FM101

Question 1

capital structure

Answer 1

the mixture of long term debt and equity maintained by a firm.

Question 1

corporate finance questions

Answer 1

what long-term investments should you make? Where will you get the long term financing to pay for your investment? how will you manage your everyday financial activities such as collecting from customers and paying suppliers

Question 2

equity

Answer 2

the amount of $ raised by a firm that comes from owners (shareholders) investment

Question 3

working capital

Answer 3

a firms short term assets and liabilities; a day-to-day activity which ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions

Question 4

financial goals

Answer 4

market share; bankruptcy avoidance; environment and sustainability; making good financial decisions to increase the market value of the owners equity.

Question 5

the goal of financial management

Answer 5

to maximise the current value per share of the existing equity

Question 6

TBL

Answer 6

the concept that corporate objectives should focus equally on society, the environment, and profit. (it is difficult to measure in monetary terms the effect a company has on society and the environment)

Question 7

shareholder wealth maximisation

Answer 7

managers work in the favour of shareholders, assuming that shareholders value society and the environment in the same way as the general population, the goal of shareholder wealth maximisation will necessarily capture societal and environmental objectives and reflect the TBL.

Question 8

Primary markets

Answer 8

in a primary market transaction, the corporation is the seller and the transaction raises money for the corporation. Corporations engage in two types of primary market transaction:
1. Public offerings: involves selling securities to the general public
2. Private offerings: involves selling securities to venture capital, private equity & institutional investors.

Question 9

secondary markets

Answer 9

investors can buy and sell existing securities. Involves one owner or creditor selling to another, therefore the secondary markets provide the means of transferring ownership to corporate securities. Investors are more willing to purchase securities in a primary market transaction when they know those securities can be later sold if desired.

Question 10

dealer

Answer 10

buy and sell for themselves, at their own risk (e.g. car dealers)

Question 11

brokers and agents

Answer 11

match buyers and sellers, but they don’t actually own the commodity that is bought or sold

Question 12

over the counter markets

Answer 12

dealer markets in equities and long term debt are called over-the-counter (OTC) markets.

Question 13

auction markets

Answer 13

have a physical location; matches those who wish to sell and those who wish to buy

Question 14

listing

Answer 14

securities that trade on an organised exchange are said to be listed on that exchange

Question 15

dealer markets

Answer 15

those markets where firms make continuous quotations of prices for which they stand ready to buy and sell money-making instruments on their own inventory and at their own risk.

Question 16

agency markets

Answer 16

those in which stockbrokers act as agents for customers in buying and selling shares. An agent doesn’t actually acquire the securities.

Question 17

direct finance

Answer 17

when a borrower sells a security directly to a lender

Question 18

indirect finance

Answer 18

in which an institution like a bank stands between a lender and borrower

Question 19

the role of investment banks

Answer 19

when a lender purchases a security issued by a specific firm or government, the transaction takes place through a securities broker or an investment bank that helps the issuer distribute new stocks/bonds. These securities become assets for the lenders who buy them and liabilities to the government or corporation that created them to obtain funds.

Question 20

financial instrument

Answer 20

the written legal obligation of one part to transfer something of value, usually money, to another party at some future date, under specified conditions.

Question 21

uses of financial instruments

Answer 21

means of payment; store of value (transfer purchasing power into the future - stocks & bonds); transfer of risk (futures contract)

Question 22

standardisation

Answer 22

standard applications for financial instruments (mortgages) - easy to understand

Question 23

underlying instruments (primitive securities)

Answer 23

are used by savers/lenders to transfer resources directly to investors/borrowers

Question 24

derivative instruments

Answer 24

Derivative instruments are financial contracts whose value is derived from the value of an underlying asset, index, or rate. They are used for a variety of purposes, including hedging risk, speculation, and gaining exposure to specific assets or markets. The primary types of derivative instruments include futures, options, and swaps.

Question 24

Futures contract

Answer 24

Definition: A futures contract is a standardized agreement between two parties to buy or sell an asset at a predetermined price at a specified time in the future. Underlying Assets: These can be commodities (like oil, gold, or wheat), financial instruments (like bonds or currencies), or indices. Purpose: Futures are often used by hedgers to lock in prices and by speculators looking to profit from price movements. Example: A farmer might use a futures contract to sell their crop at a set price to avoid the risk of price drops at harvest time.

Question 25

Options contract

Answer 25

Definition: An option is a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price before or at a certain date. Underlying Assets: Similar to futures, options can be based on stocks, commodities, currencies, or indices. Purpose: Options are used for hedging, speculation, or to generate income. They offer more flexibility compared to futures since the holder is not obligated to execute the trade. Example: An investor might buy a call option on a stock if they believe its price will rise but want to limit their potential loss to the premium paid for the option.

Question 26

Swaps contract

Answer 26

Definition: A swap is a contract in which two parties agree to exchange cash flows or other financial instruments over a specified period. Types: The most common swaps are interest rate swaps, currency swaps, and commodity swaps. Interest Rate Swaps: Involve exchanging fixed interest payments for floating interest payments. Currency Swaps: Involve exchanging principal and interest payments in one currency for equivalent payments in another currency. Commodity Swaps: Involve exchanging cash flows related to commodity prices. Purpose: Swaps are primarily used by institutions to manage different types of financial risks, such as interest rate risk or currency risk. Example: A company might enter into an interest rate swap to convert its variable-rate debt into fixed-rate debt, reducing its exposure to rising interest rates. there are many types of swaps that differ in: 1. how long they last 2. how often the payments are made 3. the type of cash flows exchanged

Question 27

what gives a financial instrument value

Answer 27

size, timing, payments that are likely to be made are more valuable; payments that are made when we need them most are most valuable

Question 28

financial instruments that are used primarily as a store of value

Answer 28

bank loans, home mortgages (house is collateral), stocks (transfer of risk), asset backed securities

Question 29

financial instruments used to primarily transfer risk

Answer 29

1. insurance contracts 2. options 3. futures contract 4. swaps

Question 29

asset backed securities

Answer 29

are like investment products that let you buy a piece of the income generated from specific assets e.g. home mortgages, student loans, credit card debt, movie ticket sales.

Question 29

collateral

Answer 29

used to describe specific assets a borrower pledges to protect the lenders interests in the event of a non-payment

Question 30

centralised exchanges vs OTC markets

Answer 30

centralised exchanges: dealers meet in a central, physical location over the counter markets: where dealers stand ready to buy and sell securities electronically electronic communications networks (ECNs): an electronic system that brings buyers and sellers together for an electronic execution of trades without the use of a broker/dealer

Question 30

the role of financial markets

Answer 30

1. market liquidity: ensure that owners of financial instruments can buy and sell them cheaply and easily 2. information: pool and communicate information about the issuer of a financial statement (does the company have good prospects for future growth? is the borrower likely to repay the bond?) 3. risk sharing

Question 30

benefits and disadvantages of decentralised electronic exchanges over physical central location

Answer 30

(+) customers can see the order (+)orders are executed quickly (+) trading occurs 24 hrs a dya (+)costs are low (+)reduces a menacing operations risks (-) new trading patterns have arisen that render the entire system fragile, raising serious worries amongst investors about the liquidity and value of their assets (-)efforts to speed up electronic trading drain resources for more efficient uses

Question 30

major groups of financial institutions

Answer 30

1. despository institutions (banks) 2. insurance companies 3. pension funds 4. securities firms (asset management firms, hedge funds, private equity and venture capital firms, mutual funds) 5. finance companies govt sponsored enterprises

Question 31

characteristics of a well run financial mkt

Answer 31

1. designed to keep transaction costs low 2. info that the market pools and communicates must be widely available 3. investors need protection

Question 31

debt and equity vs derivative markets

Answer 31

debt and equity markets: actual claims are bought and sold for immediate cash payment derivative markets: investors make agreements that are settled later

Question 32

insurance companies

Answer 32

accept premiums, which they invest in securities and real estate (their assets) in return for promising compensation to policyholders should certain events occur (their liabilities)

Question 33

asset management firms

Answer 33

invest pooled resources from individuals and companies into portfolios of bonds, stocks, and real estate

Question 34

hedge funds

Answer 34

invest pooled resources from wealthy investors into portfolios of bonds, stocks and real estate

Question 35

private equity & venture capital firms

Answer 35

acquire and actively manage stakes in a few firms to increase returns before re-selling

Question 36

mutual funds

Answer 36

made up of passive investors who don't influence management

Question 37

formulas for ch.4&5

Answer 37

FV, PV, annuity PV, annuity FV factor, annuity due, prepetuity, growing annuity PV, EAR

Question 38

pure discount loan

Answer 38

the borrower recieves money today, and repays a single lump sum some time in the future (PV formula)

Question 39

interest only loan

Answer 39

the borrower pays interest every period and pays the entire original loan amount sometime in the future

Question 40

amortized loan

Answer 40

the lender may require the borrower to repay parts of the loan amount over time (e.g. the borrower pays interest each period + some fixed loan amount)

Question 41

NPV

Answer 41

the difference between the market value of the cash flows generated - the PV of the expected future cash flows discounted at the appropriate discount rate. The NPV measures how much value is created/destroyed by undertaking the project. If a firm undertakes projects with NPV<0 the shareholders would be better off investing in financial markets and earn r - the discount rate in which case NPV = 0 instead of negative.

Question 42

NPV advantages

Answer 42

1. incorporates the time value of money 2. uses all cash flows information which an analyst must forecast, including LT cash flows which might be very certain BUT alternative rules might be easier to communicate to investors

Question 43

IRR

Answer 43

the average return earned by undertaking in investment opportunity accept projects where IRR > opportunity cost of capital find the discount rate such that NPV = 0

Question 44

Problems with IRR

Answer 44

1. occasionally doesn't exist, i.e. there is no discount rate such that NPV = 0 2. sometimes there may be multiple IRRs (when cash flows alternate in sign) so you don't know which one to choose 3. doesn't tell you if you are financing/investing, NPV does 4. since IRR is a return you can't tell how much value will actually be created without knowing the scale of investment 5. just looking at the IRR of projects isn't enough to select projects, depends on the opportunity cost of capital

Question 45

The payback period rule

Answer 45

the amount of time required for an investment to generate sufficient cash flows to recover its initial cost states that you should only accept a project if its payback period is less than a benchmark years before break even + (unrecovered amount/ cash flow in recovery year)

Question 46

the discounted payback period

Answer 46

the length of time required for an investment's discounted cash flows to equal its initial cost

Question 47

discounted pay back period advantages and disadvantages

Answer 47

1. includes time value of money 2. easy to understand 3. doesn't accept negatively estimated NPV investment 4. biased towards liquidity but may reject positive NPV investment; ignores cash flows beyond the cut off date & is biased against long term projects, such as research and development, and new projects

Question 48

AAR

Answer 48

average net income/average book value - a project is acceptable if AAR > target AAR (+) easy to calculated (+) needed info will usually be available (-) not a true rate of return; time value of (-)money is ignored (-)uses an arbitary benchmark cut off rate (-)based on accounting values, not CF and market values.

Question 49

profitability index

Answer 49

- the PV of cash inflows divided by the PV of cash outflows. Also called the benefit cost ratio (+) closely related to NPV (+) easy to understand and communicate (+) may be useful when available investment funds are limited (-) may lead to incorrect decisions in comparisons of mutually exlusive events

Question 50

incremental cash flows

Answer 50

the difference between a firm's future CFs wth a project and without a project

Question 51

relevant costs

Answer 51

1. future cost 2. relate to the firm's objectives 3. affect the future cash flows (incremental) relevant: opportunity costs, externality costs irrelevant: sunk costs, financing costs

Question 52

why are financing costs irrelevant?

Answer 52

in analysing a proposed investment, we shall not include interest paid or any other financial costs such as dividends or principal repaid, because we are interested in cash flows generated by the assets of the project.

Question 53

bottom up approach OCF

Answer 53

projected net income = EBIT - taxes OCF = net income + depreciation

Question 54

top down approach OCF

Answer 54

sales - costs - taxes

Question 55

tax shield approach OCF

Answer 55

(sales - costs - depr)(1-tax)+depr

Question 56

depr tax shield

Answer 56

the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

Question 57

equivalent annual cost (EAC)

Answer 57

the PV of a project's costs, calculated on an annual basis

Question 58

after tax salvage value

Answer 58

refers to the net cash inflow a company expects to receive from the sale of an asset at the end of its useful life, after accounting for taxes MV + (BV-MV)tc if BV = 0, then MV(1-tc)

Question 59

EAR

Answer 59

It is the interest rate that reflects the total interest earned or paid on an investment or loan over a year, taking into account the effect of compounding. (+ formula)

Question 60

Sole Proprietorship

Answer 60

Sole Proprietorship Ownership: Single individual owns and operates the business. Governance: The owner has full control over decision-making, with no formal governance structure. There is no board of directors or need for corporate by laws. Implications: Limited to the owner's oversight; risks of poor governance include lack of accountability and oversight. No separation between personal and business liabilities.

Question 61

Partnership

Answer 61

2. Partnership Types: General Partnership: All partners share management responsibilities and liabilities. Limited Partnership (LP): Includes both general and limited partners; general partners manage the business, while limited partners have limited liability. Limited Liability Partnership (LLP): All partners have limited liabilities and may participate in management. Governance: Partnerships may have a partnership agreement outlining management roles and decision-making processes. Example: Goldman Sachs (before becoming a corporation in 1999) operated as a partnership where partners shared profits, losses, and management responsibilities.

Question 62

Corporation (C Corporation)

Answer 62

Ownership: Owned by shareholders who elect a board of directors. Governance: Formal governance structure with a board of directors overseeing executive management. Example: Apple Inc. operates as a C Corporation with a board of directors and executive officers like the CEO who manage the company’s operations.

Question 63

S Corporation

Answer 63

Ownership: Similar to a C Corporation but with restrictions on the number and type of shareholders. Governance: Governed similarly to a C Corporation but benefits from pass-through taxation. Example: Blue Sky Consulting (a hypothetical example of a small consulting firm that meets S Corporation criteria) might choose S Corporation status for tax benefits while maintaining a formal governance structure.

Question 64

Limited Liability Company (LLC)

Answer 64

Ownership: Owned by members who may manage the company themselves or appoint managers. Governance: Member-Managed LLC: Members handle day-to-day operations. Manager-Managed LLC: Managers are appointed by members to run the company. Example: Bain & Company, a global management consulting firm, is structured as an LLC in the United States, allowing it flexibility in management and limited liability for its members.

Question 65

Cooperative (Co-op)

Answer 65

Ownership: Owned and operated by members who use its services; profits are distributed among members. Governance: Members elect a board of directors, with decisions typically made democratically. Example: REI (Recreational Equipment, Inc.), a consumer cooperative, is owned by its members who receive dividends based on their purchases and vote on key company decisions.

Question 66

Nonprofit Organisation

Answer 66

Ownership: No owners; operated for public benefit. Governance: Governed by a board of directors or trustees who oversee mission fulfillment and financial accountability. Example: The American Red Cross is a nonprofit organization with a governance structure that includes a board of governors responsible for ensuring that the organization meets its humanitarian mission.

Question 67

Joint Venture

Answer 67

Ownership: Formed by two or more entities for a specific project or business activity. Governance: Governed by a contractual agreement detailing roles, responsibilities, and profit-sharing. Example: Sony Ericsson was a joint venture between Sony and Ericsson that combined their resources to produce mobile phones. The governance of the joint venture was shared between the two parent companies.

Question 68

Publicly Traded Company

Answer 68

Ownership: Owned by shareholders who can buy and sell shares on public stock exchanges. Governance: Governed by a board of directors accountable to shareholders, with extensive regulatory oversight. Example: Microsoft Corporation is a publicly traded company with a board of directors that oversees the company’s strategic direction, with shareholders voting on key issues like board appointments and major corporate actions.

Question 69

Private Equity Owned Firm

Answer 69

Ownership: Owned by private equity investors, often focused on maximizing returns. Governance: The private equity firm typically has significant influence over the board of directors and management decisions. Example: Hilton Worldwide was taken private by the private equity firm Blackstone in 2007, where Blackstone played a major role in governance until Hilton’s re-IPO in 2013.

Question 70

Family Owned Business

Answer 70

Ownership: Owned and often managed by family members. Governance: Governance structures vary, with some family businesses employing formal boards or family councils. Example: Walmart was originally a family-owned business founded by Sam Walton, and the Walton family remains heavily involved in its governance, holding significant shares and board positions.

Question 71

State Owned Enterprise

Answer 71

Ownership: Owned by the government. Governance: Typically governed by a board of directors, but with significant government influence. Example: Saudi Aramco, the state-owned oil company of Saudi Arabia, is an SOE where the Saudi government exercises significant control over its operations and governance.