THEORY Flashcards
Proprietorship and partnership MEANING
Unincorporated business owned by one individual
Unincorporated business owned by two or more individuals
Proprietorship and partnership ADVANTAGES
- easily and inexpensively formed
- subject to few govt regulations
- subject to lower income taxes than corporations
- no corporate income taxes
Proprietorship and partnership DISADVANTAGES
- unlimited personal liability
- limited life of business
- difficult to raise capital
Corporation ADVANTAGES
- Easy transfer ship of owner
- unlimited life
- limited liability (only lose what they invest)
- ease of raising capital
Corporation DISADVANTAGES
- cost of setup and report filling
- double taxation (corporation earnings taxed + dividend earnings taxed as personal income)
LLP/PARTNERSHIP (hybrid) ADVANTAGES
- Limited liability like corporations
- Taxed like partnerships
- votes in proportion of their ownership interest
LLP/PARTNERSHIP (hybrid) DISADVANTAGES
- Still evolving; requires hiring of a good lawyer when establishing
Financial management (goal)
How companies conduct their business in order to maximize its value; shareholder wealth maximization (maximize long run value of firms common stock (cash flow)
Proprietor’s goal
Maximize his own interest
Not inconsistent with being socially responsible
Intrinsic value
An estimate of the “true” value based on the best available information
- can be estimated, but not measured precisely
- changed when there’s new info
Stock prices
Set by marginal’s investor based on perceived value of the stock
Information may be inaccurate
Market equilibrium
Instrinsic price = stock price
Investors indifferent about selling or buying
Effective comms needed
Agency problem
Managers vs stockholders
- managers inclined to act in their own best interests eg pay themselves excessive salaries
Solving agency problems
@ Reasonable compensation packages
- reward managers based on long run intrinsic value of company stock not the stock price on an option exercise data
Compensation based on stock market price
Some managers paid by stocks but not the best solution
@ direct intervention by shareholders
@ threat of hostile takeovers : corporate raiders may see it as a bargain and attempt to capture the firm becoming managers = losing jobs
@ firing managers who suck
Bond holder vs stockholders
B: generally receives fixed payments regardless of how well company does
S: do better when company doing better
Bond holder vs stockholders problems
Taking on risky projects may result in bankruptcy
Usage of additional debt; more debt = riskier
Time value of money
Money available today worth more than same amount in future because we can invest
Fv formula
FV = PV ( 1 + I)^n
Pv formula
Fv /(1+n)^N
Annuities vs perpetuities
A: series of equal cash flow for fixed intervals for a specific number of periods
P: annuity that lasts forever
Ordinary annuity vs annuity due
OA: cash flows at the end of periods
AD: cash flow occur at beginning of period
Balance sheet
Statement of firm’s financial position at one point of time
Shows what assets the company owns and who has claims on the assets as of a date
Income statement
Summarizes a firm’s revenues and expenses over a given period of time
Statement of cash flows
How much cash the firm began with, how much it ended with and what it did to increase/ decrease its cash
Statement of stockholders’ equity
Shows that amount of equity the stockholders’ had at the start of the year, that items that increase of decrease equity, and equity at the end of the year
Double taxation
Interest paid by corporations: tax deductible
Dividends paid by corporations: out of after tax income
Dividends received by investors: taxed in the us
Default risk premium
Compensation for possible default that issuer will not pay principal and interests on time and at stated amounts
Diff btw us treasury bond and corporate bond of equal maturity and marketability
Inflation premium
Average expected inflation over life of debt security
r*
Real risk free rate of interest
Interest rate of borrowing when there is zero expected inflation
Liquidity premium
Compensate for the possibility of difficulty of selling debt security quickly at market value
Maturity risk premium
Compensation for possible loss in value due to increase in interest rates over maturity of debt security
Affects longer term security more than shorter
Higher maturity higher mrp
Normal yield curves
Upward sloping due to increase in ip and mrp
Inverted yield curve
Downward sloping when ip is expected to decrease and decrease more than increase in mrp
Treasury bonds
Issued by govt therefore no drp
But bond prices to decline when ir increases
Corporate bonds
Exposed to default risk
Issued by corporates
Municipal bonds
Issued by state
Exposed to some default risk
Foreign bonds
Exposed to default risk
Sinking funds
Provision in the bond contract that requires the issuer to retire a portion of the bond issue each year
Call provisions (bonds)
Provision that gives issuers the right to redeem the bonds under specified terms prior to the normal maturity date
Mainly corporate and municipal
Usually bond issuers pay bond holders an amount greater than par value if called
Companies not likely to call bonds unless I/r decline significantly since bonds issuing
Convertible bond
Bond that is exchangeable into shares of common stock at fixed price
Take advantage potential stock upside
Warrant
Long term option to buy a stated number of shares of common stock at a specified price
Capital gain if stock price rises
Putable bonds
Bond with provision that allows investors to sell it back to the company prior to maturity at a prearranged price
Income bond
Bond that pays interest only if issuer earned enough money to pay that interest
Indexed bond
Bond that has interest payments based on inflation index to protect holder from inflation
Par bond vs premium bond vs discount bond
No gain nor loss / YTM = coupon rate -> bond price = par value
Capital loss because bond value decrease over time (compensated by high cy)
YTM < coupon rate -> bond price > par value
Opposite
Steps to do bond with semiannual coupon bond
Multiply year by 2
Divide coupon by 2
Divide nominal rate by 2
Interest rate risk (bond)
Risk of a decline in bond’s price due to an increase in I/r
Bonds with longer maturity have higher I/r risk
High for long term bonds with low coupon rates
Reinvestment risk
Risk that a decline in I/r will lead to a decline in income from a bond portfolio
I/r falls, future CFs reinvested at lower rates
High for short term bonds and high coupon rates
Bond ratings
Criteria’s
Triple-B and above; investment grade bond
Financial ratios, bond contract terms, miscellaneous quantitative factors
