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Finance 302 > Test and Quiz 1 > Flashcards

Test and Quiz 1 Flashcards

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1
Q

What is a firm’s intrinsic value?
Its current stock price? Is the stock’s “true” long-run value more closely related to its intrinsic value or to its current price?

A

Intrinsic value = true value / true risk / true investor cash flows / long-run concept

Current stock price = market price / perceived risk / perceived investor cash flows

intrinsic value

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2
Q

When is a stock said to be in equilibrium? Why might a stock at any point in time not be in equilibrium?

A

Equilibrium. When intrinsic value = a stock’s price

investors perceptions are incorrect

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3
Q

If a company’s BOD wants management to maximize shareholder wealth, should the CEO’S compensation be set as a fixed dollar amount, or should the compensation depend on howell the firm performs? If it is to be based on performance, how should performance measured?Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s intrinsic value? Which would be the better performance measure? Why?

A

The BOD should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.

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4
Q

What are various forms of business organizations?

A

Proprietorships: and unincorporated business owned by ONE individual.

Partnership: 2 or more persons

Corporation: a legal entity created by a state, separated and distinct from its owners and managers, having easy transferability of ownership, and limited liability. Owners are shareholders.

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5
Q

What are the advantages and disadvantages of proprietorship and partnership?

A

Adv: ease of formation, subject to few regulations, no corporate income taxes

Disadv: difficult to raise capital, unlimited liability (remaining partners will be responsible for unsatisfied claims), limited life (life of the individual who created it)

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6
Q

What are the advantages and disadvantages of corporation?

A

Adv: unlimited life, easy transfer of ownership, limited liability, ease of rising capital

Disadv: double taxation (the corporation’s earnings are taxed; and then when its after-tax earnings, those earnings are taxed again as a personal income to the stockholders), cost of setup and report filing.

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7
Q

What are some actions that stockholders can take to ensure that management’s and stockholders’ interests are aligned?

A
  1. Managerial compensation packages
  2. Direct intervention by shareholders (this is what needs to happen)
  3. Threat of firing
  4. Threat of takeover.
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8
Q

What is a limited liability?

A

limits stockholders’ losses to the amount they invested in a firm. In other words they aren’t penalized if the company is committing fraud.

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9
Q

Behavioral Finance

A

borrows insights from physiology to better understand how irrational behavior can be sustained over time

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10
Q

What is a market?

A

Venue where goods and services are exchanged

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11
Q

What is a financial market?

A

a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

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12
Q

What are physical assets?

A

tangible or real

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13
Q

What are financial assets?

A

stocks or bonds

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14
Q

What is a spot market?

A

Assets are bought or sold for on-the-spot delivery (within a few days)

i.e. you buy the pen today.

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15
Q

What are futures?

A

a market in which participants agree today to buy or sell an asset at some future date.

i.e. you agree today to buy the pen tomorrow

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16
Q

What is a money market?

A

funds are borrowed for short periods

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17
Q

What is a capital market?

A

stocks and for intermediate - or long-term debt

> 1 year

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18
Q

Primary market

A

corporations raise capital by issuing new securities

i.e. Toyota

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19
Q

Secondary market

A

Securities are traded among investors after they have been issued by corporations

i.e. carmax

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20
Q

Public market

A

Standardized contracts are traded on organized exchanges (stocks and bonds)

i.e. new york stock exchange

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21
Q

Private market

A

Transactions are worked out directly between two parties (bank loans)

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22
Q

What are derivatives?

A

a derivative security’s value is “derived” from the price of another security.

i. e. options and futures.
i. e. oil futures are derived from the price of oil

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23
Q

How can derivatives be used to reduce or increase risk?

A

Can be used to hedge/reduce risk.

i.e. an importer whose profit falls when the dollar loses value could purchase currency futures that do well when the dollar weakens.

Also, speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices.

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24
Q

Types of financial institutions:

A

investment banks
commercial banks
financial services corporations insurance companies

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25
Q

New York Stock Exchange

Physical or Electronic?
Auction or Dealer?

A

Physical

Auction

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26
Q

Nasdaq

Physical or Electronic?
Auction or Dealer?

A

Electronic

Dealer

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27
Q

Apple computer decides to issue additional stock with the assistance of int investment bankers. An investor in apple purchases some of the newly issued shares. Is this a primary market or secondary market?

A

Primary

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28
Q

An investor buys existing shares of apple stock in the open market. Is this primary or secondary?

A

Secondary.

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29
Q

What is an IPO?

A

Initial public offering

This occurs when a company issues stock in the public market for the first time.

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30
Q

“Going public” enables a company’s owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the ___ market.

A

Secondary

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31
Q

What is meant by stock market efficiency?

A

Securities are normally in equilibrium and are “fairly priced.”

Investors cannot beat the market.

32
Q

You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?

A

No, because everyone knows this information, so you cannot get money off of the information.

33
Q

A small investor has been reading about a “hot” IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hand hands on and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?

A

No. Although in the short-run this would be good, the stock price will go down in the long-run.

34
Q

The primary financial goal of management is

A

maximization of shareholder’s wealth, which translates to maximizing price.

35
Q

Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital?

A

LOOK AT HANDOUTIn a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in three different ways:

  1. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who, in turn, give the firm the money it needs.
  2. Transfers may also go through an investment bank that underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment bank.
  3. Transfers can also be made through a financial intermediary. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses’ securities, while the savers hold the intermediary’s securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets.
36
Q

Is an IPO an example of primary or secondary market? Explain.

A

Primary because it is an initial offering.

37
Q

Indicate whether the following instruments are examples of money market or capital market securities?

  • U.S. Treasury bills
  • Long-term corporate bonds
  • Common Stocks
  • Preferred Stocks
  • Dealer commercial paper
A
  • MMS
  • CMS
  • CMS
  • CMS
  • MMS
38
Q

Differentiate between dealer markets and stock markets that have a physical location.

A

The physical location exchanges are tangible entities. Each of the larger ones occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body. A dealer market includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges. The dealer market system consists of (1) the relatively few dealers who hold inventories of these securities and who are said to “make a market” in these securities; (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a communication link between dealers and brokers.

39
Q

Identify and briefly compare the two leading stock exchanges in the US today.

A

The two leading stock markets today are the New York Stock Exchange (NYSE) and the Nasdaq stock market. The NYSE is a physical location exchange, while the Nasdaq is an electronic dealer- based market.

40
Q

Briefly explain what is meant by the term efficient continuum.

A

LOOK AT HANDOUT

There is an “efficiency continuum,” with the market for some companies’ stocks being highly efficient and the market for other stocks being highly inefficient. The key factor is the size of the company—the larger the firm, the more analysts tend to follow it and thus the faster new information is likely to be reflected in the stock’s price. Also, different companies communicate better with analysts and investors; and the better the communications, the more efficient the market for the stock.

41
Q

T/F
Derivative transactions are designed to increase risk and are used almost exclusively by spectators who are looking to capture high returns

A

F

42
Q

T/F
Hedge funds typically have large minimum investments and are marketed to institutions and individuals with high net worths

A

T

43
Q

T/F

Hedge funds have traditionally been high regulated.

A

F

44
Q

T/F

The NYSE is an example of a stock exchange that has a physical location.

A

T;
the NYSE is a physical location exchange with a tangible physical location that conducts auction markets in designated securities.

45
Q

A larger bid-ask spread means that the dealer will realize a lower profit.

A

F;

A larger bid-ask spread means the dealer will realize a higher profit

46
Q

Balance sheet

A

provides a snapshot of a firm’s financial position at one point in time.

47
Q

Income statement

A

summarizes a firm’s revenues and expenses over a given period of time.

48
Q

Statement of Cash Flows

A

reports the impact of a firm;s activities on cash flows over a given period of time.

49
Q

Statement of stockholder’s equity

A

shows how much of the firm’s earnings were retained, rather than paid out as dividends.

50
Q

What are the 4 annual reports?

A

Balance sheet, income statement, statement of cash flows, statement of stockholder’s equity.

51
Q

what is a progressive structure?

A

the higher the income, the higher the marginal tax rate. The more you earn, the more taxes you pay.

52
Q

What are the federal income tax systems?

A

individual taxes and corporate taxes

53
Q

Which federal income tax systems are progressive?

A

individual and corporate

54
Q

What is free cash flow? If you were an investor, why might you be more interest in free cash flow than net income?

A

Free cash flow is the amount of cash that could be withdrawn without harming the firm’s ability to operate and to produce future cash flows. It is calculated as after-tax operating income plus depreciation less capital expenditures and the change in net operating working capital. It is more important than net income because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company’s operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.

55
Q

Would it be possible for a company to report negative free cash flow and still be highly valued by investors; that is, could a negative free cash flow ever be viewed optimistically by investors? Explain.

A

Yes. Negative free cash flow is not necessarily bad. Most rapidly growing companies have negative free cash flows because the fixed assets and working capital needed to support rapid growth generally exceed cash flows from existing operations. This is not bad, provided the new investments will eventually be profitable and contribute to free cash flow.

56
Q

Why would the inventory turnover ratio be more important for someone analyzing a grocery store chain than an insurance company?

A

The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing before conducting a ratio analysis.

57
Q

Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between the turnover ratios, profit margins, and DuPont equations for a grocery chain and a steal company.

A

Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a high turnover will be associated with a low profit margin, and vice versa.

58
Q

Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry?

A

Firms within the same industry may employ different accounting techniques that make it difficult to compare financial ratios. More fundamentally, comparisons may be misleading if firms in the same industry differ in their other investments. For example, comparing PepsiCo and Coca-Cola may be misleading because apart from their soft drink business, Pepsi also owns other businesses, such as Frito-Lay and Quaker.

59
Q

What facts could explain a higher P/E ratio?

A

A review of Yahoo! Finance on 09/22/14 showed that the trailing twelve-month P/E ratio for Verizon was 11.17 compared to 15.83 for Walmart. The P/E ratio indicates how much investors are willing to pay per dollar of reported profits. Verizon’s lower P/E ratio indicates that investors view Verizon as being riskier than Walmart. Considering the industries in which both firms operate this is not surprising.

60
Q

T/F

In most corporations, the CFO ranks under the CEO

A

TRUE

61
Q

T/F

Partnerships and proprietorships generally have a tax advantage over corporations.

A

True

62
Q

T/F
A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to personal liabilities in the event of bankruptcy than are investors in a typical partnership

A

false

63
Q

The primary operating goal of a publicly owned firm interest in serving its stockholders should be to

A

maximize the stock price per share over the long run, which is the stock;s intrinsic value.

64
Q

what could explain why a business might choose to operate as a corporation rather than a proprietorship or partnership?

A

Corporations find it easier to raise large amounts of capital.

65
Q

T/F

An initial public offering would be an example of a primary market transaction.

A

true

66
Q

T/F
Trades on the NYSE are generally completed by having a brokerage firm acting as a dealer buy securities and adding them to its inventory or selling from its inventory. The NASDAQ operates as an auction market where buyers offer to buy and sellers to sell and the price is negotiated on the floor of the exchange.

A

false

67
Q

If you decide to buy 100 share of goole you would probably do so by calling your broker and asking him or her to execute the trade for you. this would be defined as a secondary market transaction not a primary one.

A

true

68
Q

which is an example of a capital market instrument?

Bankers acceptances
Money Market mutual funds
US T-bills
Preferred stock
Commercial paper
A

Preferred stock.

69
Q

Explain: Our tax rates are progressive.

A

Higher the income, higher the marginal ta rate.

70
Q

T/F
Free cash flow is the amount of cash that could be withdrawn without harming the fir’s ability to operate and to produce future cash flows. Investors should focus on free cash flow rather than net income.

A

true

71
Q 
t/f
The annual report consists of four basic financial statements:
income statement
balance sheet
cash flow statement
statement of stockholder's equity
A

true

72
Q

liquidity

A

can we make required payments?

73
Q

asset management?

A

right amount of assets vs. sales

74
Q

debt management?

A

right mix of debt and equity

75
Q

profitability?

A

do sales prices exceed unit costs and are sales high enough reflected in PM, ROE, and ROA?

Finance 302 (1 decks)

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