Finance Chapter 1 & 2

Management’s Goal in an Organization To maximize shareholder wealth, which means maximizing the value of the stock.
Maximize the Value of a Stock Maximize the true, long-run value
Finance the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.
Areas of Finance Financial management, capital markets, investments
Financial management aka corporate finance. Focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value.
Capital markets relate to the markets where interest rates, along with stock and bond prices are determined.
Investments relate to decisions concerning stocks and bonds and include a number of activities: security analysis, portfolio theory and market analysis.
Finance within the organization Board of DirectorsCEOCOO & CFO
Forms of Business Organizations Proprietorship, Partnership, Corporation and LLC & LLP
Proprietorship Unincorporated business owned by one individual.Advantages:-Easy and inexpensive to form-subject to few government regulations-subject to lower income taxes than corporations Limitations:-unlimited personal liability for the business’ debts-can lose more money than they invested -life of the business is limited to the life of the owner-Have difficulty obtaining large sums of capitalBusiness are often started as proprietorships and then converted to corporations when their growth results in the disadvantages outweighing the advantages.Often set up through LLPs and LLCs.
Partnership A legal arrangement between two or more people who decide to do business together.Advantages:-can be established relatively easily and inexpensively-firm’s income is allocated on a pro rata basis to the partners-taxed on an individual basis-avoids corporate income taxLimitations:-partners are subject to unlimited personal liability-partners are responsible for making up for loss of partner’s contribution (if the partner goes bankrupt)-unlimited liability makes it difficult for partnerships to raise large amounts of capital.Often set up through LLPs and LLCs.
Corporation A legal entity created by a state. It is separate and distinct from its owners and managers.Advantages:-seperation that limits stockholders’ losses to the amount they invested in the firm.-unlimited lives.-easier to transfer shares of stock than in an unincorporated business-easier for corporation to raise the capital necessary to operate large businesses.Drawbacks:-Double taxation (corporate & dividends)Corporations are generally referred to as C Corporations
S Corporation Corporation taxed as a proprietorship or partnership (exempt from corporate income tax). Can have no more than 100 shareholders.
S Corporation to C Corporation Once a company decides to sell stocks, they grow into a C Corporation because they exceed 100 shareholders.
Liquidity The ease at which assets can be turned into cash at their fair values
LLCs and LLPs -Provide limited liability protection.-Taxed as partnerships.-Investors have votes in proportion to their ownership -interest.-Growing in popularity recently but people still like C corporations because of the ability to grow.-Idea established by lawyers, so important to have a good lawyer when establishing one.
LLC Limited Liability Company-Hybrid between a partnership and a corporation.-Used by other businesses.
LLP Limited Liability Partnership-Similar to an LLC but used for professional firms in the fields of accounting, law and architecture.
Equilibrium Stock price should equal its “true” or intrinsic value
Intrinsic Value Present Value (PV) of future expected cash flows.A long-run concept.
Manager duty with intrinsic value Managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run
Deviation from Intrinsic Value To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value.
Stock’s Intrinsic Value vs. Market Price Intrinsic Value = “true”Market Price = “Perceived”
Stockholder-Manager Conflicts Managers are naturally inclined to act in their own best interest, which are not always the same as the interest of stockholders
Marginal Investor not all investors agree, so it is the “marginal” investor who determines the actual price
Corporate Raiders See an undervalued stock as a bargain and will attempt to capture the firm
Hostile takeover What happens when people see an undervalued stock as a bargain and attempt to capture the firm
Transfer of capital between savers and borrowers Direct transfers, investment banks, financial intermediaries
Direct Transfers Entity trying to obtain funds goes directly to investors
Financial Intermediaries Commercial Banks
Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it.
Suppliers of Capital Individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment
Demanders or users of Capital individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.
Market A venue where goods and services are exchanged
Types of Financial Markets Physical Assets vs. Financial AssetsSpot vs. FuturesMoney vs. CapitalPrimary vs. SecondaryPublic vs. Private
Physical Assets vs. Financial Assets Physical: for products such as wheat, autos, real estate, computers and machinery.Financial: for stocks, bonds, notes and mortgages. Deal with derivative securities (values are derived from changes in the prices of other assets).A share of Ford stock is a “pure financial asset.”An option to buy Ford shares is a derivative security whose value depends on the price of Ford stock.
Spot Markets vs. Futures Markets Spot: assets are bought or sold for “on the spot” delivery (within a few days)Futures: participants agree today to buy or sell an asset at some future date.
Hedge Reduce
Money markets vs. Capital markets Money: for short-term (less than 1 year) highly liquid debt securities. (New York, London and Tokyo money markets)Capital: for intermediate (1-10 years) or long-term (more than 10 years) debt and corporate stocks (New York stock exchange)
Primary markets vs. secondary markets Primary: markets in which corporations raise new capital. Corporation is involved.Secondary: markets in which existing, already outstanding securities are traded among investors. Corporation is not involved.
Private markets vs. Public markets Private: transactions are negotiated directly between two parties. (Bank loans and private debt placements)Public: standardized contracts are traded on organized exchanges. (Common stock or corporate bonds) Held by a large number of individuals.
IPO Initial public offeringPrimary market transaction
SEO Seasoned equity offering
Stock market efficiency Securities are normally in equilibrium and are “fairly priced”Investors cannot “beat the market” except through good luck or better information.
Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.promote economic growth.perform better than economies with poorly-functioning markets.
derivative security’s value “derived” from the price of another security
Derivatives can Increase risk
Behavioral finance borrows insights from psychology to better understand how irrational behavior can be sustained over time.
Time Value of Money Formula PV x (1 + R)^n = FV
Rule of 72 When doubling an amount, take 72 and divide it by the interest rate, and it will give you the number of years it takes.
According to finance theory, a business firm should attempt to ______ the long-term price of the firm’s ______ . The benefit to this objective is that is provides the best financial outcome for the firm’s shareholders. MaximizeCommon Stock
Two years have passed since Austin purchased his 275 common shares in the Continental Construction Company. The current price of a common share is $16.74 per share. Austin’s wealth has _____. Decreased
Different forms of businesses have different characteristics. Which of the following characteristics belong to a corporation? Easier to transfer ownership in the form of stock.NOTEnds when the owner dies.Limited to 100 owners.
Paradigm media is a company run by a group of new media professionals. The owners of the company do not have any personal liability and file taxes only on their individual tax returns. This is an example of a: LLP/LLC
Roen, the CEO of a juice beverage company, is required to file the company’s quarterly and annual employment, financial and tax reports with the state and federal authorities. This is an example of a Corporation
The intrinsic value of a company’s stock, also known as its ________, refers to the stock’s true value based on expected future cash flows and the risks involved. The value perceived by stock market investors determines the market price of a stock. Fundamental Value
A stock trading at a price below its intrinsic value is considered to be _____ . A stock trading at a price above its intrinsic value is considered to be _____. UndervaluedOvervalued
In a state of market equilibrium, the intrinsic value of the stock will be _____ the market price of the stock. equal to
In an attempt to minimize agency problems in a company, attractive compensation packages are created to retain and encourage managers. In the best interest of shareholders, compensation packages should be structured in a way such that managers have an incentive to maximize the _____ value of the company’s stock price. Long-run
Vision Tech is a software company based out of San Francisco. Its stockholders are mostly individual investors and there is relatively little institutional ownership. If several pension and mutual funds were to take large positions in Vision Tech’s stock, would direct shareholder intervention be more or less likely to motivate the firm’s management? More likely
Vision Tech’s stock price is currently trading at $22 per share. The consensus among analysts is that the intrinsic value of Vision Tech’s stock is $30 per share. Is Vision Tech more or less likely to receive a hostile takeover bid? More likely
A student sells his old computer at a computer hardware store and gets $150 for it. He uses this cash to buy computer accessories. What kind of market is this? Physical Asset Markets
An oil trader buys contracts at the New York Mercantile Exchange, and he locks in the current futures price of heating oil for delivery in the winter season. What market is this in? Futures market
Sheila saves $10,000 and buys a certificate of deposit (CD) that will mature in six months. What kind of market is this? Money markets
An investor holding 3,000 shares of stock of Strata Copr. sells them to another investor. What kind of market is this? Secondary Markets
A bank purchased a credit default swap from another financial institution to protect itself against the default of one of its borrowers. In this example, the bank is _____ . Hedging
These financial conglomerates provide a range of services, such as investment banking, commercial banking and financial advising. Financial Services Corporations
They are owned by members so that members can share funds among themselves. Members who save deposit the funds. These funds are then loans to members who need the funds. Credit Unions
with the use of advanced investment technique, these largely unregulated portfolios are invested in securities. The investment objective is to offset potential losses by investing in counterbalancing securities. They are open to only a select class of investors. Hedge funds
Which of the following characteristics accurately describes the stock market? An active market that determines the price of a firm’s shares.
The difference between the price at which a dealer will sell a certain security and the price at which a dealer will buy a security is called the _____ . bid-ask spread
Water and Power Co.’s stock finished trading at a price of $42.01 for the day. The market price had varied from $41.93 to $42.10 throughout the day as buy and sell orders came in. It would be reasonable to consider the price of $42.01 per share as the firm’s _____ for the day. equilibrium price
Michelle is a top analyst for a prestigious investment bank. She just received a large bonus from her company, and she is looking to invest this money in the stock market. Michelle has identified four stocks that she thinks are undervalued, so she is going to invest her entire bonus in those four stocks. Michelle believes that there is at least some inefficiency in the stock market.
The process for converting present values into future values is called _____ . This process requires knowledge of the values of three of four time-value-of-money variables. Which of the following is not one of these variables? The trend between the present and future values of an investment.
Investments and loans base their interest calculations on one of two possible methods: the _____ interest and the _____ interest methods. SimpleCompound
Compound Interest formula FV = PV x (1 + R)^N
Simple interest formula FV = PV + (PV x R x N)
After the end of the second year and all other factors remaining equal, a future value based on compound interest will exceed a future value based on simple interest. T/F True
All other factors being equal, both the simple interest and the compound interest methods will not generate the amount of earned interest by the end of the first year. T/F False
The process of earning compound interest allows a depositor or investor to earn interest on any interest earned in prior periods. T/F True
_____ is the process of finding the present value of a cash flow or a series of cash flows to be received in the future. Discounting
Other things remaining equal, the present value of a future cash flow increases if the investment time period increases. T/F False
Other things remaining equal, the present value of a future cash flow decreases if the investment time period increases. T/F True
Annuities Characteristics When equal payments are made at the beginning of each period for a certain time period they are treated as an annuity due.An ordinary annuity of equal time earns less interest than an annuity due.Annuities are structured to provide fixed payments for a fixed period of time.
A retirement fund set up to pay a series of regular payments is an ___ Annuity
Shania bought a new dress for her brother’s wedding for $450. She negotiated a deal with the retailer in which she would pay for the dress in three installments of $250, $100, and $100 over the next three months. Uneven Cash Flow or Annuity Payment? Uneven Cash Flows
You signed up to make a monthly payment of $10 for one year for a lifetime subscription to your favorite magazine. Uneven Cash Flow or Annuity Payment? Annuity Payments
British console are British government bonds that promise to make payments of a specified amount at regular intervals to the bearer forever. Uneven Cash Flow or Annuity Payment? Annuity Payments
You receive interest earnings from variable deposits in a regular interest-bearing savings account. Uneven Cash Flow or Annuity Payment? Uneven Cash Flows
Perpetuity characteristics Continues for a fixed time period.The principal amount of a perpetuity is repaid as a lump-sum amount.
Mortgages are examples of amortized loans T/F True
The ending balance of an amortized loan contract will be zero. T/F True
Mortgages always have a fixed nominal interest rate. T/F False
The payment allocated toward principal in an amortized loan is the residual balance – that is, the difference between total payment and the interest due. T/F True
Which groups participate in financial (capital) markets? Financial institutions, households, government, businesses
Sale of stocks and bonds by business to savers without going through a financial institution are referred to as ______ . Direct Transfers
Financial assets can be characterized as claims to future risky cash flows. T/F True
Preferred stock is _____ instrument. Equity
Which class of financial assets has earned the highest average return over 1925-2004? Micro-cap stocks
Which is very short term, highly liquid fixed income securities? Certificates of Deposit
Which financial instrument most typically comes with voting rights? Common Stock
Which of the following instruments has the right to buy financial assets at a future date at the price fixed today? Options
What was the approximate size of all U.S. mutual fund assets as of 2012? $13 Trillion
Domestic equity index funds are always more popular with the investment public than bond and hybrid funds. T/F False
______ are most likely to take high-risk derivative positions, compared to mutual funds. Hedge funds
What can be different between a corporation and a partnership? Taxation, Dividend payout policy, liability, voting rights
The popularity of corporations in the U.S. has been declining recently, compared to that of partnerships. T/F True
The “too big to fail” problem is most generally characterized as _____ . Moral Hazard
Conflict between shareholders and managers can be mitigated through ……. Contractual incentives in executive compensation, CEO turnover mechanism, takeover mechanism, monitoring
One of the major factors that led to the onset of the financial crisis of 2008 was the general underestimation of mortgage default risk. T/F True
Under the Dodd-Frank regulation, the Financial Stability Oversight Council addresses which of the following issues? Systemic risk (financial institutions growing to become “too big to fail”)

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