Final Exam Flashcards by Bennie Williamson

Three major forms of business in the United States:

Sole Proprietorship
Partnership
Corporation

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Sole Proprietorship Advantages (4):

Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income

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Sole Proprietorship Disadvantages (4):

Limited to life of the owner
Unlimited liability
Equity capital limited to owner’s personal wealth
Difficult to sell ownership interest

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What is the goal of financial management?

The goal of financial management is to maximize the current market value of the existing stock

Maximize the value of the owner’s equity/stake of the company

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Money that is leaving the company because of an agency problem

Direct Agency Cost

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Money that should’ve been coming in to the company but did not

Indirect Agency Cost

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What is a way to alleviate an agency problem?

Pay sales people on commission

- Issue stock

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Features of Common Stock (4):

-Voting Rights
-Proxy Voting
-Classes of stock
-Other Rights
Share proportionally in dividends paid
Share proportionally in remaining assets after liquidation
The right to vote on stockholder matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting
Preemptive right - first shot at new stock issue to maintain proportional ownership if desired

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A contract between a borrower and investor

Bond

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Interest payments made by the company are _____

Tax deductible

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T/F

Bond holders have part ownership in the company

False

They are just lenders and not owners

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T/F

Bonds can be traded between investors the same way as stocks

True

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Lowest rating to be an investment grade bond

BBB-

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Highest rating to be a noninvestment grade bond

BB+

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Future value interest factor

(1+r)^t

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T/F

The longer the time period, the higher the present value

False

The longer the time period, the lower the present value

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PV formula

FV/(1+r)^t

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For interest rates

If you are looking at annual periods, you need a ___ rate

If you are looking at monthly periods, you need ___ rate

annual

monthly

ALWAYS make sure they match

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Debt security, usually an interest-only loan

Bond

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Face value (par value) of a bond

Typically $1,000

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Stated interest payment made on the bond

Coupon Payment (PMT)

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State in the indenture (contract). Equals ( Annual Coupon Payments / Face Value of the bond )

Coupon Rate

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Coupon Payment calculation

(Coupon Rate)*(Face Value)/(# of payments per year)

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Specified date on which the principal amount of the bond will be repaid

Maturity

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the rate of total return (return based on purchase-vs-par value of the bond, plus coupon [interest payments] received) that a purchaser of a bond will receive if he/she holds the bond until maturity

Yield to Maturity (YTM)

T/F If a bond sells at face value, its YTM is equal to its coupon rate

True

What relationship does bond prices/values and interest rates have?

Inverse relationship They always move in opposite directions

As bond prices rise, the YTM ____

decreases/falls

o The following factors typically affect the risk-level, and therefore the required rate of return (and YTM), of bonds (5):

```  Bond Rating  Seniority  Financial health of the issuer (this should be reflected in the bond rating)  Callable vs Non-Callable  Secured vs Unsecured ```

___ = pay less

Callable

___ = price will fall, yield will rise

Unfavorable

If the NPV is positive ____ the project

NPV is a direct measure of how well this project will

meet our goal

IRR is the return that makes the NPV =

IRR Decision Rule: Accept the project if the IRR is...

greater than the required return

Two exceptions to NPV and IRR giving the same decision:

- Nonconventional cash flows | - Mutually exclusive projects

Common Types of Cash Flows:

o Sunk costs – costs that have occurred in the past o Opportunity costs – costs of lost options o Side effects o Positive side effects – benefits to other projects o Negative side effects – costs to other projects o Changes in net working capital o Financing costs o Taxes

Sunk costs are always ____ in cash flows, as well as anything in the past

Excluded

Opportunity costs are ___ in cash flows

included

Depreciation itself is a ________

Non-cash expense

T/F Depreciation does not affect taxes

False Depreciation affects taxes.

If the salvage value is different from the book value of the asset, then there is a ___

tax effect

Book value =

Initial cost - accumulated depreciation

After-tax salvage =

salvage - (salvage - book value)

When is the only time bottom-up approach works?

Only when there is no interest expense

How do you find Bottom-Up Approach

Start with the bottom line (NI) and add back non-cash deductions OCF = NI + Depreciation

Top-Down Approach

OCF = Sales - Cash Expenses - Taxes

We can examine returns in the financial markets to help us determine the ______

appropriate returns on non-financial assets

Lessons from the capital market history (3):

- There is a reward for bearing risk - The greater the potential reward, the greater the risk - This is called the risk-return trade-off

Stocks or bonds Higher risk?

Stocks Also means higher returns

Small or large cap Higher return?

Small cap

Government or corporate Riskier?

Corporate

Highest return

Small cap stock

Lowest return

Government bonds

Risk Premium =

Average return, risk free rate

Return earned in an average period over multiple periods

Arithmetic average

Average compound return per period over multiple periods

Geometric average

The ___ average will be less than the ___ average unless all the returns are equal

Geometric Arithmetic

Implications of Market Efficiency (4):

1. Stock prices respond very rapidly to new information 2. Future prices are very difficult to predict based on publicly available information (financial statements, disclosures, etc.) 3. It is very difficult for the average investor to identify and exploit mispriced stocks. 4. Financial managers cannot time stock and bond sales.

Expected returns are based on the ...

Probabilities of possible outcomes

In expected returns context, "expected" means ___

average

The "excepted return does not even have to be a ...

possible return

___ returns are generally not equal to ___ returns

Realized Expected

At any point in time, the unexpected return can be _____ Over time, the average of the unexpected component is ___

Positive or negative Zero

Announcements and news contain both ___ and ___ components

Expected Surprise

Price of the stock is driven by ...

unexpected component

Total return =

Expected return + unexpected returns

Unexpected returns =

Systematic portion + unsystematic portion

Risk factors that affect a large number of assets

Systematic Risk

Systematic risk is also known as __ or __ risk

non-diversifiable or market

Systematic risk includes such things as changes in ... (3)

GDP, inflation, interest rates

T/F Systematic risk only affects select stocks

False Systematic risk affects most stocks in the market

Risk factors that affect a limited number of assets

Unsystematic Risk

Unsystematic risk is also known as __ and __ risk

unique and asset-specific

Unsystematic risk includes such things as .. (2)

Labor strikes, part shortages

Examples of unsystematic risks (2)

Price of oil rising | CEO's plane crashing

Investment in several different asset classes or sectors

Portfolio Diversification

Are you diversified if you own 50 technology stocks?

No, but if you own 50 stocks that span 20 different industries then you are

Diversification can substantially reduce the _____ without an equivalent reduction in ___

variability of returns expected returns

Reduction in risk arises because ___ than expected returns from one asset are offset by ___ than expected returns from another

worse better

There is a minimum level of risk that cannot be diversified away and that is the _____

systematic portion

T/F Diversification reduces risk without a corresponding reduction in return which brings down the risk level much moe

True

The standard deviation of returns is a measure of

total risk

For well-diversified portfolios, _______ is very small

unsystematic risk

The total risk for a diversified portfolio is essentially equivalent to

systematic risk

The expected return on a risky asset depends only on that asset's...

systematic risk since unsystematic risk can be diversified away

How do we measure systematic risk?

We use the beta coefficient

What does beta tell us? A beta of 1 implies.. A beta < 1 implies.. A beta > 1 implies..

of 1 implies the asset has the same systematic risk as the overall market <1 implies the asset has less systematic risk than the overall market >1 implies the asset has more systematic risk than the overall market

Systematic Risk Less than 1 = More than 1 =

Less risky | More risky

Security with higher total risk has higher

standard deviation

Higher beta is higher

systematic risk, expected return

The Capital Asset Pricing Model defines the relationship between __ and __

risk and return

If we know an asset's systematic risk, we can use the capital asset pricing model (CAPM) to determine its

expected return

The Pure Play Approach (5):

o Find one or more companies that specialize in the product or service that we are considering o Compute the beta for each company o Take an average o Use that beta along with the CAPM to find the appropriate return for a project of that risk o Often difficult to find pure play companies

Subjective Approach (4):

o Consider the project’s risk relative to the firm overall o If the project has more risk than the firm, use a discount rate greater than the WACC o If the project has less risk than the firm, use a discount rate less than the WACC o You may still accept projects that you shouldn't and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

Subjective Approach Less risk = High risk =

subtract | add

Final Exam Flashcards

(96 cards)