Unit 2 Exam (FIN 3310) Flashcards
1
Q
What is a financial security?
A
It is a contract between the provider of funds and the user of funds which specifies:
(1) Amount of money provided
(2) Terms & conditions of repayment
2
Q
What is the difference between debt & equity financial securities? (ownership, voting, taxes, legal resource, bankruptcy)
A
3
Q
What kind of financial security is a bond?
A
Debt security
4
Q
What two parties are involved in the purchase of a bond?
A
User of funds: borrower
Provider of funds: bond holder
5
Q
What are the 5 key features of a bond?
A
(1) Par Value (face value)
(2) Coupon Rate
(3) Coupon Payment
(4) Maturity Date
(5) Yield to Maturity
6
Q
(1) Par Value
A
Face amount, repaid at maturity
Assume $1,000 for corporate bonds
7
Q
(2) Coupon Rate
A
Stated Interest Rate (Usually = YTM at issue)
Multiply by par value to get (3) coupon payment
8
Q
(4) Maturity Date
A
Years until bond is repaid
9
Q
(5) Yield to maturity (YTM)
A
The market required rate of return for bonds of similar risk and maturity
Discount rate used to value a bond (usually = coupon rate at issue)
Quoted as an APR
10
Q
Describe the Valuation of a Bond
A
The price of bond is the PV of all the future cash flow you will receive from the bond
Bond Value = PV(coupons) + PV(par)
11
Q
Define a Fixed-Coupon Bond
A
Pays a fixed amount (coupon) every period until bond matures
Pays the face value (usually $1,000) at maturity
12
Q
Describe what it means for a Fixed-Coupon Bond (FCB) to sell at Par, Discount, or Premium
A
13
Q
Describe the relationship between bond price and YTM
A
14
Q
What is the relationship of Bond Value ($) vs. Years Remaining to Maturity
A
15
Q
What 3 factors causes bonds to fluctuate?
A
(1) YTM
(2) Coupon Rate
(3) Maturity
16
Q
What is the difference between a bearer bond and a registered bond?
A
Bearer bonds are payable to the holder (they must be kept in a safe location, because they can be stolen)
Registered bonds are payable only to the registered owner of the bond (anytime bond is bought or sold, it must be registered to its new owner)
17
Q
What are the 4 types of Security Bond Classifications?
A
(1) Collateral
(2) Mortgage
(3) Debenture
(4) Notes
18
Q
(1) Collateral
A
Secured by financial securities
19
Q
(2) Mortgage
A
Secured by real property, usually land or buildings
20
Q
(3) Debenture
A
Unsecured bond
21
Q
(4) Notes
A
Unsecured debt with original maturity less than 10 years
22
Q
What is the order of payment (seniority) of bonds?
A
Senior > Junior > Subordinate > Shareholders
23
Q
What is the difference between Callable and Non-Callable Bonds?
A
Callable bonds can be redeemed by the issuer before maturity
Non-callable bonds cannot be redeemed by the issuer before maturity, unless a penalty is paid
24
Q
What are the 3 different kinds of Treasury Securities? (Federal Government Debt)
A
(1) Treasury Bills (T-Bills) - Pure Discount bond; Original maturity less than 1 year
(2) Treasury Notes - Coupon debt; Original maturity between 1-10 years
(3) Treasury Bonds - Coupon debt; Original maturity greater than 10 years
25
Describe Municipal Securities (risk, tax)
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate debt
Interest received is TAX EXEMPT at the federal level (often tax exempt at state level too)
26
Define Zero Coupon Bonds
Make NO PERIODIC INTEREST PAYMENTS
Entire YTM comes from difference between purchase price and par value (capital gains)
Cannot sell for more than par value (often called deep discount bonds) (ex. T-Bill)
27
Define Floating Rate Bonds
Coupon Rate floats depending on some index value
Have less price risk (coupon floats, so is less likely to differ substantially from YTM)
28
Describe Interest Rate Risk (price risk)
Change in price, due to changes in Interest Rates
Long-Term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon rate bonds
29
What does the Nominal Rate of Interest Represent?
Includes desired real rate of return, plus an adjustment for expected inflation
30
What does the Fischer Effect Define? What is the equation for the Fischer Effect?
31
Define Term Structure. What graph represents this?
The relationship between time to maturity and yields, all else equal
The Yield Curve represents this relationship
32
What are the two different kinds of yield curves?
33
What factors affect bond yield?
34
If you own a share of a stock, you can receive cash in two ways. What are they?
(1) The company pays you dividends (cash income)
(2) You sell your shares, either to another investor in the market or back to the company (capital gains)
35
How is the price of a stock determined?
The present value of all future dividends
36
What formula is used to calculate the present value (PV) of all future dividends
37
What are the 3 special cases for estimating dividends?
(1) Constant dividend/zero growth
(2) Constant Dividend Growth
(3) Supernormal Growth
38
Define (1) Constant Dividend/Zero Growth
Firm will pay a constant dividend forever
Price is computed using the perpetuity formula
39
Define (2) Constant Dividend Growth
Firm will increase the dividend by a constant percent every period
40
Define (3) Supernormal Growth
Dividend Growth is not consistent initially, but settles down to constant growth eventually
41
What is the formula for the Dividend Growth Model? ("Gordon Growth Model")
42
How is stock price related to dividend growth?
43
How is stock price related to required return?
44
When solving for Required Return (R) using the dividend growth model, what portion of the required return is Dividend yield, and what portion is capital gains yield?
45
What are the 6 conditions of the constant growth model?
46
What voting rights are associated with common stock?
Stockholders elect directors
Boards are often staggered (or classified)
47
What is the difference between cumulative voting and straight voting?
Cumulative voting combats the dominance of majority shareholder in straight voting
In cumulative voting a shareholder has a total number of votes equal to the (# of shares) x (# of director) positions. The shareholder can cast these votes all for one director position or spread them out.
48
What is proxy voting?
The term proxy vote refers to a ballot cast by a single person or firm on behalf of a corporation's shareholder who may not be able to attend a shareholder meeting, or who may not choose to vote on a particular issue.
49
What are the 3 classes of stock?
Founder's shares, Class A shares, Class B shares
50
What "other rights" are associated with common stock?
Share proportionally in declared dividends and remaining assets during liquidation
51
Define Preemptive Right (stockholder)
Right of first refusal to buy new stock issue to maintain proportional ownership if desired
52
Can a firm go bankrupt for not declaring dividends?
No. Dividends are not a liability of a firm until declared by the board of directors.
53
How do taxes affect dividends? (for the firm and the individual)
Dividends are NOT tax deductible for a firm
Taxed as ordinary income for individuals
Dividends received by corporations have a 50% exclusion from taxable income
54
What are the features of preferred stock?
Dividends must be paid to preferred stock holders, before it can be paid to common stockholders
Dividends are not a liability to the firm, can be deferred indefinitely
Preferred stock generally does not carry voting rights
55
What is the difference between primary and secondary stock markets?
56
What is the difference between a broker and a dealer?
Broker: Facilitates trades on behalf of others (think real estate agent)
Dealer: Facilitates trades on behalf of itself or its company (think used car salesman)
57
How do you become a member of the NYSE?
Buy a trading license (historically own a seat)
58
What is the role of Designated Market Makers (DMM's) in the NYSE?
Each stock is assigned a DMM. Their role is to keep the marketplace operating
Trading takes place between customer orders placed with the DMMs and “the crowd”
“Crowd” = Floor brokers and SLPs
59
What is the role of a floor broker on the NYSE?
A floor broker executes orders for their clients. They do not execute on their own accounts. To put it simply, a floor broker is someone who represents client orders at the point of sale on the NYSE floor
60
What is the role of a Supplemental Liquidity Provider (SLP) on the NYSE?
Supplemental liquidity providers (SLPs) are market participants that create high volume on stock exchanges with the goal of bringing liquidity to the markets
SLPs are paid via rebates or fees for their role in facilitating market transactions
61
Describe NASDAQ
Computer-based quotation system
Electronic communications network
Large portion of technology stocks
62
Define Capital Budgeting
Analysis of potential projects for long-term decision making in a firm (determines a firm's strategic direction)
Difficult/impossible to reverse
63
What are the 5 "Good-Decision" criterias associated with capital budgeting?
1. All cash flows considered?
2. TVM considered?
3. Risk-adjusted?
4. Ability to rank projects?
5. Indicates added value to firm?
64
What are the 5 Capital Budgeting Rules used for capital budgeting decision-making?
(1) Net Present Value (NPV)
(2) Profitability Index (PI)
(3) Internal Rate of Return (IRR)
(4) Payback Period (PBP)
(5) Average Accounting Return (AAR)
65
Define (1) Net Present Value (NPV)
When do we accept it?
What does it directly measure?
NPV: Difference between benefits and costs
Accept project if NPV is positive (B-C>0)
V is a direct measure of how well this project will meet the goal of increasing shareholder wealth.
66
What makes NPV prevail over all other capital budgeting rules?
Considers all CFs
Considers TVM
Adjusts for risk
Can rank mutually exclusive projects
67
Define (2) Profitabliity Index (PI)
PI = Benefits/Costs
Accept project if > 1
**Note that wherever NPV>0, PI>1
68
How do we calculate benefit for (2) Profitability Index?
Benefit = NPV + Cost
69
Define (3) Internal Rate of Return (IRR)
***Most important alternative to NPV***
IRR: The discount rate that makes NPV=0
Widely used in practice, intuitively appealing
Based entirely on estimated cash flows (independent of interest rates)
70
What is the decision rule for (3) Internal Rate of Return (IRR)
71
What are the advantages and disadvantages of (3) IRR
Advantages:
Executives prefer it (intuitively appealing)
Considers TVM
Considers all cash flows
Provides indication of risk
If the IRR is high enough, may not need to estimate a required return
Disadvantages:
Can produce multiple answers
Cannot rank mutually exclusive projects
72
Will NPV & IRR always give the same decisions? If not, what are the exceptions?
73
Define (4) Payback Period
What does it measure?
How do you calculate it?
What is the decision making process?
Payback Period: "How long does it take to recover the initial cost of a project?"
Computation:
1. Estimate the cash flows
2. Subtract the future cash flows from the initial investment until initial investment is recovered
Decision Rule: Accept if the payback period is less than some preset limit
74
What are the advantages and disadvantages of (4) Payback Period?
Advantages:
Easy to understand
Adjusts for uncertainty of later cash flows
Biased towards liquidity
Disadvantages:
Ignores TVM
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects (such as research and development)
75
How do we calculate (5) Average Accounting Return (AAR)?
76
Describe "Non-Conventional Cash Flows" for IRR
Cash flows change sign more than once!
This gives you more than 1 IRR... so which one do you use?
77
Describe how the Descartes Rule of Signs relates to IRR of non-conventional cash flows
Whenever you solve for IRR, you are solving for the square root of an equation
Only 1 real root per sign change (the rest are imaginary)
78
Define Modified Internal Rate of Return (MIRR)
What are the 3 methods?
Controls for some problems with IRR
(1) Discounting Approach
(2) Reinvestment Approach
(3) Combination Approach
MIRR will be unique (different) number for each method
79
Describe the (1) Discounting Approach to MIRR
Discount future cash OUTFLOWS to present and add to CF0
80
Describe the (2) Reinvestment Approach to MIRR
Compound all CF's, except the first one, forward to the end
81
Describe the (3) Combination Approach to MIRR
Discount outflows to present; compound inflows to end
82
Compare MIRR vs. IRR
MIRR avoids the multiple IRR problem
Managers like rate of return comparisons, and MIRR is better for this than IRR
83
Describe the difference between Independent and Mutually Exclusive Projects
Independent: The cash flows of one project are unaffected by the acceptance of the other.
Mutually Exclusive: The acceptance of one project precludes accepting the other. (you can only have 1 project, not both)
84
How do you decide between Mutually Exclusive projects that have **EQUAL LIVES**?
With mutually exclusive projects that have equal lives, choosing the project with the *HIGHEST NPV* is always correct.
85
When there is a conflict between NPV and IRR, which measure should you use?
Whenever there is a conflict between NPV and another decision rule, *ALWAYS use NPV*
86
Describe Relevant Cash Flows
Include only cash flows that will occur only if the project is accepted (incremental cash flows)
87
Define the "Stand-Alone Principle"
Allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
88
Are these relevant Cash flows?
89
Define "Sunk Costs"
Costs which cannot be recovered regardless of whether the firm undertakes the project.
Examples: R&D expenses, consultant fees.
90
Define "opportunity cost"
An asset’s opportunity cost is the money that the firm can receive if the asset is put to the next best use. The ‘next best’ use may be to sell the asset.
91
Define "Side Effects/Erosion"
spillover effects (good or bad)
Example: introducing a new car model at the cost of existing car models.
92
Define "Net Working Capital"
Current Assets - Current Liabilities; Supplied at the beginning and recovered at the end
Example: cash on hand, initial investment in inventories
93
Define "Financing Costs"
Interests, principal repaid, dividends
94
Define Pro Forma Financial Statements
Projects Future Operations
95
What is "Operating Cash Flow" (OCF) equal to? (Tax Shield Approach)
96
What is "Cash Flow From Assets" (CFFA) equal to?
97
What does NCS stand for?
Net Capital Spending
98
How do you calculate depreciation using the tax-shield approach?
99
