FIN 305 Exam 1

Types of corporate stock

1. common stock - holders own a portion of the company and can vote on major decisions (last to get anything) 2. preferred stock - holder are not owners, have no voting rights but have priority in receiving dividends

Underwriting

The process by which an investment banker purchases all the new securities from the issuing company and then resells them to the public

Financial Management

The role of the financial manager is to make decisions that add value to the firm (i.e. be more profitable).

Commercial Banks

Financial institutions that exist primarily to lend money to businesses. They make their money by charging a higher interest rate on the money they lend than the rate they pay on money lent to them in the form of deposits. -Also lends to individuals, governments, and other entities, but the bulk of their profits typically come from business loans.

Mutual Funds

Financial intermediary that builds a stock portfolio and resells shares of this portfolio to individual investors.

Financial Intermediary/Institution

Firm that helps channel funds from savers to borrowers. Surplus economic units can channel their funds into financial institutions by purchasing saving accounts, checking accounts, life insurance policies, casualty insurance policies or claims on a pension fund. The financial institution can then pool the funds received and use them to purchase claims issued by deficit economic units, such as Treasury, municipal, or corporate bonds; and common or preferred stock. -Includes: Banks (depository), mutual funds, and pension funds and life insurance companies. -Why do we need a middle man?: It can complicate the process, but is also does some good!

Types of Financial Institutions: Non-Depository

Generate funds from sources other than deposits. -Includes: Finance companies, mutual funds, securities firms, insurance companies, and pension funds.

What is the biggest group from lenders or savers?

Households

Investment banking

Institutions that exist to help businesses and state and local governments sell their securities to the public

What is Finance?

Lecture: "Science of decision making" The study of how people and businesses evaluate investments and raise money (capital) to fund them.

Real rate of interest

Nominal interest rate - inflation rate

Primary Markets

facilitate the issuance of new securities

Secondary Markets

facilitate the trading of existing securities, which allows for a change in the ownership of the securities

Capital Market Securities

higher risk, less liquidity

Money market securities

highly liquid, low risk

Negotiable CDs

interest-bearing securities issued by financial institutions -maturities of less than one year -denominations of $100,000 or more -negotiable=can be traded on secondary market

Diversification

investing in several assets with unrelated, or independent, risks: reduced risk (putting all your eggs in different baskets)

Market Efficiency

refers to the ease, speed, and cost of trading securities -the more efficient the market, the easier it is for funds to move from surplus units to deficit markets -if funds remain idle, this results in lower growth for the economy and higher unemployment

Equity Securities/stocks

represent equity or ownership in the firm

Treasury Bills (T-bills)

short-term securities issued by the Federal government -after initial sale, they have an active secondary market -bought at a discount and at maturity the investor receives the full face value

Liquidity

degree to which securities can easily be liquidated (sold) without loss of value

Debt Securities/credit

(borrowed funds) incurred by the issuer -issued by borrowers -purchased by creditors

Deficit units

(borrowers) -Need to borrow money

Stocks

(equity securities) represent partial ownership in the corporations that issued them -no maturity -long term source of funds -subject to risk due to uncertainty about future prices

Surplus units

(savers) -Have money to invest (lend)

Principle 1: Cash Flow is what Matters

-Cash flow, not profits, drive the value of a business. -We must look at incremental or marginal cash flows when making financial decisions.

Orgins of the Fed

-Created in response to the financial panic of 1907 -Federal Reserve Act of (1913) established reserve. requirements for commercials banks. -Decentralized structure with a system of checks and balances. -Specified location of 12 Federal Reserve Banks and their associated district.

Principle 2: Money has a Time Value

-A dollar received today is worth more than a dollar received in the future (because of the opportunity cost). -Since we earn interest on money received today, it is better to receive money sooner rather than later.

Corporation Advantages Disadvantages

-An entity ("person") that legally functions separate and apart from its owners -Advantages: limited liability, permanency, separation of ownership and management, transferability of ownership, and better access to capital -Disadvantages: separation of ownership and management, double taxation, and time and cost of incorporation (c-corporations pay income tax, s-corporations do not)

Corporation

-C-corporation -S-corporation -Limited Liability Company (LLC)

Basic Areas of Finance: Financial Markets and Institutions

-Facilitate the flow of funds in the economy. -Markets in which financial assets are sold. -Impact of interest rates on that flow of funds. Concerns jobs that channel funds through the economic system such as careers in banking, insurance, the brokering of stocks and bonds, and real estate.

Partnership

-General -Limited

Principle 4: Market Prices are Generally Right

-In an efficient market, the market prices of all traded asserts (such as stocks and bonds) fully reflect all available information at any instant in time. -Thus stick prices are a useful indicator of the value of the firm -Price changes reflect changes in expected future cash flows -Good decisions will tend to increase in stock price and vice versa -NOTE: there are inefficiencies in the market that may distort the market prices from value of assets. Such inefficiencies are often causes by behavioral biases

Principle 3: Risk Requires a Reward

-Investors expect to be compensated for "delaying consumption" and "taking on risk". -Investors will not take on additional risk unless they expect to be compensated with additional reward or return. -Thus, investors expect a return when they deposit their savings in a bank (ex. delayed consumption) and they expect to earn a relatively higher rate of return on stocks compared to a bank savings account (ex. taking on risk).

Basic Areas of Finance: Investments

-Looks at financial analysis from perspective of investor (not a firm). -Locate, select, and manage money producing assets. Jobs in investments (including personal financial planning) deal with the efficient allocation of money wealth to various financial assets.

Duties of Financial Managers

-Measure a firm's performance -Determining policies and making decisions related to firm's finances ( i.e. investment, financing, capital structure, etc.) -Locating external sources of financing (issuing loans, stock, etc.)

Basic Areas of Finance: International Finance

-Money essentially moves around companies outside of the United States. -Specialization in all other basic areas of finance Jobs may allow you to work in other countries or at least travel on a regular basis. Need to be familiar with exchange rates and political risks. Need to understand the customs of other countries; speaking a foreign language is helpful.

Can all partners be limited?

-No there must be at least one general partner

Three Tasks of a Financial System

-Task 1: reducing transaction costs (the expenses of negotiating and executing a deal) -Task 2: reducing risk -Task 3: providing liquidity

What is the goal of the firm?

-The primary financial goal of the business is to maximize the wealth of the firm's owners through increasing the value of product to investors/customers. -This is NOT the same as maximizing profits. -The value of the firm is determined by what people are willing to pay for it. -Value depends on future prospects and risk. -The financial manager should make decisions that maximize the price of existing stock.

Proprietorship Advantages and Disadvantages

-a business owned by one person -Advantages: easy to start, least regulated, single owner keeps all profits, minimal organization costs, taxes once as personal income -Disadvantages: unlimited liability, losses absorbed by owner, limited capital, limited life

Limited Partnership

-a partnership in which one or more of the partners has liability

Partnership Advantages and Disadvantages

-an association of two or more persons coming together as co-owners for the purpose of operating a business for profit -General Partnership: a partnership in which all partners are fully responsible for the liabilities incurred by the partnership -Advantages: more capital available, relatively easy to start, income taxes once as personal income -Disadvantages: unlimited liability, must be dissolved or reorganized if a partner leaves or dies

How do investors earn returns?

-dividends (sometimes) = a portion of earnings distributed to stockholders by corporations on a periodic basis -capital gains = selling for a higher price than they paid

S-corporation

-gives small business owners limited liability protection, but taxes company profits only once, when they are paid out as dividends. It cannot have more than one hundred stockholders

Limited Liability Corporation

-hybrid between partnership and corporation -no double taxation -best of both worlds -profits and losses are passed through to owners -owners, not LLC, are taxed -limited liability

Limited Liability Partnership

-similar to general partnership -operates like a corporation - limited liability -partnership not taxed -income passed through to partners and partners are taxed

List the borrowers/spenders from biggest to smallest

1. Business firms 2. Government 3. Households 4. Foreigners

What are the 5 basic principles of Finance?

1. Cash flow is what matters 2. Money has a time value 3. Risk requires a reward 4. Market prices are generally right 5. Conflicts of interest cause agency problems

What are the five major components of the Fed?

1. Federal Reserve District Banks (12 banks) 2. Member Banks 3. Board of Governors (7) 4. Federal Open Market Committee -Board of Governors plus five district Federal Reserve bank presidents -located in DC -votes on open market operations * Board of governors and FOMC have the most power in the Fed 5. Advisory Committees -compile reports

List the lenders/savers from biggest to smallest

1. Households 2. Business firms 3. Government 4. Foreigners

Financial managers decisions are restricted by:

1. Legal Considerations: Environmental regulations, workplace safety standards, civil rights laws, and intellectual property laws 2. Ethical Codes of Conduct: Fair treatment of employees, customers, the community and society as a whole

Jobs of the Federal Reserve

1. Monetary Policy: controls the US money supply and is charged with regulating it to offset macroeconomics. 2. Central Banking (A banks for banks): holds deposits for them and extends loans to them (lender of last resort). 3. Bank Regulation: one of the primary entities charged with ensuring the financial stability of banks, including the determination of reserve requirements.

Principle 5: Conflicts of Interest Cause Agency Problems

1. The principal-agent problem constrains financial decision making - financial managers act as agents for the stockholders who are principals - agency problem = problems and conflicts resulting from separation of the management and ownership of the firm - agency conflict is reduced through things such as monitoring (e. annual reports) and/or compensation schemes (ex. stock options) 2. Interests of non-owner stakeholders - Workers, creditors, suppliers, customers, and other are not owners, but may have a stake in the business 3. The interests of society as a whole may not coincide with the interests of owners of the firm - sometimes the right thing must be done in spite of the cost of the company - the government often imposes rules that force companies to respond to the best interests of society

Absorbing Credit Risk

A financial institution can better predict who (DEU's) will pay and who will not pay that SEU's. Thus, awareness of this knowledge and the amount of funds they have accumulated from many SEU's allows for financial institutions to occasionally absorb a loss when someone fails to pay.

Marginal Cash Flows

A measure of how efficiently a company can turn their sales dollars into cash. A profitability ratio- the higher the percent, the more cash that is available from sales.

If you lend someone $1000 for a year at a 4% interest rate, how much does that person repay you at the end of one year? A. $1040 B. $1000 C. $40 D. $4 E. none of the above

A. $1040 $1000 x 4% = $40 $1000 + $40 = $1040

I. Banks are financial intermediaries that accept deposits and make loans. II. The term "banks" includes firms such as commercial banks, savings and loan associations, credit union, insurance companies, and pension funds. A. (I) is true, (II) is false B. (I) is false, (II) is true C. Both are true D. Both are false

A. (I) is true, (II) is false -Insurance companies and pension funds are both non-depository institutions.

Christine is a barista at a local coffee shop. When her friends come into the store, on their way to class, she uses her employee discount to given them drinks at a discount. With which of the following do you agree? A. If Christine were an owner of the store, she would have been more likely to charge her friends for their drinks B. If Christine were an owner of the store, she would have given her friends the drinks for free C. If Christine were an owner of the store her behavior would not be any different. D. None of the above

A. If Christine were an owner of the store, she would have been more likely to charge her friends for their drinks

Peak Community Dental is a business owned by two dentists. Each dentist is liable for the activities of the business as a whole, and so they invest in liability insurance. Which form of business organization best describes Peak Community Dental? A. partnership B. corporation C. limited liability company (LLC) D. none of the above

A. Partnership

Yield curves of U.S. Treasury securities are most common because A. yield curves are only used for US Treasury securities B. People are lazy so they always use the same securities C. it is easiest to hold everything other than maturity constant with US Treasury securities D. I've been sleeping...what class am I in and what is a yield curve?

C. It is easiest to hold everything other than maturity constant with US Treasury securities

Eurodollars

dollar denominated deposits, located in non-US banks -used to facilitate international transactions

Types of Financial Institutions: Depository

Accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities. -Includes: Banks, credit unions, and saving and loans

Knowledge required of Financial Managers

Accounting: use of basic financial statements Economics: theoretical knowledge of how economic factors influence the firm and use the information to make managerial decisions.

Brokers

Agents who work on behalf of an investor (real estate agents).

Basic Areas of Finance: Corporate/Business Finance

Analyze and forecast a firm's performance and evaluate investment opportunities.

In the context of the example above, the owner(s) of the coffee shop is/are known in finance jargon as the: A. Agents(s) B. Principal (s) C. Master(s) of the universe D. Explo

B. Principal(s)

When yield curves slope downward: A. long-term interest rates are above short-term interest rates B. short-term interest rates are above long-term interest rates C. medium-term interest rates are above both short-term and long-term interest rates D. short-term interest rates are about the same as long-term interest rates E. medium-term interest rates are below both short-term and long-term interest rates

B. short-term interest rates are above long-term interest rates

Best Effort

Bankers sell securities on a best efforts basis meaning the investment banks will try its best to sell the securities for the desired price but there are no guarantees.

Who are biggest borrowers or spenders?

Business firms

Dealers

Buy securities and resell them to others. They operate like car dealers who buy cars from manufacturers for resale to others.

George goes to the Bank of America branch in upstate NY and borrows $50,000 to be paid after graduation in four years. Sandra buys a one-year CD from Bank of America for $10,000. Which of the following did Bank of America provide for George and also for Sandra? A. Denomination Matching B. Maturity Matching C. All of the above D. None of the above E. Impossible to determine

C. All of the above -Often a combination of both denomination and maturity matching

What would be the best way for George and Sandra to meet their financial goals? A. Sandra should find George through a "young writers group" and/or mutual friends on Facebook, hire an attorney to verify George's information. Then Sandra could offer to loan George the money for school after they negotiate a fee (interest rate) B. Sandra should place an offer on Craig's List to loan money for a certain price and George should answer it C. They should each use the financial system independently of one another and allow the system to direct the funds D. Any of the above would be a good option E. None of the above would be a good option

C. They should each use the financial system independently of one another and allow the system to direct the funds

Which of the following long-term bonds should have the highest interest rate? A. corporate investment-grade bonds B. U.S. treasury bonds C. corporate junk-grade bonds D. municipal bonds E. impossible to determine

C. corporate junk-grade bonds (bottom tier, super risky)

Typically yield cures are: A. gently downward sloping B. steeply upward sloping C. gently upward sloping D. steeply downward sloping E. none of the above

C. gently upward sloping

Which of the following markets would NOT be considered efficient? A. stock market B. T-bill market C. real estate market D. all of the above would be considered efficient E. none of the above would be considered efficient

C. real estate market -it takes the longest for movement of transactions (selling a house can take a while)

What are the factors that affect the value of a firm's stock price?

Cash Flows -Not the same as sales or profits (e.g. could be credit sales, but there is not an actual exchange of cash in the transaction). -Necessary to pay the bills Timing of Cash Flows -Cash received sooner is better than cash received later (because there is an opportunity cost to waiting- thus, there must be an incentive to wait). Risk -Definite cash inflows are generally preferred to uncertain cash inflows (e.g. uncollectable accounts).

George receives the student loans he needs in the financial system to go to school. However during his final year there he went out to celebrate and racked up a a bar tab and end up short on rent. He approaches his sister Mia for a loan of $1000. He knows Mia has other uses for her money and offers to pay interest. An article in the Wall Street Journal reports that inflation is expected to be at 2% this year. If George offers to pay 5% interest for the loan, what is the real rate of interest Mia earns from loaning to George? A. 5% B. 2% C. 7% D. 3% E. none of the above

D. 3% nominal rate - inflation = real rate of interest 5% - 2% = 3%

When their brother Paul discovers the deal, he too asks Mia for a loan. Although he has a job, he often spends Friday night at the casino. Paul asks to borrow money from Mia at 5% interest as well. Mia says she will loan him the money, but only at a 15% interest rate. What is the most likely explanation for why she would do this? A. she is a mean sister who likes to play favorites B. she is charging Paul a higher inflation premium C. She is exploiting the poor out of fairness D. It is nothing personal, but she feels that she must charge Paul a "default risk premium" relative to George E. all of the above are equally good explanations

D. It is nothing personal, but she feels she needs to charge Paul a "default risk premium" relative to George She is charging more because it more risky to loan to Paul thank George

What should be the goal of the firm? A. Maximize profits B. Minimize costs C. Maximize market shares D. maximize the current value of the company's stock

D. Maximize the current value of the company's stock * The more you increase the value of your stock, the more money you are making. Essentially, people are willing to invest a lot in your firm.

In which market(s) would you NOT expect participation from investment bankers? A. bond market B. stock market C. primary market D. secondary market E. we would expect participation by investment bankers in all of the above markets

D. secondary market -these are used/existing securities and investment bankers make new securities to bring to the market

Securities

Documents that represent the right to receive funds in the future.

Which of the following are securities in the money markets? A. T-bills B. negotiable CD's C. commercial paper D. banker's acceptance E. all of the above

E. all of the above

What is the Fed?

Serves as the central bank of the United States. It regulates the nation's money supply, makes loans to member banks and other financial institutions, and regulates the financial system. -Hybrid; not a government institution

Sole Proprietorship

Single owner

Incremental Cash Flows

The difference between the projected cash flows if the project is selected, versus what they will be if the project is not selected.

Equilibrium rate of interest

The interaction of demand and supply in the financial markets -determined by: real rate of interest, expected inflation, default risk, maturity risk, illiquidity risk

Maturity Matching

The large number of surplus economic units providing funds allows the few deficit economic units to hold onto those funds long-term, even though surplus economic units only have funds available for a short amount of time. -It is unlikely that SEU's will all want their short-term funds at one given time. -Large percentage of the funds held by the financial institution can be invested in the long-term securities of deficit economic units, with little danger of running our of funds; Pooling makes this possible.

Denomination Matching

When a financial intermediary/institution (bank, savings and loan, or insurance company) takes small amounts of funds from many individuals, form a large pool of funds, and then uses that large pool to purchase securities from individual businesses and governments. -Members of households (surplus economic units) tend to only have small funds available to invest in securities and businesses and governments (deficit economic units) need large sums of funds. SEU's together, however, can provide large enough funds to allow financial institutions to fund DEU's.

What is the yield curve?

a graph comparing interest rates on securities of various maturities at a given point in time

Financial Markets

categorized between two dimensions 1. New vs. Used 2. Length of Time

Hostile Takeover

company being purchased that does not want to be bought -happens because they were publicly traded

Banker's Acceptance

debt securities that have been guaranteed by a bank -used to facilitate international transactions -banks promise via check that you will get your money if you deliver what you say you will

Bonds

long-term debt securities (IOU's) -issued by the Treasury, government agencies, and corporations to borrow money to finance their operations -pay interest periodically -contracts=maturity and timing of payments -coupon (interest) rate=depends on credit worthiness of issuer (borrower)

FInancial intermediaries

specialize in certain services that would be difficult to for individual participants to perform, such as matching buyers and sellers of securities

What is the nominal interest rate?

the interest rate offered by bank account or bond

Money Markets

trade securities that mature in one year or less, have low risk (easier to sell), low return, and high liquidity

Capital Markets

trade securities with maturities greater than one year, expose the investor to somewhat higher risk, have higher expected rates of return, and are less liquid

Financial risk

uncertainty about future outcomes that involve financial losses or gains

Commercial Paper

unsecured (no collateral, no payment back) debt issued by corporations with good credit ratings -most buyers are large institutions