mos exam Flashcards
The Goal of a Firm
Create value for the shareholders. To maximize the price of common stock.
Role of management
Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders and objectives.
Creditors, managers, employees and customers hold contractual claims against the company. Shareholders have residual claims against the company.
Role of Finance in Business
Capital budgeting decision, Capital structure decision, Operating decision
Capital budgeting decision
What long-term investments should the firm undertake?
Capital structure decision
How should the firm raise money to fund these investments?
Operating decision
How to manage cash flows arising from day-to-day operations?
Principles of Finance
P.1 (Cash Flow is What Matters),
P.2(Money has a time value), P.3 (Risk requires a reward)
P.1 (Cash Flow is What Matters)
Accounting profits are not equal to cash flows.
It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.
Cash flow, and not profits, drive the value of a business.
We must determine additional cash flows when making financial decisions.
P.2(Money has a time value)
A dollar received today is worth more than a dollar received in the future.
Since we can earn interest on money received today, it is better to receive money sooner rather than later
Typical cash flows
Outflows: Initial Investment (cash need to purchase asset), Incremental operating costs, Repairs and Maintenance of new equipment, Additional investment in inventory
Inflows: Incremental revenues, Reduction of operating costs, Salvage value
Choosing a discount rate
The firm’s cost of capital is usually regarded as the minimum required rate of return.
The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds
P.3 (Risk requires a reward)
Risk is the uncertainty about the outcome or payoff of an investment in the future.
Rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk.
Diversification of Investments
All investment risk is not the same.
Some risk can be removed or diversified by investing in several different securities.
Firm specific risk vs. market risk
Real assets
are tangible things owned by persons and businesses: Residential structures and property, Major appliances and automobiles. Office towers, factories, mines. Machinery and equipment
Financial assets
are what one individual has lent to another: Consumer credit, Loans, Mortgages
The Functions of Money
Medium of Exchange, Standard of value, Store of value
Medium of Exchange
How transactions are conducted:
Something that is generally acceptable in exchange for goods and services. In this function, money removes the need for double coincidence of wants by separating sellers from buyers.
Standard of value
How the value of goods & services are denominated:
Something that circulates and provides a standardized means of evaluating the relative price of goods and services.
Store of value
How the value of goods & services are maintained in monetary terms:
The ability of money to command purchasing power in the future.
Channels of money transfers
Financial intermediaries, Market intermediaries, Non-market transactions
Financial intermediaries
transform the nature of the securities they issue and invest in (bank, insurance company)
Market intermediaries
make the markets work better (i.e. real estate broker, stock broker)
Non-market transactions
in which the markets are not involved (i.e. lending money to your sibling so they can buy a car
Intermediation
the transfer of funds from lenders to borrowers
First channel
Direct intermediation – the lender provides money directly to the borrower (non-market transaction)
Second channel
Direct intermediation through a market intermediary – the borrower uses a market intermediary to help find suitable lenders. Market intermediary= an entity that facilitates the working of markets (mortgage brokers, insurance brokers, stockbrokers)
Third channel
Indirect intermediation – the financial intermediary lends the money to the ultimate borrowers but raises the money itself by borrowing directly from other individuals
The Financial System (Financial Intermediaries)
Banks and other deposit-taking institutions
Insurance companies
Pension Funds
Mutual Funds- simply act as a “pass through” for individuals, providing them with a convenient way to invest in the equity and debt markets.
Do not change the nature of the underlying financial security.
Financial Instruments
Debt and Equity
Debt Instruments
Legal obligations to repay borrowed funds at a specified maturity date and to provide interim interest payments. Bank loans, commercial paper, treasury bills (T-Bills), etc.
Equity instrument
Ownership in a company comes in two main types: Common shares provide partial ownership and voting rights, while Preferred shares offer fixed dividends prioritized over common shareholders.
Equity instruments issued by Corporations (Common stocks)
The common stockholders are the owners of the corporation’s equity
Voting rights
No specified maturity date and the firm is not obliged to pay dividends to shareholders
Returns come from dividends and capital gains
On liquidation of company, common stockholders are last in list for company assets, only after creditors, bondholders, and preferred shareholders are paid out
Preferred Stock
Equity instruments
Usually entitle the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders
Generally do not have voting rights in the company
Have characteristics of both bonds and stocks
On liquidation of the company, preferred stockholders will be paid out before common stockholders (but after creditors/bondholders)
Primary markets
Involve the issue of new securities by the borrower in return for cash from investors (or lenders) [i.e. new securities are created]
Secondary markets
Secondary markets facilitate the buying and selling of existing securities, ensuring investment liquidity. They are vital for the primary market’s functioning, enabling investors to sell investments when needed. In equity, secondary trading surpasses primary markets, while in debt, it’s the opposite.
Money market securities
short term debt instruments (maturities less than one year i.e. T-bills)
Capital market securities
include debt securities with maturities greater than one year (i.e. bonds & equity securities) & equity securities
Exchanges or auction markets
secondary markets that involve a bidding process that takes place in a specific location
Dealer or over-the-counter (OTC) markets
secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another
The distinction has become blurred in recent years because trading on most of the major exchanges in the world is now fully computerized, making the physical location of the exchange of little consequence.
Commercial paper
debt that operates in the money market and is traded over the counter (like an IOU)
Bankers Acceptance
like commercial paper but the bank of the borrowing company guarantees the repayment of the debt
Corporate Bonds
you buy a bond from a company for a certain amount of time (loan them money), then they pay you back with interest when the time is up (e.g. 10 years)
Debentures
unsecured debt, backed only by the general assets of the issuing corporation, no collateral or belief that the company will pay except for the company’s word
Secured debt
(mortgage debt) - secured by specific assets, you can take the company to court if they don’t pay you back
Subordinated debt
in default, holders get payments only after other debt-holders get their full payment, you get paid last
Senior debt
in default holders get payment before other debt-holders get, you get paid first, will pay less interest than subordinated because subordinated debt is taking a much larger risk
Retractable
means that you can force the company to give you your money back as an investor
Zero coupon
pay face value at maturity only, sold at discount, you don’t get interest throughout it, you just get paid right amount with interest at the end
Junk bonds
bonds with below investment grade rating, high yield, a risk bond, really high interest, there’s a risk you won’t get paid back
Convertible
you, the investor, can choose to exchange or convert or change your bond into shares of the company
Extendable
the company can choose to take longer to pay you back, if they extend, they still have to keep sending you regular interest payments during extended period
Callable (Redeemable)
the company can choose to pay you back early, the don’t have to wait till the full duration
Equity instruments issued by Corporations: Preferred stocks
Preferred shares are like special stock with fixed payments, acting a bit like bonds. They can be cumulative (payments accrue if missed) or non-cumulative, and participating (get more if the company does well) or non-participating. If the company skips dividends, preferred shareholders might get voting rights. They’re seen as a liability, not equity, on financial statements. Companies use them because they’re sort of a cheaper alternative to regular stock, similar to debt.
Derivatives securities
Derivatives are like financial sidekicks, their value linked to something else. They don’t have standalone value but gain it from an underlying asset. The key players are options and futures. Stock options aren’t for raising funds; they’re a form of compensation. Prices depend on market forces, showcasing expectations about the future from existing info.
IPO: initial public offering (company)
can raise money by themselves, by merging with another firm, or by going public with their shares
How New Businesses Get Started
Initiated by entrepreneurs rather than large corporations, the startup process involves securing “seed” money and essential resources. This early phase, lasting 1 to 2 years, sees founders relying on their own initial investments as venture capitalists or banks typically hesitate to fund. Success is gauged by providing convincing evidence to potential investors that the business concept is viable and merits financial support.
Venture capitalists
are individuals or firms that help new businesses get started and provide much of their early-stage financing
Angel investors
individual venture capitalists who are wealthy individuals who invest their own money in emerging businesses at the very early stages
individual investor capitalist or angel investors
are typically wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals
3 reasons as to why traditional sources of funding do not work for new or emerging businesses:
The high degree of risk,Types of productive assets,Informational asymmetry problems
The high degree of risk
most suppliers of capital, such as banks, pension funds, and insurance companies are averse to undertaking high-risk investments, and much of their risk-averse behaviour is mandated in regulations that restrict their conduct
Types of productive assets
no assets to weigh risk over, most assets are not tangible, it’s easier to secure loans when tangible assets are present, so new firms whose primary assets are intangibles, like patents or trade secrets, often find it difficult to secure financing from traditional lending sources
Informational asymmetry problems
Banks and investors may not fully grasp your idea like you do. In specialized or new industries, investors might struggle to tell good entrepreneurs from bad ones, making them hesitant to invest in those firms.
Venture capitalism more
Venture capitalists invest to gain equity in a company, usually through preferred stock that can convert to common stock if they choose. How much they get involved depends on the expertise of the management team.
Important info on venture capitalism
One crucial role of venture capitalists is to offer advice. Leveraging their industry expertise, they guide businesses on how to succeed, providing valuable counsel to entrepreneurs in the startup and early operational phases.
The Venture Capital Funding Cycle
Bootstrap financing, Seed-stage financing, Early-stage financing, Latter-stage financing (mezzanine financing)
Venture capitalists then exit by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public
Bootstrap financing
entrepreneur supplies funds, prepares business plan, and searches for initial outside funding
Early-stage financing
VCs provide funds to finish development of the concept
Seed-stage financing
venture capitalists provide funds to finish development of the concept
Latter-stage financing (mezzanine financing)
typically includes 1-5 additional stages
Value proposition
why consumers find your business/product attractive
How Venture Capitalists Reduce their Risk
Funding the ventures in stages, Requiring entrepreneurs to make personal investments, Syndicating investments, Maintaining in-depth knowledge about the industry
Funding the ventures in stages
not giving all of the money at once, e.g. $1 Million for 8 months, then more later if you show you are using the money properly
Requiring entrepreneurs to make personal investments
proves commitment and confidence in business
VCs want your financial rewards to come from building a successful business, not from your salary
Syndicating investments
Venture capitalists share risk by forming groups. This reduces risk in two ways: it diversifies the investment portfolio of the original venture capitalist, as others now own part of the deal, and the initial VC has less money at stake.
Maintaining in-depth knowledge about the industry
specializing in and understanding a business field gives the VC an advantage over other lenders who may be generalists
The Exit Strategy
Venture capitalists aren’t in for the long haul; they typically exit in 3 to 7 years. Each agreement outlines key decisions for the exit, such as when to exit, the method, and the acceptable price.
Sell to financial buyer in the private market
In financial sales, firms are purchased for financial gain, not personal improvement. This often happens in leveraged buyouts by private equity firms, where the goal is to hold the company for 3-5 years and sell it at a profit. Unlike strategic buyers, financial buyers don’t expect gains from operational or marketing synergies. Instead, they focus on improving operations independently to create value.
Initial Public Offering: selling common stock in an initial public (IPO)
To get the best price in an IPO, a VC won’t sell all their shares right away; selling everything might worry investors. Most VCs prefer exiting through strategic and financial sales rather than public sales (IPOs).
The Cost of Venture Capital Funding
Venture capital involves high costs but offers the potential for significant returns. Typically, only 1 or 2 out of every 10 VC-backed businesses succeed. If successful, venture capitalists contribute substantially to creating value for other owners. On average, a VC fund is estimated to generate annual returns of 15-25%, surpassing the S&P 500’s average annual return of 11.82%.
IPO
To get a lot of cash or let a venture capitalist exit, companies often go for an IPO, selling their common stock to the public. These first-time stock deals have a special name because they’re crafted to attract investors as the company makes its debut in the market.
Advantages of going public
IPOs get big money, more than private sources. After, you can raise extra cash cheaply through follow-on public offerings because public shares are easier to trade and valued higher than private ones.
Disadvantages of IPO
IPOs are costly because the stock is new, lacking an established record. Out-of-pocket expenses, like legal and accounting fees, add up. Complying with ongoing SEC disclosure rules is also pricey. Publicly sharing all company info may eliminate competitive advantages over private firms. Some investors say SEC’s quarterly reporting pushes managers toward short-term profits, not long-term value.
Seasoned public offering
A public offering is when a company sells more stocks or bonds that are already publicly traded. This means these securities are registered with the Securities and Exchange Commission, making them legally available for sale to the general public. Only registered securities can be sold to the public.
Investment-Banking Services
For an IPO, a company relies on investment bankers, specialists in introducing new securities to the market. These bankers offer three essential services in the process: origination, underwriting, and distribution.
Origination
Investment bankers get firms ready for an IPO, offering financial advice. BOD and shareholder approvals are needed. A preliminary prospectus provides detailed info to help investors make smart decisions about the security issue and its risks.
Underwriting
The risk-bearing part of investment banking
The securities can be underwritten in 2 ways
On a firm-commitment basis
In an IPO deal, the investment banker (IB) agrees to buy your shares at a set price and then sells them to the public. The underwriter takes on the risk that the resale price might be lower, known as price risk. The IB’s pay is the underwriter’s spread, which, in a firm-commitment offering, is the difference between the IB’s purchase price and the offer price.
On a best-efforts basis
In a best-effort IPO, the investment banker aims to sell as many shares as possible at the highest price, taking a commission. They don’t guarantee a price or the number of shares. Most companies prefer firm-commitment IPOs (over 95%) where the price is guaranteed. Best-effort contracts arise when underwriters avoid the risk of setting a guaranteed offering price.
Underwriting Syndicates
Underwriters form an underwriting syndicate to share risk and efficiently sell a new security issue. Each participating underwriter gets a portion of the fee and an allocation of securities to sell. To expand investor outreach, syndicates may involve other IB firms in a selling group, earning commissions for each security sold without bearing underwriting risk.
Determining the Offer Price
An investment banker’s challenge is to find the optimal price for a quick sale of all offered shares, ensuring a stable secondary market. This involves considering the firm’s future cash flows and comparing stock prices to earnings and total firm value of similar public firms. A road show follows, with management presenting to potential investors. This helps the IB gauge how many shares investors might buy at different prices.
Due Diligence Meeting
Before selling shares, the underwriting syndicate and the issuer hold a due-diligence meeting. This is to protect the underwriters and minimize the risk of investor lawsuits in case the investment faces issues later. These meetings make sure all significant details about the firm and the offering are uncovered and fully disclosed to investors.
