Finance Basics Flashcards
(41 cards)
What is the primary role of the financial system?
To efficiently and optimally allocate savings to investments.
Who are the key players in the financial system?
Savers such as individuals, borrowers which can be governments, companies and individuals and financial institutions which bring them together.
What is the primary role of financial institutions?
The primary role of financial institutions is to efficiently match savers and borrowers by providing information gathering and distribution, risk sharing and liquidity
What are examples of institutional investors?
Pension funds, insurance companies and endowments
What are examples of alternative investments?
Private Equity, venture capital and hedge funds
Why is money today worth more than money tommorrow?
Three main reasons are risk associated with receiving and being able to use the money the longer out in the future you go. Secondly there is inflation in which money has less purchasing power in the future. Third money today could be invested and earn some return.
What is the discount rate?
An investor´s opportunity cost of capital is the return required by investors to invest in a project of a specified level of risk and for a specified time period
How would you estimate a discount rate?
you take the risk free rate for the appropriate period of time and add the expected inflation rate and appropriate risk premium for an investment at that level of risk
How do you value perpetuity?
Take perpetual cash flow and divide it by the discount rate, we assume same cash flows at same time. Perpetuity with constant growth the divide by the discount rate less constant growth rate
Perp= Cf/r
Perp_g= Cf/ r-g
How do you calculate future value of money?
Present value and multiply by one plus discount rate raised to the number of periods
FV= PV(1+r)^t
How do companies decide whether or not to invest in a project?
If the NPV is positive and the largest NPV possible between all options. Or if the project´s internal rate of return (IRR) is greater than the project´s discount rate
Calculate net present value
add each of the period´s cash flows divided by one plus discount rate raised to each time period
NPV= CF/1+r + CF/(1+r)^2…
Calculate IRR
Solve for the discount rate in an equation where zero equals sum of each period´s cash flows divided by one plus the discount rate to each time period
0= CF/1+r + CF/(1+r)^2…
What things do you include and don´t you include when doing an IRR or NPV
You should include all cash flows that directly relate to the project including initial capital investment and ongoing costs and capital expenditures, working capital requirements, revenues and profits
You should not include the sunk costs or any allocation on expenses that would have been spent regardless such as CEO salaries
When will NPV equal 0
NPV will equal 0 when the project´s IRR equals the discount rate used in the NPV formula
What is capital structure?
Reflects a company´s choice of funding and specifically its makeup of debt and equity
What is more expensive debt or equity?
Equity is more expensive because it is riskier than debt, has less certain cash flows, is subordinate to debt in bankruptcy or liquidation and dividends are not tax deductible unlike interest.
Why does adding more debt to the capital structure raise the cost of debt?
It raises the risk of distress and bankruptcy which results in significant loss of value and therefore makes all of the company´s debt riskier.
Why does adding more debt to capital structure raise the cost of equity?
This is due to debt increasing the risk of distress and bankruptcy which results in significant loss of value to the company and usually a complete loss of value to equity shareholders. And more debt requires higher levels of interest which reduce flexibility of management.
Why is the cost of capital U shaped
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.
Advantages and disadvantages of issuing debt?
Some advantages include a lower cost of capital than equity given it is less risky to investors and because interest is tax deductible. Disadvantages include increased risk of financial distress or bankruptcy, mandatory payment of interest expense which reduces flexibility of management and covenants which restricts the company´s ability to issue more debt and penalise the company if it does not mantain certain operating performance and leverage
Advantages and disadvantages of issuing stock?
Advantages is that there are no mandatory dividend payments, least risk adverse investor class and a currency that can be used for acquisitions. Some disadvantages to issuing stock include the highest cost of capital of any funds, highest transaction costs to raise the funds and vulnerability from activist investors.
Differences between secured and unsecured debt?
Secured debt is debt that is collateralised by specific assets and unsecured debt is not collateralised. Unsecured debt has a higher cost of capital because debt is not collateralised by specific assets. Secured debt is also more senior than unsecured.
