ex, $1,000)
10
Q
What is the coupon amount of the bond?
A
The value of the bond (ex, annual of $120)
11
Q
What is the Coupon Rate?
A
The annual coupon amount divided by the face value of the bond (ex. $120/$1000 = 12%)
12
Q
What is a bond’s maturity?
A
The specified date on which the principal amount of a bond is paid (ex. 30 years)
13
Q
Overtime interest rates change in markets, but the cash flows of a bond remain the same, thus, the value of the bond will…
A
fluctuate.
14
Q
when interest rates rise, the present value of the bond’s remaining cash flows…
A
declines, and the bond is worth less
15
Q
When interest rates fall… (In terms of bonds)
A
The bond is worth more
16
Q
To find the value of a bond at a point in time, what information do we need?
A
- Number of periods remaining until maturity
- Face value
- Coupon
- Yield to maturity (YTM) which is the rate required in the market for a specific bond
17
Q
If a bond sells for exactly the face value, what’s it called?
A
A par value bond
18
Q
If a bond sells for less than face value, what’s it called?
A
A discount bond
19
Q
A bond that sells for more than face value is called?
A
A premium bond
20
Q
What does the degree of interest rate risk a bond has depend on?
A
The bond’s sensitivity/responsiveness to interest rate changes
21
Q
A bond’s sensitivity to interest rates depend on what two things?
A
- Time to maturity
- Coupon Rate
22
Q
In regards to a bond’s sensitivity, assuming all other things being equal, what happens the longer the time to maturity a bond has regarding time to maturity?
A
The greater the interest rate risk and vice versa
23
Q
In regards to a bond’s sensitivity, assuming all other things being equal, what happens the longer the time to maturity a bond has regarding coupon rate?
A
The lower the coupon rate, the greater the interest rate risk
24
Q
a relatively small change in interest rates will lead to a
A
substantial change in the bond’s value
25
When the yield to maturity increases…
bonds with bigger maturities lose more value
26
The bond with a higher coupon has a larger cash flow early in its life, so its value is… (sensitivity wise)
less sensitive to changes in the discount rate
27
the greater the maturity and the smaller the coupons on a bond,
the more sensitive it will be to changes in the yields
28
Often, instead of finding the coupon value for a given yield to maturity, we observe the value of the bond, and retrieve the...
yield of maturity
29
Debt is not an ownership interest in the firm, which means that creditors don't have...
Voting power
30
Corporation's payments of interest on debt is considered a cost of doing business and is... (in relation to tax)
Tax deductible (up to certain limits)
31
Unpaid debt is a liability of the firm, thus, if not paid, creditors can...
legally claim assets of the firm
32
The two actions of creditors claiming assets of the firm due to unpaid debt are...
- liquidation (selling assets at i's market value)
- reorganisation
note: they are two of the possible consequences of bankruptcy
33
One of the costs of issuing debt is the possibility of financial...
failure.
34
Seniority in bonds indicates preference of position over who? and how are they labelled?
Position over other lenders, and they are labelled as senior or junior bonds.
35
Bonds can be repaid at maturity, at which time the bondholder will receive... (2)
the stated face value of the bond, or may be repaid in part or in entirety before maturity
36
What is the agreement that gives the option to repurchase a bond at a specified price before maturity?
Call provision
37
In terms of bond ratings, how can they change?
when the bond issuer's financial strength changes
38
What is the highest rating a firm's debt can have, and what is the assessment of said bond in terms of quality and risk?
AAA or Aaa ratings, and this debt is judged to be the best quality and have the lowest degree of risk.
39
What are investment grade bonds rated at?
BBB or Baa.
40
What are junk bonds, and how common are they?
Bonds rated below investment grade, if rated at all, and large part of corporate borrowing is from these bonds.
41
What are Zero coupon bonds?
Bonds that make no coupon payments are initially priced at a high discount.
ex. face value: $1000
purchase price: $800
profit: $200
no yearly interest payments are done.
42
What are floating rate bonds?
Coupon payments are adjustable (tied to an interest rate index), thus the value depends on how the adjustments are defined.
43
What are inflation linked bonds?
Coupons that are adjusted according to the inflation rate
44
Whats a convertible bond?
One that can be swapped for a fixed number of shares of stock anytime before maturity.
45
What's a put bond?
Allows the holder to force the issuer to pay back the bond at stated price. It's a reverse of the call provision.
46
What are structured notes? (in regards to bonds)
Bonds that are based on stocks, bonds, commodities or currencies.
47
Why are common stocks more difficult to value than bonds (3 reasons)?
- with common stock, promised cash flows are not known in advance
- Life of the investment is essentially forever as there's no maturity
- Harder to observe rate of return
48
What are dividends?
Payments by a corporation to shareholders, made in cash or stock
49
Who makes/decides on the payment of dividends?
The board of directors
50
What are important characteristics of dividends? (2, relation to liability and tax)
- Unless a dividend is declared, it is not a liability to the corporation, thus they cant go bankrupt because of dividend nonpayment
- payment of dividends are not a business expense, thus they are not deductible for corporate tax purposes.
51
Where do dividends come from?
Company earnings
52
How do firms create dividends and distribute them?
Firms turn part of its earnings to be dividends, and they are distributed by each share.
53
What determines a shareholder's value of dividends?
It's based on how many shares they own.
54
What are the two potential cash flows from owning a stock?
- Dividends
- Price appreciation
55
What is an approach that allows us to obtain the value of the returns with the two potential cash flows from owning a stock? (model)
Divident discount model
56
What is *common* stock?
equity without priority for dividends in case of bankruptcy
57
In addition to voting rights for directors, shareholders also have: (3)
- right to share proportionally in dividends paid
- right to share proportionally in assets remaining after liabilities are paid in liquidation
- right to vote on stockholder matters (mergers)
58
What is *preferred* stock?
they have dividend priority over common stock, normally with a fixed dividend rate.
59
What happens if the board of directors decide not to pay dividends on preferred share?
Common shareholders must also forgo dividends
Holders of preferred shares are often granted voting and other rights if not paid for some time
60
It can be argued that preferred stock is really debt in disguise (a kind of equity bond), for the following reasons (6)
- receive a stated dividend only
- if firm liquidates, they get a stated value
- carry credit ratings much like bonds
- is convertible to common stock
- callable
- issues such as obligatory sinking funds, creating a final maturity.
61
What is a expected return?
The return on a risky asset expected in the future
62
What is a portfolio?
a group of assets such as stocks and bonds held by an investor
63
Portfolio weights are...
percentages of a portfolio's total value invested in a particular asset
64
If we have $50 in one asset, and $150 in another, what is our total portfolio?
50 + 150 = $200
65
If we have $50 in one asset, and $150 in another, what is our portfolio weight?
asset value/total portfolio = relative weight
50/200 = 0.25
150/200 = 0.75
66
The *total* return on stock traded in financial markets is made up of two parts:
- Normal, expected return from stock (predicted by shareholders)
- Unexpected return (from unexpected information revealed within the year)
67
What is systematic risk?
A market risk that influences many assets (uncertainties about general economic conditions such as interest rates, GDP, inflation)
68
What is a unsystematic risk?
a risk that affects at most a small number of assets (new product, oil strike by a company)
69
As we diversity a portfolio, we should expect the risk to decrease, until only ________ risk exists.
systematic
70
The more we diversity, the less and less the reduction of _____ occurs.
risk.
71
what is the principle of diversification?
Implies some of the riskiness with individual assets can be eliminated by forming portfolios. But there is a minimum level of risk that cannot be eliminated by diversifying (non diversifiable risk)
72
Some risk associated with individual assets can be diversified and some can't, why is this so?
Diversification helps reduce the risk of individual stocks, but it can’t eliminate risks that affect the entire market.
73
As the resources used (inputs) in investment projects are obtained in the market, under competitive conditions, the company will have to...
use the resources more efficiently than it's competitors to create value.
74
An efficient company produces outputs at maximum at a given level of input. From a production perspective, this is called:
Technical efficiency
75
Another way to achieve efficiency is to act on side of costs and reducing them. This is called:
Economic efficiency
76
One of the ways for companies to finance themselves in the medium and long term is to resort to the capital of the shareholders. This is called:
Equity
77
What is the balance sheet equation?
Equity = Assets - Liablities
78
What is equity made up of?
Capital invested by shareholders (shareholder equity) when the company was incorporated, capital increases and reserves
79
The shareholders benefit from the company's sucess, but they only receive payouts once...
all remaining obligations with creditors (liabilities) are settled.
80
The main sources of equity that are available to companies are:
- Initial capital
- Capital increases
- Self-funding
- shareholder loans
81
What is initial capital?
the money injected into the company at inception.
82
When investments are large, what is one possible way to finance them in terms of equity?
increase capital
83
How do capital increases occur (in terms of equity)?
Issuing new shares
84
Shares can take two forms:
- Common shares
- Preferred shares
85
What are preferred shares?
Shares with no maturity and pay a fixed dividend.
86
What is the cost of preferred shares?
the promised dividend (D) divided by the current market price Po
Rp= D / Po
87
Why are preferred shares riskier than debt? and are there tax benefits/costs?
Due to ts junior position and thus require a higher return, but they may benefit from lower taxes.
88
Preference shares can thus be considered a hybrid instrument, what does this mean?
It eans it combines debt characteristics with the fact that they represent part of the company's capital.
89
What is an advantage of preferred shares in terms of company power?
Holders of preferred shares don't have the right to vote at general shareholders meetings.
90
what are shareholder loans?
cash injections provided by partners/shareholders
91
What is the cost of equity capital?
The return that shareholders expect for investing in a company (the price the company pays to use shareholder money)
92
Why do shareholders need compensation?
Shareholders take on risk as they are last to get paid if the company runs into trouble (residual rights) To make up for this risk, they demand a higher return.
93
What is the higher return that shareholders demand, to make up for the risk on cost of equity capital called?
Risk Premium
94
What is the equation of return and risk?
Expected return = RiskFreeRate + Risk Premium
95
What is the RiskFreeRate in the return and risk equation?
The return that partners/shareholders would obtain if they invest in assets without credit risk (public debt)
96
What is the capital asset pricing model (CAPM)
its a general equilibrium model in the capital markets, which is based on several assumptions. It describes the behaviour of expected return, but doesn't explain the behaviour of individual investors.
97
What are some of the assumptions of the CAPM? (5)
- There are no transaction costs
- Assets are infinitely divisible (investors can invest any amount)
- No taxes
- Asset prices aren't influenced by individual investors
- Investors make their decisions based on expected values and standard deviation of portfolio returns.
98
What are some assumptions of the CAPM? part 2 (3)
- There's no limit to borrowing or lending at the riskless asset rate
- All investors have the same expectations in terms of portfolio management
- All assets are tradable.
99
In the context of the CAPM, what does risk translate to?
the amount of compensation required by the investor for assuming an additional risk.
100
What is Beta (𝛽i) in the CAPM?
measures the volatility of a stock and multiplies by risk premium.
101
What are the main holders of corporate debt?
Banks and Bondholders
102
Partners and shareholders can default on debt payments and consequently hand over the company's_______ to creditors. However they will only do so if...
Assets
If the assets are worth less than the liabilities.
103
What is the main objective of shareholders?
Increase their wealth through maximizing company value.
104
The interest rate modality is usually based on: (2)
- A flat rate
- A variable rate
105
Companies can create special purpose vehicles (SPVs) in order to do what?
Resort to financing from investors, anticipating the receipt of future amounts. This take the form of securitizations.
106
What is the process of the SPV?
1. Clients make payments with principal and interest
2. Originator (promoter) sells assets like loans
3. SPV issues securities
4. Investors buy these securities and receive payments with principal and interest from the SPV.
107
what is a CFO?
Chief Financial Manager
108
What are financial managers responsible for?
- Managing the firm’s cash
- Making investment decisions
- Making Financial decisions
109
what are investment decisions?
Purchase of real assets, such as machinery, real estate and R&D
110
What are Financing decisions?
They correspond to the sale of financial assets, such ass long term debts, short term debts
111
what must a CFO do in regards to Cash Management?
The CFO must ensure that the firm has enough cash on hand to meet its day to day obligations
112
How important is the management of working capital?
It can be crucial in a young, growing or distressed company
113
With regards to investment decisions, what must the CFO do?
- weight the costs and benefits of investments and projects and decide which of them qualify as good uses of money
-
114
What does the CFO do as the bridge between financial markets and the firm?
- helps manage the firm’s operations, helping them make good investment decisions
- deals with investors, financial institutions and financial markets
115
How does a firm do in terms of value creation? (the financial goal)
- the financial goal all shareholders want is to maximize current market value of the shareholder’s investment in the firm (value of their shares)
116
What is opportunity cost?
- the price of the next alternative foregone in an economic decision
- describes benefits lost when choosing an option over another.
117
What are investors's preferences regarding a firm's risk profile and how does it affect their financial goal?
If investors do not like a firm's risk profile, they can divest and invest in a safer, steadier firm. It doesn't change the assumption that managers should maximise firm value
118
If a manager claims that he wants to maximise profits, what two main questions remain open?
- Which year's profits?
- Just because an investment is profitable, does it make it desirable?
119
Why does the question of which year's profit matter?
A firm can increase current profits by cutting back on maintenance or staff training, but this will reduce future profits
120
Why does the question of "just because an investment is profitable does it make it desirable?" matter?
A company can increase future profits by cutting this year's dividend and investing the freed-up cash in the firm. This may be or may not be in shareholder's interest.
