Week 1

Question 1

What is finance?

Answer 1

The raising of funds (capital).

Question 2

What is capital money used for?

Answer 2

Investments.

Question 3

What are the two types of capital?

Answer 3

Debt & equity.

Question 4

3 ways we can finance? (and whether they are debt or equity capital)

Answer 4

1. Existing funds of owners (equity).
2. Sharing ownership; selling part of the business to the public (equity).
3. Borrow money (debt).

Question 5

What is investment?

Answer 5

The making of money using capital.

Question 6

How do we invest?

Answer 6

Once the capital is raised, it is used to buy assets that make money (generate a return).

Question 7

What does the type of assets bought depend on?

Answer 7

What type of business is buying (e.g. woolies buys inventory.)

Question 8

Capital budgeting

Answer 8

The process of using capital to buy assets.

Question 9

Cost of capital

Answer 9

How much (in %) needs to be paid for debt and equity.

Question 10

Capital structure

Answer 10

The breakup or mix of capital between debt and equity. (How much capital is equity and how much is debt in a business).

Question 11

Weighted average cost of capital (WACC)

Answer 11

Measures the cost of capital, using a weighted average of debt and equity costs.

Question 12

Required rate of return (RRoR)

Answer 12

Minimum rate of return (aka Hurdle Rate). The cost of capital or the WACC.

Question 13

What is important about the required rate of return?

Answer 13

Any asset must be earning at least RRoR (e.g. 5%) (preferably more) otherwise they will lose money.

Question 14

Expected rate of return

Answer 14

What you believe/expect the asset to generate in returns.

Question 15

How does having to pay 5% for capital (or having a RRoR of 5%) affect a company’s choice of what assets to buy?

Answer 15

The asset bought must have an expected return E(R) than is greater than the RRoR (5% in this case).

Question 16

E(R) of assets must be greater than …

Answer 16

RRoR for capital.

Question 17

What is the flow of funds?

Answer 17

Where capital is transferred from surplus units to deficit units in an economy.

Question 18

Surplus unit

Answer 18

Any entity in the economy which has more than enough capital than it needs.

Question 19

Deficit unit

Answer 19

Any entity in the economy that does not have enough capital - it needs more.

Question 20

The efficient flow of funds is important for economic growth because … (2)

Answer 20

1. Capital is not mis-priced (price paid is appropriate).
2. Surplus & deficit units have liquidity (deficit units are able to raise the capital they need and surplus units have enough capital to meet deficit units needs.

Question 21

What are the 3 ways for the flow of funds to occur in an economy?

Answer 21

1. Direct transfer between surplus and deficit units.
2. Indirect transfer using an investment bank.
3. Indirect transfer, using a financial intermediary.

Question 22

Key benefits of inter-mediation (4)

Answer 22

• asset transformation.
• credit risk transformation and diversification.
• liquidity transformation.
• economies of scale.

Question 23

Can all economic units successfully engage in direct financing?

Answer 23

No, they need to possess a sufficient size, influence, reputation.

Question 24

3 advantages of direct finance

Answer 24

1. Saves on the cost of intermediation.
2. Allows access to non-standard/unique products not offered by intermediaries.
3. Deficit units can issue finance that is unique to their specific funding requirements instead of relying on a ‘cookie-cutter’ product.

Question 25

3 disadvantages of direct finance

Answer 25

1. Difficulty with matching preferences between surplus and deficit units. 2. Higher risk of liquidity and marketability of direct finance instruments. 3. Higher search and transaction costs.

Question 26

3 components of the financial system

Answer 26

1. Financial institutions. 2. Financial instruments. 3. Financial markets.

Question 27

Financial institutions

Answer 27

Business that facilitate the flow and transfer of funds by providing intermediation. (E.g. Bank).

Question 28

Financial instruments

Answer 28

Primarily types of debt and equity that are vehicles for the flow/transfer of funds. Eg. Home loan.

Question 29

Financial market

Answer 29

Where financial instruments are created and traded. Eg. ASX

Question 30

Investment bank:

Answer 30

Facilitate the buying and selling of stocks and other investments.

Question 31

Commercial bank

Answer 31

Manage deposit accounts for individuals and companies.

Question 32

Financial intermediation

Answer 32

The use of a third party to bring together surplus and deficit units and allows the preferences of both to be met.

Question 33

Direct financing

Answer 33

Deficit and surplus units seek each other out and enact the flow of funds between them, without the use of an intermediary.

Question 34

4 opposites for financial markets

Answer 34

1. Primary vs secondary. 2. Public vs private. 3. Money vs capital. 4. Wholesale vs retail.

Question 35

Primary market | Secondary market

Answer 35

Primary - investors buy securities directly from the company issuing them. Secondary - investors trade securities amongst themselves and the company with the security being traded does not.

Question 36

Public market | Private market

Answer 36

Public - customer is not always obvious so assessing needs and measuring performance is more difficult. Private - there is an obvious customer and preference is easily measured by whether the customer is satisfied or not with the service and price paid.

Question 37

Money market | Capital market

Answer 37

Money - cash market. | Capital - market for the buying and selling of long term debt or equity securities.

Question 38

Retail market | Wholesale market

Answer 38

Retail - you the product manufacturer or producer, sell your product directly to the consumer. Wholesale - you typically sell your product in bulk quantities to a 'middle man' who in turn sells to the consumer.

Question 39

Rate of return

Answer 39

The % earned on the capital invested.

Question 40

Eg. You invest $100 and earn $10 over one year, what is the rate of return?

Answer 40

10% p.a.

Question 41

Can financial instruments be both assets and liabilities?

Answer 41

Yes.

Question 42

You are borrowing money (a home loan - instrument) from the bank (institution). Is this loan an asset or liability to the bank? To the borrower?

Answer 42

Bank - asset. | Borrower - liability.

Question 43

IPO (initial public offering)

Answer 43

The first time that the stock of a private company is offered to the public.

Question 44

Market risk premium =

Answer 44

Expected rate of return - risk-free rate

Question 45

Real risk free rate of return

Answer 45

The minimum return an investor requires.

Question 46

Nominal interest rate

Answer 46

An interest rate that does not take inflation into account.

Question 47

Premium

Answer 47

A sum additional to the interest paid for the loan of money.

Question 48

Inflation

Answer 48

A sustained increase in the general price level of goods and services in an economy over a period of time.

Question 49

Inflation premium

Answer 49

The part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.

Question 50

Default risk premium

Answer 50

The additional amount a borrower must pay to compensate the lender for assuming default risk.

Question 51

Maturity risk premium

Answer 51

Associated with interest rate uncertainty - the longer the time to mature, the higher the premium.

Question 52

Liquidity risk premium

Answer 52

The explanation for a difference between 2 types of financial securities that all have the same qualities except liquidity.