Week 2 - What is Finance?

Question 1

What does Kd stand for?

Answer 1

Cost of debt

Question 1

What is WACC?

Answer 1

Weighted Average Cost of Capital is the average rate of return a company is expected to pay its investors for using their capital. It represents the company’s overall cost of capital, including both debt and equity,.

Question 2

What does Ke stand for?

Answer 2

Cost of Equity

Question 2

Define Cost of Equity?

Answer 2

Is the minimum return owners need to earn, to keep their equity invested in the business

Question 3

Define Rate of Return?

Answer 3

is defined as the percentage earned in the capital invested over a given period (typically per annum).

Question 4

What is a risk-free rate of return? Give examples?

Answer 4

Government debt is considered to be the only risk-free asset. Risk-free is represented by Rf. Examples are treasury bonds (long-term) or bills (short-term).

Question 5

What is the difference between Treasury Bonds and Treasury Bills?

Answer 5

Treasury Bonds are long term, while Treasury Bills are short term

Question 6

What is Premium in terms of finance?

Answer 6

is a rate of return above a benchmark from risk-free assets.

Question 7

What is Yielding?

Answer 7

is another word for paying interest.

Question 8

What is the inflation premium?

Answer 8

is the rate of return added to compensate for inflation. Higher inflation = higher inflation premium

Question 9

What is Default-risk premium?

Answer 9

is the rate of return added to compensate for default-risk (risk of a borrower defaulting, not making debt repayments). Higher default risk = high default-risk premium

Question 10

What is maturity-risk premium?

Answer 10

is the rate of return added to compensate for assets that have longer terms to maturity. The longer it takes to get your money back, the more risky it is. E.g. a loan of 30 years will have a higher maturity-risk than a loan of 1 year.

Question 11

What is the formula for Return?

Answer 11

Return = Rf + inflation premium + maturity risky premium + default risk premium.

Question 12

Define Financial Market?

Answer 12

is a general term that includes a number of different types of markets (e.g. money market, capital market) for the creation and exchange of financial assets, such as loans, bonds and shares.

Question 13

Define Financial Institutions?

Answer 13

are companies such as commercial banks, credit unions, insurance companies, superannuation funds and finance companies that provide financial services to the economy.

Question 14

Define Investment banks?

Answer 14

specialise in helping companies sell new debt or equity, although they also provide other services, such as the broker and dealer services discussed later. When investment bankers help companies bring new debt or equity securities to market, they perform two important tasks: origination and underwriting

Question 15

Define Origination in terms of finance?

Answer 15

is the process of preparing for a security issue for sale.

Question 16

Define Underwriting in terms of finance?

Answer 16

is the process by which the investment banker, the underwriter, guarantees that the company will raise the funds it expects from its new security issue.

Question 17

What’s the difference between Money Market and Capital Market?

Answer 17

Money market –> short term funds which are less than 12 months.

Capital market –> long term funds which are more than 12 months

Question 18

What is a primary market?

Answer 18

is any market where companies initially sell new security issues (debt or equity)

Question 19

What is a secondary market?

Answer 19

is any market where owners of securities (i.e. those who have already bought the securities) can sell them to other investors.

Question 20

What does IPOs stand for?

Answer 20

Initial Public Offerings

Question 21

Define Marketability in terms of finance?

Answer 21

is the ease with which a security can be sold and converted into cash.

Question 22

Define Liquidity in terms of finance?

Answer 22

is the ability to convert an asset into cash quickly without loss of value.

Question 23

Who are Brokers?

Answer 23

are market specialists who bring buyers and sellers together for a sale to take place.

Question 24

What are public markets?

Answer 24

are organised financial markets where members of the general public buy and sell securities through their stockbrokers.

Question 25

What are private placements?

Answer 25

are transactions in a private market.

Question 26

What are foreign exchange markets?

Answer 26

are where foreign currencies are bought and sold.

Question 27

What is Credit Risk?

Answer 27

is when a financial institution makes a loan or invests in a bond or other debt security. This is because it is accepting the possibility that the borrower will fail to make either interest or principal payments in the amount and at the time promised.

Question 28

What is interest rate risk?

Answer 28

is the risk of fluctuations in a security’s price or reinvestment income caused by changes in market interest rates.

Question 29

What is liquidity risk?

Answer 29

is the risk that a financial institution will be unable to generate sufficient cash inflow to meet required cash outflows.

Question 30

What is foreign exchange risk?

Answer 30

is the fluctuation in the earnings or value of a financial institution that arises from changes in exchange rates.

Question 31

What is Political Risk?

Answer 31

is the risk of fluctuation in the value of a financial institution resulting from the actions of Australian or foreign governments.

Question 32

What is Reputational Risk?

Answer 32

is defined as the potential for negative publicity regarding an institution’s business practices to cause a decline in the customer base, costly litigation or revenue reduction.

Question 33

Define Flow of funds?

Answer 33

is where capital is transferred from surplus units to deficit units.

Question 34

What are surplus units?

Answer 34

Units with excess capital available to provide

Question 35

Define Deficit units?

Answer 35

units with the need of capital for investment and consumption

Question 36

What's the difference in terms of the banking services between commercial and investment banks?

Answer 36

Commercial banks focus on providing banking services to individuals and businesses, while investment banks focus on corporate finance and advisory services. Some banks offer both services, they are known as universal banks,

Question 37

What are the 4 key benefits of financial intermediation?

Answer 37

1. Asset transformation 2. Credit risk transformation & diversification 3. Liquidity transformation 4. Economies of scale

Question 38

What is a public market?

Answer 38

is a central marketplace open to the public where buyers and sellers meet to trade.

Question 39

What is a private market?

Answer 39

buyers and sellers transact without open advertisement and inclusion of the public.

Question 40

Define Wholesale Market?

Answer 40

is direct and private market where large fund flow transactions occur between the government, institutional, and corporate surplus and deficit units.

Question 41

Define Retail Market?

Answer 41

is primarily an intermediary market where surplus and deficit units are individuals, households, and small businesses, and involves small transactions.