Finance 341

What is the fundamental goal of a business? Create value for the company’s shareholders or “maximize shareholder wealth”
What are the 5 principles that form the Foundation of Finance? 1) Cash flow is what really matters2) Money has a time value3) Risk requires a Reward4) Market prices are generally right5) Conflicts of interest cause agency problems
What are cash flows? Money that can be spent.Usually determines the value of a business.
What is incremental cash flow? The difference between the cash flows a company will produce both with and without the investment it is thinking about making.
What is opportunity cost? the cost of making a choice in terms of the next best alternative that must be foregone.
Which 2 requirements do investors feel need to be satisfied when investing in a company? 1) A return for delaying consumption2) An additional return for taking on risk
What is an efficient market? a market in which the prices of the assets traded in that market fully reflect all available information at any instant time.
What is an agency problem? Problems and conflicts resulting from the separation of the management and ownership of the firm.
What is securitization? Why is it useful? 1) The process of packaging mortgages2) for increasing the supply of new money that can be lent to new homeowners.
What are the 3 basic types of issues in finance and what do they mean? 1) Capital Budgeting: the decision making process with respect to investments in fixed assets.2) Capital Structure Decision: the decision making process with funding choices and the mix of long term sources of funds.3) Working Capital Management: management of the firm’s current assets and short term financing.
What are financial markets? institutions and procedures that facilitate financial transactions.
What is sole proprietorship? an business owned by a single individual
What is a partnership? What are the 2 kinds of partnerships? 1) an association of 2 or more individuals joining together as co-owners to operate a business for profit1) General and Limited Partnership
What is the difference between a general and limited partnership? 1) General: each partner is fully responsible for the liabilities incurred by the partnership2) Limited: one or more partners has limited liability, restricted to the amount of capital he or she invests in the partnership.
What are the conditions that qualify one to be a limited partner? 1) one general partner must have unlimited liability2) the names of limited partners may not appear in the name if the firm3) limited partners may not participate in the management of a business.
What is the definition of a corporation? an entity that legally functions separate and apart from its owners.
What is an S-corporation? a corporation that, because of specific qualifications, is taxed as though it was a partnership.
What is a Limited Liability Company? (LLC) A cross between a partnership and corporation under which the owners retain limited liability but the company is run and taxed like a partnership.
What does maximizing shareholder wealth mean? It means to maximize the market value of the firm’s common stock.
What are some advantages of having a corporation? 1) Transferability of ownership2) Ability of the corporation to raise capital
What are some disadvantages to a Partnership? 1) lack of permanence2) unlimited liability
Why is it hard to find extremely profitable projects? 1) To find high profit projects, the product or service must be differentiated and/or have a cost advantage over the competition.2) To find high profit projects, you must locate imperfections in the market that are not currently being taken advantage of.3) If an industry is generating large profits, then new entrants are attracted, driving down profits.
What are some benefits of organizes security exchanges? 1) They provide a continuous market.2) Establish and publicize fair security prices.3) They help businesses raise new financial capital
What is meant by the “NASDAQ system”? 1) National Association of Security Dealers Automates Quotation System2) it is a telecommunications system that provides a national information link among the brokers and dealers operating in the over the counter markets.3) The final trade is still consumated by direct negotiation between traders.
What are 3 major functions of that an investment banker performs? 1) Advising2) Distributing3) Underwriting
What is underwriting? the purchase and subsequent resale of a new security issue. the risk of selling the new issue at a satisfactory (profitable) price is assumed (underwritten) by the investment banker.Assuming a risk
What is the underwriter’s spread? The difference between the price the corporation raising money gets and the public offering price of a security.
What is an investment banker? A financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds.
What are the 2 major categories of flotation costs? 1) Underwriter’s spread (Larger of the two)2) Issuing Costs
What are flotations costs the highest on? Common Stock
What is the maturity-risk premium? the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes
What is the liquidity risk premium? the additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price.
What are two major reasons why underdeveloped countries remain underdeveloped? 1) They lack effective financial market systems.2) They lack political stability.
What are Capital Markets? All financial institutions that help businesses raise long term capital
What are 3 ways to Transfer Capital into the Economy? 1) Direct Transfer of Funds2) Indirect Transfer using the investment banker3) Indirect Transfer using the financial intermediary
What happens in a direct transfer of funds? The firm seeking cash sells its securities directly to savers (investors) who are willing to purchase them in hopes of earning a large return.
What is an angel investor? a wealthy private investor who provides capital for a business start-up.
What is a venture capitalist? An investment firm (or individual investor) who provides money to business start-ups.
What happens in an Indirect Transfer using the investment banker? Investment bankers work with other investment bankers to increase capital, the syndicate will buy the entire issue of security from the firm in need of capital and then sell them to investors at a higher cost than they bought them.
What happens in an Indirect Transfer using the financial intermediary? 1) This is the type of system insurance companies, mutual finds, and pension funds operate within.2) The financial intermediary collects the savings of individuals and issues its own (indirect) securities in exchange for these savings. The intermediary then uses the funds collected from the individual savers to acquire the business firm’s (direct) securities, such as stocks and bonds.
What is the difference between public offering and private placement? 1) Public offering: a security offering where all investors have an opportunity to acquire a portion of the financial claims being sold. An impersonal market.2) Private Placement: a security offering limited to a small number of potential investors. More personal
What are two ways a corporation can obtain external capital? A public offering or private placement
What is a primary market? A market in which securities are offered for the first time for sale to potential investors.
Why are venture firms unappealing to the broader public markets? 1) small absolute size2) very limited or no historical track record of operating results3) Obscure growth prospects4) inability to sell stock easily or quickly
What is an initial public offering? (IPO) the first time a company issues stock the public
What is a seasoned equity offering? (SEO) the sale of additional stock by a company whose shares are already publicly traded.
What is a secondary market? a market in which currently outstanding securities are traded.
What is a money market? all institutions and procedures that facilitate transactions for short term issued by borrowers with very high credit ratings.Short term: 1 year or less maturity
Who regulates the primary and secondary markets? the Security and Exchange Commission (SEC)
What are spot markets? Cash Markets (where something sells today, right now, on the spot)
What are Futures Markets? Markets where you can buy or sell something at a future date.
What are organized security changes? Formal organizations that facilitate the trading of securites
What are over the counter markets? all security markets except organized exchanges.ex:) Money Market, Corporate Bonds
What is the oldest organized exchange? The New York Stock Exchange (NYSE) also called the “Big Board”
What is a syndicate? A group of investment bankers who contractually assist in the buying and selling of a new security issue.
What is a privileged subscription? Which 3 markets are involved? 1) The process of marketing a new security issue to a select group of investors.2) Current stockholder (most prevalent) , Employees, and customers of the firm
What is a Dutch Auction? A method of issuing securities (common stock) by which investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares.
What is a Direct Sale? the sale of securities by a corporation to the investing public without the services of an investment banking firm
What are the 3 most important investing groups? (Regarding private placements) 1) Life Insurance Companies2) State and Local Retirement Funds3) Private Pension Funds
What are 2 things firms can do while arranging private placements? 1) avoid the use of an investment banker and work directly with the investing institutions2) engage the services of an investment banker
What are the advantages to private placement? Disadvantage? 1) Speed, Reduced Cost, Financially Flexibility2) Interest Costs, Restrictive Covenants, the possibility of future SEC registration
What are flotation costs? the transaction cost incurred when a firm raises funds by issuing a particular type of security.
What is the difference between Underwriter spread and Issuing Cost? 1) US: the difference between the gross and net proceeds from a given security issue expressed as percent of the gross proceeds.2) IC: Printing and engraving of security certificates, legal fees, accounting fees, trustee fees, several other miscellaneous components
When was the Sarbanes Oxley Act passed? (SOX) 2002
What is the real risk free interest rate? the required rate of return on a fixed income security that has no risk in an economic environment of zero inflation.
What is the term structure of interest rates?What is yield to maturity? 1) the relationship between the interest rates and the term to maturity, where the risk of default is held constant.2) the rate of return a bondholder will receive if a bond is held to maturity.
What are the three basic financial statements? 1) the income statement2) the balance sheet3) the statement of cash flows
What are the purposes of financial analysis? 1) Restating accounting data in relative terms so that comparisons can be made with firms of different sizes and with the same firm over time.2) To identify some of the financial strength and weaknesses of a company
In which scenarios might financial ratios be used? 1) Major suppliers to decide whether or not to grant terms to a company2) Credit Rating agencies to determine the firm’s creditworthiness3) Firm managers to evaluate a firm’s performance4) Investors or decide whether or not to invest in a company5) Lenders to decide whether or not to make a loan to the company
Which differences in the accounting practices of firms limit the usefulness of financial ratios? 1) Different methods to depreciate their fixed assets.2) Different methods to allocate their inventory.
Why should you be careful when comparing a firm with industry norms? 1) sometimes it is difficult to identify the industry to which your firm belongs, so you must select you peers and construct your own norm.2) Accounting practices differ widely among firms. These differences can make the computes ratios of different firms difficult to compare3) an industry average is not necessarily a desirable target ratio or norm, you may want to be in the top 10%4) many firms experience seasonal changes in their operations5) Publishes peer or group industry averages are only approximations
How do you calculate the default risk premium in bonds? 1) Nominal Interest rate = real risk free interest rate +inflation premium +default risk premium + maturity risk premium + liquidity risk premium2) For treasury bonds, drp and lrp are 0.3) Corporate bond yieldings – treasury bond yield – liquidity risk premium
How do you calculate the (inferred) real rate of interest? nominal rate of interest – inflation rate
How do you calculate the nominal rate of interest? real rate of interest + inflation rate +product of the real rate of interest and inflation rate
How do you calculate maturity risk premium? How do you calculate the nominal risk free interest rate? 1) Treasury note yield – nominal risk free interest rate2) real risk free interest rate + inflation rate
How do you calculate tax liability? 1) Compute taxable income (operating income – depreciation expense – interest expense)2) Operating income= sales – cost of goods sold – operating expenses
how do you calculate savings? initial investment x (1 + amount security pays) ^ end of wanted year
How do you calculate the required interest rate? additional saving/savings in 1 year security (note that this is problem specific)
What are 2 ways financial ratios make meaningful comparisons of a firm’s financial data? 1) We can examine ratios across time to compare the firm’s past and present performance2) We can compare firm’s ratios with that of other firms
How do managers use financial ratios? 1) Identify deficiencies in the firm’s performance and take corrective actions2) Evaluate employee performance and determine incentive compensation.3) Compare financial performance in the firm’s different divisions.4) Prepare financial projections5) Understand competitor’s financial performance6) Evaluate financial condition of major supplier
How are financial ratios used outside of the company? 1) lenders decide whether or not to make a loan to the company2) credit ranging agencies determine firm’s credit worthiness3) Investors decide whether or not to invest in company4) Major suppliers decide whether or not to grant credit terms to company
What 2 things are analyzed when discussing the liquidity of a firm? 1) the amount of current assets relative to current liabilities (Current Ratio)2) the quality of the individual current assets that will be used in meeting current debt payments
What are limitations of financial ratio analysis? 1) It is sometimes difficult to determine which industry a firm belongs to when they engage in multiple line of business2) Published peer group or industry averages are only approximations3) An industry average is not necessarily a desirable target ratio or norm.4) Accounting practices differ widely among firms making it difficult to compare5) Financial Ratios can be too high or too low 6) Many firms experience seasonal changes in operations as a result balance sheets and ratios may vary with time of year

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