LECTURE 1

Question 1

2 main areas of financial economics

Answer 1

1. Asset pricing

2. Corporate finance

Question 2

4 types of firms

Answer 2

1. Sole trader/sole proprietorship
2. partnership
3. LLC
4. Corporation

Question 3

Ownership, liability, tax and life of sole trader

Answer 3

Individual
Unlimited 100% - treat individual’s assets as business
Income tax
owner’s decision/life

Question 4

Ownership, liability, tax and life of partnership

Answer 4

2 or more
Unlimited 100% overall, split
Income tax
decisions/lives

Question 5

2 types of partnerships and how they differ

Answer 5

General partnership = equal responsibility for all debts

Limited partnership = cannot lose more than initial investment & none have management authority

Question 6

Ownership, liability, tax and life of LLC

Answer 6

2 or more
Limited < 100%
Income tax and other benefits
Decisions/lives/registration expiry

Question 7

Ownership, liability, tax and life of corporation

Answer 7

Unlimited
Limited liability < 100%
Income tax and other benefits
Unlimited

Question 8

Who are principals and who are agents in principal-agent problem?

Answer 8

Principals = owners = shareholders
Agents = managers

Question 9

Securities =

Answer 9

financial assets that can be traded in financial markets

Question 10

2 types of securities

Answer 10

equity and debt

Question 11

equity =

Answer 11

collection of shares of a corporation owned by shareholders who receive ownership and dividends, but may never get their principal back.

Question 12

debt =

Answer 12

finance without ownership - receive principal back + interest

Question 13

How do bonds differ from loans?

Answer 13

Both debt
But bonds can be traded = security
Loans cannot be traded

Question 14

In the case of bankruptcy, who has priority?

Answer 14

Lenders/creditors get paid back first, then shareholders receive the residual which could be -VE.

Question 15

Why might bankruptcy not necessarily lead to the firm’s liquidation?

Answer 15

The debt holders as the new owners may decide to keep the business operating.

Question 16

Balance sheet =

Answer 16

a financial statement that reviews a company’s assets, liabilities and equity at ONE POINT IN TIME such as the end of a financial year.

Question 17

Assets =

Answer 17

an economic resource with a price s.t. fluctuations which is controlled/owned by individuals/corporations with a capability of producing future returns.

Question 18

2 types of assets and how do they differ by liquidity?

Answer 18

Real = tangible, physical assets
Financial = non tangible - more liquid as can more easily be converted to cash.

Question 19

Liabilities =

Answer 19

Obligations a company must pay back in the future.

Question 20

When firms borrow, they sell claims on…

Answer 20

existing assets or future cash flow

Question 21

Balance sheet formula:

Answer 21

assets = liabilities + equity

Question 22

Net worth of a company =

Answer 22

total assets - total liabilities

Question 23

Net working capital =

Answer 23

current assets - current liabilities

Question 24

Difference between investment and financing decisions in terms of assets:

Answer 24

Investment = purchase of REAL assets
Financing = sale of FINANCIAL assets + decision to reinvest/borrow

Question 25

Capital structure =

Answer 25

the decision to finance through debt or equity.

Question 26

Market capitalisation =

Answer 26

market price per share * number of shares issued | = total market value of equity

Question 27

2 factors giving rise to principal-agent problem

Answer 27

1. Conflicting interests | 2. Asymmetric info

Question 28

3 ways to overcome principal-agent problem

Answer 28

1. Incentives to managers 2. Increase monitoring 3. Increase control over very important decisions

Question 29

1 problem with trying to overcome principal-agent problem

Answer 29

AGENCY COSTS

Question 30

Hurdle rate =

Answer 30

shareholders' expected minimum return from new investments - must be above the return they could've got by investing their money elsewhere with a similar level of risk.

Question 31

Opportunity cost of capital =

Answer 31

the amount of return investors forego on the best alternative investment of equivalent risk and term when they take on the new investment

Question 32

Difference between money today and in the future is caused by...(2)

Answer 32

1. IR | 2. Inflation

Question 33

Compound interest =

Answer 33

earn interest on the original value AND interests

Question 34

Discount factor =

Answer 34

1/(1 + r)^t

Question 35

Total cash flow comes from...(3)

Answer 35

1. Operating activities 2. Investment activities 3. Financing activities

Question 36

Discounted cash flow can only be used if... | Does it incorporate risk?

Answer 36

CFO is certain about expected future cash flows. | Since DCF does NOT include risk.

Question 37

NPV =

Answer 37

PV - investment

Question 38

NPV rule is suitable when...(2)

Answer 38

1. Returns are ON TIME - WITHOUT DELAY | 2. NO RISK

Question 39

NPV rule

Answer 39

Accept if NPV > 0 | Reject if NPV < 0