Module 1 - Chapter 1 Flashcards
Answer:
There is no ___(a)___ of finance
a. unifying
List:
Basic Ideas Used in Many Areas of Finance
- Trade off between risk and return
- All else equal, more money is better than less money
- All else equal, money today is better than money at some point in the future
Answer:
In the trade off between risk and return, people want ___(a)___ when accepting ___(b)___
a. higher promised return
b. higher risk
Answer:
Most people won’t take risk when there is a ___(a)___
a. less risky alternative at the same price
Answer:
There is a lot of controversy as to if markets are ___(a)___ and ___(b)___
a. efficient
b. to what extent
Define:
Market Efficiency
All relevant information about the risk and cash flows of a financial asset is quickly and accurately incorporated into price
Answer:
There is “no free lunch”, in other words, it is hard to find ___(a)___ to buy, or ___(b)___ to sell/short
a. undervalued
b. overvalued assets
Answer:
Wise/good investments are associated with price ___(a)___ because it becomes an assessment of ___(b)___
a. increase
b. managements performance
Answer:
It is more expensive to raise capital in equity markets if stock is ___(a)___
a. undervalued
Answer:
If stock is undervalued, the firm would need to ___(a)___ to raise a given amount of capital, which it may not want to do due to ___(b)___
a. issue more shares
b. dilution of existing shares
Answer:
If stock is overvalued, the firm has incentive to ___(a)___ in order to ___(b)___
a. issue equity or raise capital in the equity markets now
b. get overvalue money (“get lunch for free” for the firm)
List:
How/When to raise capital
- Debt vs equity
- Private Placement (of debt or equity) vs public issue (in financial markets)
- Timing - when to raise capital
List:
Financial Decisions Regarding Capital
- How/when to raise capital for investment
- How to Manage Liquidity/How to Finance Ongoing Operations - financing vs internally generated funds
- How to Invest Capital
- How to Measure Performance
List:
Steps to Invest Capital
- Allocation through market mechanism (external)
2. Allocation through individual/group decisions (internal)
Define:
Allocation Through Market Mechanisms
External
Investors in market choose what to invest in
Define:
Allocation Through Individual/Group Decisions
Internal
Capital budgeting decisions
Allocation through market mechanism leads to this
List:
Measures of Performance
- Returns
- Profits
- Market Share
- Value
Define:
Liquidity
Availability of cash
Define:
Value
The measure generally considered to incorporate the most characteristics that investors and people in general care about
List:
What We Look at With Cash Flows
- Magnitute
- Timing
- Risk
List:
Measurement of Value Incorporates Measures of
- Time Value of Money
- Risk/Return trade off
- More Money Being Better than Less
Define:
Value of the Firm
The present value of all expected future cash flows, discounted to the current period at the appropriate risk adjusted discount rate
Answer:
Returns measure ___(a)___ relative to the ___(b)___, but it often doesn’t consider ___(c)___ or ___(d)___
a. magnitudes of cash flows
b. original price
c. risk/return trade off
d. time value of money
Answer:
Profit is a measure of ___(a)___ relative to ___(b)___
a. cash flow magnitude
b. cost
Answer:
Market value is a measure of ___(a)___ compared to ___(b)___, but it often doesn’t look at ___(c)___ or ___(d)___
a. magnitude of sales
b. competitor’s magnitude of sales
c. time value of money
d. risk/return trade off
Answer:
Value measures ___(a)___ and ___(b)___ better than ___(c)____, ___(d)___ or ___(e)___
a. time value of money
b. risk/return trade off
c. returns
d. Profit
e. Market Value
Accronym:
FCF
Free Cash Flows
Define:
Free Cash Flows
Measures magnitude of the cash flow at the point in time it is received
(expected in the future)
Answer:
What is the goal of the firm?
*Maximize value
Maximize present value of all expected future cash flows
Acronym:
PV
Present Value
Acronym:
NPV
Net Present Value
Answer:
Most projects are ___(a)___ because they have a/an ___(b)___
a. finite
b. expected end point
Answer:
How is the value added by a project estimated?
The present value of all investment outlays/costs is deducted from the present value of expected future cash flows
Decision Rule:
NPV Project
The firm should accept any positive NPV project that it is able to identify
The project will maximize the value of the firm as a whole
List:
Factors Influencing Firm Financial Decisions
- Size of the firm and form of business organization
- Agency problems - do managers/employees act in their own best interests or in the interest of the owners of the firm
- Conditions in external financial markets
List:
Advantages of Sole Proprietorship
- Easy to start
- Less regulation and reporting requirements
- Single owner keeps all profits
- Profits are taxed as personal income to the owner
List:
Disadvantages of Sole Proprietorship
- Limited to life of owner
- Equity capital limited by owner’s personal wealth (limits size)
- Unlimited liability
- Difficult to sell/transfer ownership
List:
Advantages of Partnership
- Allows for multiple owners
- Can make use of personal wealth of all partners for equity
- Relatively easy to set up
- Income taxed as personal income of partners
List:
Disadvantages of Partnership
- Unlimited liability for general partner(s); limited partners are not liable for business debts
- Partnership dissolve when one partner dies or wishes to sell
- Difficult to transfer ownership/partnership
Answer:
A partnership has the capacity to grow ___(a)___ than a ___(b)___
a. larger and faster
b. sole proprietorship
List:
Advantages of C-Corporation
- easier to raise external capital, take in new equity
- Unlimited life
- Transfer of ownership is not difficult
- Separation of ownership and management
List:
Disadvantages of C-Corporation
- Double taxation if income is distributed to owners
2. Separation of ownership and management
Answer:
Why is separation of ownership and management an advantage for a C-Corporation?
Allows for specialization of employees within the firm to maximize value
Answer:
Why is separation of ownership and management a disadvantage for a C-Corporation?
Because of the agency problem (do managers/employees act in their own best interest or in the interest of the owners of the firm
Answer:
An S-Corporation primarily differs from a C-Corporation in terms of ___(a)___. A firm that has filed (form 2553) as an S-Corporation is a ___(b)____ entity
a. tax status
b. pass-through
Answer:
Explain how there is no income tax at the corporate level for a S-Corporation
Profits or losses are “passed through” to the owners, and are reported for tax purposes on the owner’s personal tax returns.
Any taxes paid are at personal level and at personal rate
List:
Restrictions on S-Corporations
- Restricted to no more than 100 shareholders
- Shareholders must be US citizens/residents
- Cannot be owned by other corporations or trusts
- Can only have one class of voting rights
Answer:
S-Corporations are ___(a)___ common than C-Corporations because they are ___(b)___
a. less
b. more restrictive
Answer:
What is the tax status of LLC’s?
Do not pay taxes at corporate level
Members report a share of profits or losses on personal tax returns, the same as a partnership
List:
Disadvantages of LLC
- limited life (ignore that this is incorrect)
- Self employment taxes are contributed to Medicare and Social Security - entire net income of the LLC is subject to the tax
List:
Financial Managers in a Corporation
- Treasurer
- Controller
- Chief Financial Officer (CFO)
Define:
Treasurer
Manages cash and credit (short term liquidity), capital expenditures, provides input to financial planning
Define:
Controller
Manages cost accounting, financial accounting/reporting, taxes, and financial data
Define:
Chief Financial Officer
Oversees the treasurer and controller, all financial operations. Signs off on financial disclosures of the firm. Contributes to decisions related to risk management. Increasingly involved in decisions and operations of key areas of the firm
Answer:
What is the result of the Sarbanes-Oxley on CFOs?
Must sign off on financial disclosures
Answer:
When does an agency relationship arise?
- When principal hires an agent to represent their interests
- When stockholders (principals) hire managers (agents) to run the company, make decisions
Answer:
Describe the conflict of interest when an agency relationship arises
- Stockholders want to maximize the value of the firm
&
-Managers want to maximize personal wealth and consumption
Answer:
Separation of ownership and control allows for ___(a)___, but usually results in ___(b)___
a. specialization
b. conflicts of interest
List:
Methods for Reducing the Agency Problem
- Provide incentives that give managers ownership stake
- Market for corporate control
- Role of Stakeholders
List:
What incentives giving managers and ownership interest can be offered?
- Stock options
2. Stock grants
Define:
Stock Options
Give managers (agents) the option to purchase stock at the price on the grant date
Define:
Stock Grants
Stock blocks given to managers (agents) - usually with a vesting period
Answer:
How does the market for corporate control reduce the agency problem?
Threat of takeover by other firms gives incentives to operate efficiently, increase value
Poor management increases the possibility of takeover at which point the manager may be removed
List:
Other stakeholders that can reduce the agency problem
- Board of directors
- Other employees competing for the job
- Shareholder initiatives
Answer:
How can the board of directors reduce the agency problem?
Have the capacity to fire the manager/agent
Answer:
How can shareholder initiatives reduce the agency problem?
Shareholders can act together to fire or replace a manger/directors
List:
The primary function of financial markets is to facilitate transactions between which 2 parties
(2 sets of 2)
- Those who need capital
- Those with excess capital
OR
- Those who want to reduce risk and are willing to pay someone to take it
- Those who want returns and are willing to bear risk to get high return
Answer:
In many financial market transactions, there is a combination between ___(a)___ and ___(b)___, so there are not always separate transactions for ___(c)___ and ___(d)___
a. needing to to raise capital
b. willingness to assume risk
c. capital
d. risk
List:
Market Participants
a. Business firms
2. Households
3. Governments
4. Financial Intermediaries
Define:
Business Firms as Market Participants
Net borrowers
Borrowing/raising money in equity markets to invest in projects and create value
Define:
Households as Market Participants
Net savers
Generally savings increase with age
Define:
Governments as Market Participants
Can be both borrowers and savers
Define:
Financial Intermediaries as Market Participants
Connectors of borrowers and lenders, but may also trade on their own account
List:
Types of Financial Intermediaries as Market Participants
- Commercial Banks
- Investment Banks
- Insurance companies
- Pension funds
- Hedge funds
List:
Primary Issues of Cash Flows to the Firm
- Initial Public Offerings (IPOs)
- Seasoned Equity Offerings (SEOs)
- Private Equity Investment
- New debt issue (can be publicly or privately placed)
- New loan initiated with commercial bank
Answer:
With the exception of ___(a)___, most transactions issuing cash flows to the firm require the assistance of ____(b)___ to ____(c)____
a. commercial bank loans
b. investment banks
c. facilitate the transaction
