Finance Exam 1

Relationship among the three areas

-Investors are in investments area -Firms are in financial management area -Investors give funds to firms, and firms give securities to investors, through money and capital markets -Firms give profits directly to investors -Firms issue stocks/bonds (securities) to investors for money

what is a bond

-a security with a lifetime of 1+ years -borrow $ from investors with interest payments -at the end of the term, all the money gets paid back

constraints on shareholder wealth maximization

-agency problem -social responsibility

potential solutions to the agency problem

-appropriate compensation packages -outside directors -disgorging of cash in declining industries -threat of management termination

common types of capital market securities

-bonds -preferred stocks—get priority of dividends -common stocks -convertible securities: *starts out with base of bond, but can convert into a certain number of shares after x amount of time (especially if a company does well) *popular because stable base with possibility for big upside

relationship between book value and market value of equity

-can be quite different -financial statements don't show market value

Ratio analysis

-convenient way to summarize significant quantities of financial data -compare the same statistics across firms uniformly -look for trends that may allow prediction of future profitability, etc. of the firm -compare ratios to own company's previous years' ratios to see how the company is performing overall (trends)

disgorging of cash in declining industries

-declining industries occur because of technology changes, and can immediately collapse -pay more money to shareholders in dividends so they can invest as they see fit

examples of the agency problem

-excessive perquisite consumption: unneeded corporate jet—CEO takes it somewhere & gets more benefits than they "pay for" in stock; holding meetings in "party spots" -shirking: being a slacker, wasting time -project selection: picking a project with no risk out of self-interest, rather than a risky project that the shareholders want; occurs when self-interest > shareholders' interest -management resistance to takeover bids: discourages takeovers to keep their own jobs, at the expense of shareholders

outside directors

-hire people with no ties to the CEO/management, so if they're misbehaving, the directors have no problem ousting them -effective check -stock price increases if outside directors are added because they're a swing vote and known to be aggressive

financing decisions

-how to pay for assets that the firm decides to own (investing) - should the company issue stock, short-term debt, long-term debt, or more exotic securities to pay for its assets? -what is the optimal mix of securities? -involves capital structure decisions -provides the logistics for investment decisions

the rule of 72

-if you earn r% per year, compounded annually, your money will double in ABOUT 72/r% years (keep r as a percent, not a decimal) -you would never want to use it on an exam unless you're asked to because it's not precise -works for reasonable/conventionally available interest rates -breaks down for high interest rates -practical!

appropriate compensation packages

-in general, an increase in firm value by $1000 only increases CEO's benefits by $3.25—this could make them fall into the agency problem -put more shares in CEO's compensation package so they're happy -set the stock option = to the market price so any time something good happens, the profit's already there -the higher the stock price, the more mangers make, so their goals align with the shareholders'

financial statements

-insight to financial health of company -annual report consists of: 1. management's overview 2. balance sheet 3. income statement 4. cash flow statement 5. footnotes (explains outliers) 2-4 are the most objective picture of a company's financial health; they're not perfect because they can be manipulated, but they are helpful

tips for any annuity equations

-make sure you use the correct k(eff)! -draw a timeline & specify what t= when you're doing an equation

income statement

-measures firm performance OVER A SPECIFIED PERIOD OF TIME -based on the following identity: REVENUES — EXPENSES = INCOME -links 2 balance sheets together

facts about net income

-might be used to pay shareholders -retained earnings go back into the company (internal financing) -if a company has growth, shareholders will want them to invest in themselves -if company is in a dying industry, shareholders will take dividends

earnings per share

-net income can be used to calculate earnings per share -calculate stock price EPS = net income/# shares outstanding

two types of secondary markets

-registered exchange -over the coutner

why a firm's goal is NOT profit maximization

-short run vs. long run profits (don't focus on short-term at the expense of the long-term) -ignores timing of cash flows -does not have a risk dimension

social responsibility constraint

-social responsibility should keep the company from polluting -green programs have become benefits to shareholders -constraint because it has a cost but it's ethical to do, and therefore should still be done

Future value of a single cash flow

-the amount of money an investment will grow to, at a specified point in the future, at a given interest rate we can choose any effective rate period we wish, as long as we choose the corresponding n *if k(eff) is over multiple years or months, n must be divvied up the same way

what is the goal of the firm & why

-the firm is owned by shareholders, who elect a board of directors who hire the firm's management -*the goal is maximization of shareholder utility (satisfaction with company—"happiness")* -since it's difficult to measure utility, wealth is a good proxy. -recently, companies have been pursuing additional goals (helping/caring about "stakeholders") THE GOAL OF THE FIRM IS TO MAXIMIZE SHAREHOLDER WEALTH

Effective interest rate

-the true rate that your money actually earns -different from nominal (quoted/stated) rate when the rate is not annual

purposes of financial markets

-to facilitate the acquisition and investment of money -to bring together those who have capital and those who need capital -efficiently channel funds from savers (households) to users (government, corporations) -to establish market prices and rates of return *access to reliable prices allows investors to keep track of the market values of their assets (helps them make important life decisions) -market prices also tell managers how investors think managers are performing *stock prices change within seconds of a company's announcement of a new project—direction changes directly with the public's view of the project -organized markets make trade safe/reliable and easy

what are three major money market instruments

-treasury bills (issued by the government) -certificates of deposit [CDs] (issued by banks—less than one year, though many CDs have longer maturity) -commercial paper (issues by corporations—borrow $ form investor to quickly fund a project and pay back quickly)

investment decisions

-what assets should the firm own? -a company must decide which people to hire, what equipment to buy, and whether to acquire other businesses -Involves capital budgeting decisions -financing decisions provide the logistics -are important drivers for firm value

default facts about time value of money

1. when interest rate is stated, it's always stated per year—even when the words "per year" aren't found anywhere 2. if nothing is said about the compounding, assume that it's annual

how can we conceptualize financial management?

INVESTMENTS (ASSETS): -current assets (things the company owns that will be cash in 12 months) -fixed assets (machines, property, etc.) FINANCING (CLAIMS): -how a company pays for assets -current liabilities (short-term borrowing) -long-term debt (bonds—long-term borrowing 1+ years) -Shareholders' equity [stock] (you own part of the company. after bondholders are paid, you get leftover amount of dividends)

set up of an income statement

Net Sales — Costs and Expenses (including depreciation) ——————————————— Operating Income (EBIT—earnings before interest & taxes) +Nonoperating Income (interest) — Nonoperating expense (interest) ——————————————— Income before taxes (EBT—earnings before taxes) — Taxes ——————————————— *Net Income*

What is finance

Study of 3 things: 1. Financial management 2. Investments 3. Money and Capital markets

Agency theory

The stockholders (principals) appoint the managers (agents) to act in their interest, so there is a separation between ownership and management -this is the only way to manage a company

Money and Capital Markets

The study of markets were financial assets are exchanged Firms issue securities, buyers buy/sell securities -exchange of securities and funds occurs here

what is a financial asset

a claim against some issuer (example: a bond)

what is a financial market

a place where financial assets trade

balance sheet

a snapshot of the firm at a given point in time Assets = liabilities + stockholders equity Assets: -investment decisions made by management (includes current & fixed assets) Liabilities & Stockholder equity: -financing decisions made by management (includes current liabilities, long-term debt, stockholder equity)

examples of current liabilities

accounts payable, accrued wages payable, taxes payable

examples of current assets

accounts receivable, cash, marketable securities

debt/equity ratio

answers: is a company doing their financing via bonds or stock?

Threat of management termination

being terminated is massive repetitional cost -being aware of that keeps management in line

examples of fixed assets

factories, fleet

important difference between finance and accounting

finance: cash flow based accounting: accrual based -in finance, it is cash flow that matters -investors can use accounting data to assess future cash flows -these cash flow estimates can be used to value the firm

over the counter

firms not listed on a registered exchange can still have their shares traded -electronically links together broker-dealers -no physical building for the exchange -tend to be smaller, tech-oriented companies -ex: NASDAQ

current assets liquidity

in order of liquidity: -cash -marketable securities -accounts receivable -inventory (described by carl ackerman as "savage")

fixed assets

include total property, plant, and equipment, less accumulated depreciation

fundamental financial management decisions

investment and financing decisions

book value of equity

is identical to stockholder equity on the balance sheet

market value of equity

is the aggregate value of a firm's shares. computed via: market value of equity = # shares outstanding x price per share

what are capital markets

long-term financial markets -characteristics: *maturity of one year or more *higher risk *possible illiquidity—private placement bond: bond issue goes to one investor who can't sell it for a certain amount of time

agency problem

managers generally have other motives than maximizing shareholder wealth -problem occurs when managers act in self-interest, rather than stockholder wealth maximization -they have other motives because managers generally only have a small amount of share in the company

primary markets

markets were new securities are bought and sold

definition of net working capital

net working capital = current assets — current liabilities

current liabilities

represent short-term financing by the firm include: -short-term debt -accounts payable -accrued taxes -accrued compensation

long-term debt

represents bonds issued by the firm with a maturity of one year or more

annuity

series of equal and regular cash flows (same amount, same time apart)

how to calculate shareholder wealth

shareholder wealth = # of shares x stock price -a good investment will increase stock price. this measure is straightforward and quantifiable -maximizing price is the same thing as maximizing shareholder wealth

what are money markets?

short term financial markets -characteristics: *short maturity (less than one year) *low risk *liquid

regulation

the SEC regulates new security issues and secondary markets -SEC doesn't tell you what to buy, they just ensure that companies are honest & truthful

what determines a liquidating company's liquidation value?

the outside value of assets to other firms

registered exchange

the physical marketplace (building) where traders gather to exchange securities -still exists because the quickest way to find true price of a security is to have the trading floor scream it -ex: NYSE

Investments

the valuation of financial assets. how much is a bond, or a share of stock worth (financial instruments)? -investors are here

present value of a perpetuity

the value, AS OF ONE INTERVAL BEFORE THE FIRST CASH FLOW IN THE SERIES, of a stream of equal and regular cash flows that go on forever, discounted at an appropriate discount rate -if the cash flows are 1 year apart, the PV(perp) comes out at 1 year before the first cash flow -k(eff) must be calculated for the interval between cash flows

present value of annuity

the value, AS OF ONE INTERVAL BEFORE THE FIRST CASH FLOW IN THE SERIES, of a stream of equal and regular cash flows, to be received for a specified period, discounted at an appropriate discount rate *if cash flows are 2.5 weeks apart, PVA finds the value of the money 2.5 weeks before the first payment *once again, k(eff) must be calculated for the interval between ash flows

future value of annuity

the value, AS OF THE LAST CASH FLOW IN THE SERIES, of a stream of equal and regular cash flows, the be received for a specific period, which accumulate at a specified interest rate *FVA comes out at the MOMENT of the LAST cash flow *you should be indifferent to receiving x amount (calculated through FVA) in the future and receiving the payments *k(eff) must be calculated for the interval between cash flows—CANNOT use any rate

present value of a single cash flow

the value, at a specific point to the left of the timeline, of a future cash flow, discounted at an appropriate discount rate we can choose any effective rate period we wish, as long s we choose the corresponding n

stockholder (shareholder) equity

total assets minus total liabilities, or the shareholders' claims on the firm's assets after all other claimants have been paid sometimes called "residual claimants"

Financial Management

what assets should the firm invest in and how should those assets be paid for? -firms are here

secondary markets

where investors trade existing securities. These markets offer an investor liquidity -can sell investments for cash -The reason why primary markets do well is people aren't afraid to buy, since they know they can sell on a secondary market