Chapter 3 - Finance Overview

Question 1

1. What is the primary role of the financial system?

Answer 1

The primary role of the financial system is to efficiently and optimally
allocate savings to investments.

Question 2

2. Who are some of the key players in the financial system?

Answer 2

Some of the key players in the financial system are savers such as individuals,
borrowers such as individuals, companies and governments,
and the financial institutions that are supposed to bring them together.

Question 3

3. What is the primary role of financial institutions?

Answer 3

The primary role of financial institutions is to efficiently match savers
and borrowers, specifically by providing information gathering and
distribution, risk sharing, and liquidity.

Question 4

4. What are some examples of institutional investors?

Answer 4

Some examples of institutional investors include pension funds, insurance
companies, and endowments.

Question 5

5. What are some examples of alternative investments?

Answer 5

Some examples of alternative investments include private equity, venture
capital, and hedge funds.

Question 6

6. Why is money today worth more than money tomorrow?

Answer 6

Money today is worth more than money tomorrow for at least three
reasons. First, there is risk associated with receiving and being able to
use the money the longer out in the future you go. Second, in an inflationary
environment, money has less purchasing power in the future.
Third, money today could be invested and earn some return.

Question 7

7. What is a discount rate?

Answer 7

A discount rate, also referred to as an investor’s opportunity cost of
capital, is the return required by investors to invest in a project of a
specified level of risk for a specified time period. The discount rate is
also the rate used to present value cash flows.

Question 8

8. Conceptually, how do you estimate a discount rate?

Answer 8

Conceptually, you can estimate a discount rate by taking the riskfree
rate for the appropriate time period and adding the expected inflation
rate and an appropriate risk premium for an investment at that
level of risk.

Question 9

9. What is the basic present value formula?

Answer 9

The basic present value formula is: Cash flow in a certain time period
divided by one plus the discount rate raised to the appropriate time
period.

Question 10

10. How do you value a perpetuity?

Answer 10

You can value a perpetuity by taking the perpetual cash flow and
dividing by the appropriate discount rate.

Question 11

11. How do you value a perpetuity with constant growth?

Answer 11

You can value a perpetuity with constant growth by taking the next
period’s cash flow and dividing by the discount rate less the constant
growth rate.

Question 12

12. How do you calculate the future value of an amount of money?

Answer 12

You can calculate the future value of an amount of money by taking
the present value and multiplying by one plus the discount rate raised
to the number or periods.

Question 13

13. How should companies decide whether or not to invest in a project?

Answer 13

In theory at least, companies should decide whether or not to invest
in a project if the project’s internal rate of return (IRR) is greater than
the project’s discount rate or hurdle rate, or if the net present value
(NPV) of the project is greater than zero.

Question 14

14. How do you calculate net present value?

Answer 14

You calculate net present value by summing each period’s cash flow
divided by one plus the discount rate raised to each time period.

Question 15

15. How do you calculate the internal rate of return?

Answer 15

You calculate the internal rate of return by solving for the discount
rate in an equation where zero equals the sum of each period’s cash flow
divided by one plus the discount rate raised to each time period.

Question 16

16. What kinds of things should companies include in cash flow when analyzing
    NPV or IRR?

Answer 16

When analyzing NPV or NRR, cash flow should include all of the
cash flows that directly relate to the project, including the initial investment
as well as ongoing costs and capital expenditures, working capital
requirements, and revenues and profits.

Question 17

17. What kinds of things should companies not include in cash flow when
    analyzing NPV or IRR?

Answer 17

When analyzing NPV or NRR, companies should not include sunk

costs or any allocation of expenses that would need to be spent regardless.

Question 18

18. Under what circumstances will the net present value equal zero?

Answer 18

Net present value will equal zero when a project’s IRR is exactly
equal to the discount rate used in the NPV formula.

Question 19

19. What is capital structure?

Answer 19

Capital structure reflects a company’s choice of funding, and specifically
its makeup of debt and equity.`

Question 20

20. Which is more expensive, debt or equity, and why?

Answer 20

Equity is more expensive because it is riskier than debt, has less certain
cash flows, is subordinate to debt in a bankruptcy or liquidation,
and because dividends, unlike interest, are not tax deductible.

Question 21

21. Why does adding more debt to the capital structure raise the cost of debt?

Answer 21

Adding more debt to a company’s capital structure raises the cost of
debt because it raises the risk of distress and bankruptcy, which results
in a significant loss of value, and therefore makes all of the company’s
debt riskier.

Question 22

22. Why does adding more debt to the capital structure raise the cost of
    equity?

Answer 22

Adding more debt to a company’s capital structure raises the cost of
equity because debt raises the risk of distress and bankruptcy, which results
in a significant loss of value to the company and usually a complete
loss of value to equity holders. Moreover, more debt requires higher
levels of interest, which reduces the flexibility of management.

Question 23

23. Why is the cost of capital U‐shaped?

Answer 23

The cost of capital is U‐shaped because debt is less expensive than
equity but also because adding debt raises the cost of both debt and
equity due to bankruptcy costs, agency costs, and the potential loss of
tax deductions if interest expense exceeds operating income.

Question 24

24. What are some advantages and disadvantages to issuing debt?

Answer 24

Some advantages to issuing debt include a lower cost of capital than
equity, given it is less risky to investors and because interest is tax deductible.
Some disadvantages to issuing debt include an increased risk
of financial distress or bankruptcy; mandatory payment of interest
expense, which reduces the flexibility of management; and covenants,
which may restrict the company’s ability to issue more debt and penalize
the company if it does not maintain certain operating performance
and/or leverage.

Question 25

25. What are some advantages and disadvantages to issuing stock?

Answer 25

Some advantages to issuing stock include no mandatory dividend payments, the least risk‐adverse investor class, and currency that can be used for acquisitions. Some disadvantages to issuing stock include the highest cost of capital of any type of funds, the highest transaction costs to raise the funds, and vulnerability from activist investors.

Question 26

26. What is the difference between secured debt and unsecured debt?

Answer 26

Secured debt is debt that is secured or collateralized by specific assets. Unsecured debt is not secured by specific assets.

Question 27

27. What has a higher cost: secured debt or unsecured debt? Why?

Answer 27

Unsecured debt has a higher cost of capital because the debt is not collateralized by specific assets.

Question 28

28. What is preferred stock?

Answer 28

Preferred stock, while technically a form of equity, is a hybrid security that has features of both debt and equity. It is a mandatory dividend obligation, like interest, though the dividend can be deferred. It has a cost of capital in between that of debt and common stock.

Question 29

29. What are some different ways in which a company can return money to investors?

Answer 29

A company can return money to investors by paying back or retiring its debt, by issuing dividends to stockholders, and by buying back its stock.

Question 30

30. What are the pros and cons of dividends versus stock buybacks?

Answer 30

Some investors, such as widows and orphans and non‐taxable investors, prefer dividends, while taxable investors and investors who do not need income generally prefer stock buybacks. Moreover, most of the time, capital gains tax rates are lower than taxes paid on dividend payments. Also, companies generally have more flexibility with stock buybacks than they do with dividends since cutting dividends sends a negative signal to the market.

Question 31

31. How do you value a bond?

Answer 31

You can value a bond by computing a bond’s net present value by summing each period’s cash flow (coupon payments and principle payment) divided by one plus the appropriate market interest rate raised to the cash flow’s time period.

Question 32

32. What is yield to maturity, and how do you calculate it?

Answer 32

Yield to maturity represents an investor’s average return earned on a bond that is held to maturity. You can calculate yield to maturity by using the IRR formula. Specifically, set the bond’s price equal to the sum of each period’s cash flow (coupons and principle payment) divided by one plus the YTM to appropriate time period and solve for the YTM.

Question 33

33. What is yield to call, and how do you calculate it?

Answer 33

Yield to call represents an investor’s average return earned on a bond that is called at the first possible call date. You can calculate yield to call the same way as yield to maturity, except substitute the call price for the par value and use the first call date instead of the maturity date.

Question 34

34. What is yield to worst, and how do you calculate it?

Answer 34

Yield to worst represents an investor’s lowest possible average return earned on a bond that is either called or held until maturity. If there is only one call date, the yield to worst is calculated as the lesser of the yield to call and the yield to maturity. If there are multiple call dates, it is calculated as the lesser of the lowest yield to call rate (given each call date) and the yield to maturity.

Question 35

35. What is a bond’s current yield, and how do you calculate it?

Answer 35

A bond’s current yield reflects the bond’s annual coupon divided by the bond price.

Question 36

36. If interest rates rise, what will happen to the price of a bond?

Answer 36

If interest rates rise, the price of a bond will fall.

Question 37

37. What is duration and why is it important?

Answer 37

Duration reflects the average maturity of a bond or, equivalently, the average amount of time to each cash flow (the coupon payments and the principal payment). Duration is important because it helps measure a bond’s sensitivity to interest rate changes and helps institutional investors match their investment income with their expected liabilities.

Question 38

38. What are the key assumptions of the Black‐Scholes formula for pricing options?

Answer 38

The key assumptions of the Black‐Scholes formula used for pricing options are the risk free interest rate, the underlying stock price, the exercise price, the stock’s expected volatility, and the time until maturity.

Question 39

39. What are the differences between an option and a warrant?

Answer 39

An option does not result in new shares being issued and therefore does not cause dilution to existing shareholders, whereas warrants are issued by the company and result in new shares being issued.

Question 40

40. How would a change in the level of the risk‐free interest rate affect the value of a call? A put?

Answer 40

An increase in the level of the risk‐free interest rate will raise the value of a call and lower the value of a put.

Question 41

41. How would a change in the underlying stock price affect the value of a call? A put?

Answer 41

An increase in the stock’s underlying price will raise the value of a call and lower the value of a put.

Question 42

42. How would a change in the exercise price affect the value of a call? A put?

Answer 42

An increase in the exercise price will lower the value of a call and raise the value of a put.

Question 43

43. How would a change in a stock’s expected volatility affect the value of a call? A put?

Answer 43

An increase in the stock’s expected volatility will raise the value of a call and raise the value of a put.

Question 44

44. How would a change in the time until expiration affect the value of a call? A put?

Answer 44

An increase in the time until expiration will raise the value of a call and raise the value of a put.