Corporate Finance Final

What is a pure discount loan? An interest-only loan?

-A pure discount instrument is a type of security that pays no income until maturity. Upon expiration, the holder receives the face value of the instrument. -An interest-only loan is a loan that temporarily allows you to pay only the interest costs, without requiring you to pay down your loan balance. After the interest-only period ends, which is typically five to ten years, you must begin making principal payments to pay off the debt.

What does it mean to amortize a loan?

-An interest payment based on the unpaid principal balance as of the beginning of the month -A principal payment that will cause the unpaid principal balance to decrease each month so that the principal balance will be zero at the time of the final payment

What is indenture? What are protective covenants? Give some examples.

-The indenture is the written agreement between the corporation (the borrower) and its creditors. "Deed of trust". Legal document made for tedious reading, but includes, the basic terms of bonds, total amount of bonds issued, description of property used as security, the repayment arrangements, the call provisions, details of the protective covenants. -Protective Covenant- part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan. -Negative covenant: limits or prohibits actions the company might take. -Positive covenant: specifies an action the company agrees to take or a condition the company must abide by

Describe how to calculate the future value of a series of cash flows.

1 Plug the first of a series of cash flows into the formula C(1 + R)^Y. In the formula, C represents the cash flow, R represents the interest rate the cash flow will earn each period and Y represents the number of periods the cash flow will earn interest.

Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions? When might they conflict?

1. If the project are independent and the cash inflow of the project are positive without even a single negative cash flow during the life of the project both NPV and IRR will give the same result. 2. The life of the project should be the same, and there should be no multiple investment in the project. Conflict between NPV and IRR 1. The conflict between IRR and NPV occurs when the project are mutually exclusive. A mutually exclusive project is a project where accepting one project will lead to a rejection of another project. 2. The result also varies if the intial amount of investment is differnet, if the net cash flow pattern of the project is different, with the variation of life of the project and if it has a multiple investment option. Even if the project are independent, if the cash flows during the life of the project are negative even for a single particular year, the conflict will arise between IRR an NPV.

What is a balloon payment? How do you determine its value?

A balloon payment is a larger-than-usual one-time payment at the end of the loan term. If you have a mortgage with a balloon payment, your payments may be lower in the years before the balloon payment comes due, but you could owe a big amount at the end of the loan

What is the difference between a securities broker and a securities dealer?

A broker is a person who executes the trade on behalf of others, whereas a dealer is a person who trades business on their own behalf

What is a proxy?

A proxy is an agent legally authorized to act on behalf of another party or a format that allows an investor to vote without being physically present at the meeting.

What is a sinking fund?

A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond's maturity.

What is a sunk cost? An opportunity cost?

A sunk cost refers to money that has already been spent and which cannot be recovered. Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them.

What is an APR? What is an EAR? Are they the same thing?

APR refers to the annual percentage rate that is interest rate which is quoted by investment and EAR is an effective annual rate which is calculated by using the APR rate is given and so both the rate are different as EAR would consider the compounding elements given in APR.

Unless we are explicitly told otherwise, what do we always assume about the timing of cash flows in present and future value problems?

Cash Flows occur at the end of the month

What rights do stockholders have?

Common shareholders are granted six rights: voting power, ownership, the right to transfer ownership, dividends, the right to inspect corporate documents, and the right to sue for wrongful acts

What does continuous compounding mean?

Continuous compounding means the interest earned on investment is continuously compounding indefinite period of time and so the investment amount under continuous compounding is higher than under other investment

What are the distinguishing features of debt compared to equity?

Debt is an amount that is payable to a person or organization for the amount of funds that has been borrowed. Equity is the ownership interest of shareholders in a corporation in the form of common stock or preferred stock. Payment of interest on the debt is tax-deductible - the cost of doing business - and debt holders are not like equity owners because unpaid debt is a liability.

What is meant by the term depreciation tax shield?

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

Explain what erosion is and why it is relevant?

Erosion can include any negative impact on a company's associated assets or funds. Erosion can be experienced with regard to profits, sales, or tangible assets, such as manufacturing equipment. Erosion is often considered a general risk factor within an organization's cash management system, as the losses may be slow and occurring over time.

What are the relevant cash flows for valuing a share of common stock?

Expected Future dividends

What is the Treasury yield curve?

It is a plot of the yields on all Treasury maturities ranging from 1-month bills to 30-year bonds. In normal circumstances, it has an arcing, upward slope because bond investors expect to be compensated more for taking on the added risk of owning bonds with longer maturities.

Why is preferred stock called preferred?

Preferred stock shares are "preferred" because they have the preference over the common shares to receive dividends and company assets if the business is liquidated. If a company does not have enough cash to pay dividends to both the preferred shares and the common shares, the preferred shareholders must be paid first.

Describe how to calculate the present value of series of cash flows

Present Value=FV/(1+r)n where: FV=Future Value r=Rate of return n=Number of periods​

What is the definition of project operating cash flow? How does this differ from net income?

Project Operating Cash Flow is defined as the operating cash flow required for the day to day operation of the project. Project operating cash flow= Project cash flow+ Project change in net working capital+ Project capital spending.

What do you think would be the effect of a put feature on a bond's coupon? How about a convertibility feature? Why

Put feature of a bond allows bond holders to force bond issuers to buy back at a stated price. Whenever the market rate of interest increases bondholders force issuers to buy the bond, this is a risk for issuer so that they give lesser coupon. Convertibility feature give an option to bondholders to convert its bond-holding for fixed number of shares before maturity. The number of shares gets fixed at the time of issue of bond. The same could be known from the indenture.

Is it true that the only risk associated with owning a bond is that the issuer will not make all the payments?

no, another risk is the interest rate risk, meaning the price of the bond fluctuates with changes in the interest rate

For the shark attractant project, why did we add back the firm's net working capital investment in the final year?

At the end of the project's life, the fixed assets will be worthless, but the firm will recover the money that was tied up in working capital. This will lead to cash inflow in the last year. On a purely mechanical level, notice that whenever we have an investment in net working capital, the same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.

Why do we say bond markets may have little or no transparency?

Because it is not easy to observe neither the bond prices nor the trading volume. Transactions are negotiated between the parties with no centralized reporting.

Why do we say that the payback period is, in a sense, an accounting break-even measure?

Because time value if ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.

What is the general expression for the value of a bond?

Bond value = PV of the coupons + PV of the face value. Bond Value = C x [1-1 / (1+r)^t] / r + F / (1+r)^t Where C is the coupon payment and F is the face value.

What does a bond rating say about the risk of fluctuations in a bond's value resulting from interest rate changes?

Bond-rating are concerned only with the possibility of default. Bond-rating does not measure interest rate risk, which is the risk of a change in the value of a bond resulting from a change in interest rate. As a result, the price of a highly rated can still be quite volatile

What are the most commonly used capital budgeting procedures?

IRR or NPV

If an interest rate is given as 12 percent compounded daily, what do we call this rate?

If an interest rate is given as 12 percent compounded daily refers to quoted interest rate that is interest rate quoted at the time of investment.

How would you state the profitability index rule?

If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.

In words? what is the discounted payback period? Why do we say it is, in a sense, a financial or economic break-even measure?

In discounted payback period, first expected future cash inflows are discounted. By discounting the cash flows time value of money is considered. Discounted payback periods is considered as financial or economic break-even measure as time value of money is considered. In other words, it gives the time required for initial amount to recover along with interest that could be earned elsewhere. Thus, discounted payback is break-even in financial or economic terms.

What are the top-down and bottom-up definitions of operating cash flow?

In the Top-down approach: we start at the top of the income statement with sales and work our way down to net cash flow by subtracting costs,taxes,and other expenses. Along the way, we simply leave out any non cash items such as depreciation. The bottom-up approach, we start with the accountant's bottom line( net income) and add back any non cash deductions such as depreciation. It is crucial to remember that this definition of operating cash flow as net income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income.

Why might an income bond be attractive to a corporation with volatile cash flows? Can you think of a reason why income bonds are are not more popular?

Income bonds differ to conventional bonds only in one aspect that is payment of coupon. The payment of interest on income bonds depends upon the income of the company. The company makes payments of interest to bondholders if the company has a sufficient amount of income to pay interest on the bond. These bonds appear attractive if the company has a good record of earnings. The volatility in the income of the issuer company is the only reason (in slowdown state of the economy) which restricts it to become popular.

Explain why interest paid is an irrelevant cash flow for project evaluation?

Interest paid is a financing expense, not a component of operating cash flow

Why is it important to consider changes in net working capital in developing cash flows? What is the effect of doing so?

It is important to consider changes in net working capital in developing cash flows because net working capital requirements change as sales change. Every year businesses will generally either add to or recover some of its project net working capital. An increase in net working capital is a cash outflow it shows positive sign represents net working capital returning to the firm.

What are the weaknesses of the AAR rule?

It is not a true rate of return because the time value of money is ignored. It uses an arbitrary benchmark cutoff rate. Lastly, it is based on accounting net income and book values, not cash flows and market values.

If we say investment has an NPV of $1000, what exactly do we mean?

It means that the cost of obtaining the cash flows for investment have been subtracted from the expected cash flows which give us the NPV of $1000 which is positive so we should move forward with it.

What is a junk bond?

Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.

What is the difference between a nominal and a real return? Which is more important to a typical investor?

Nominal rates are called "nominal" because they have not been adjusted for inflation. Real rates are rates that have been adjusted for inflation Real interest rate = nominal interest rate - expected inflation rate

What is the value of a share of stock when the dividend grows at a constant rate?

P= D(little)1 / R-G P= Current price of the stock D= Next dividend expected r= Required return of investor g= Constant growth rate

What are the cash flows associated with a bond?

There are two: (1) Regular interest payments called coupons and (2) the face value to be paid at the end.

In setting a bid price, we used a zero NPV as our benchmark. Explain why this is appropriate.

Setting a zero NPV is appropriate because it ensures that underbidding does not happen. Since a zero NPV takes into account your expected rate of return, it ensures that the bidder does not lose out by lowering the bids too much.

Under what circumstances do we have to worry about unequal economic lives? How do you interpret the EAC?

The EAC( Equivalent annual cost) approach is appropriate when comparing mutually exclusive projects with different lives that will replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared. For example, if one project has a three-year life and the other has a five-year life, then a 15- year horizon is the minimum necessary to a place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid, implies that the project cash flows remain the same over the common life, thus ignoring the possible effects of inflation, changing economic conditions, increasing unreliability of cash flow estimates that occur far into the future, and the possible effects of future technology improvement that could alter the project cash flows.

What are the relevant incremental cash flows for project evaluation?

The Relevant cash flows are the incremental cash flows associated with the decision to invest in a project. The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows, that are a direct consequence of taking the project.

What is an average accounting rate of return (AAR)?

The accounting rate of return (ARR) is the percentage rate of return expected on investment or asset as compared to the initial investment cost. ARR divides the average revenue from an asset by the company's initial investment to derive the ratio or return that can be expected over the lifetime of the asset or related project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business. ARR=Average Annual Profit/​Initial Investment

If NPV conceptually the best procedure for capital budgeting, why do you think multiple measure are used in practice?

The accurate measure of NPV depends upon the accurate rate of discounting. Many times a project with GOOD IRR gets rejected due to lower NPV. So that evaluation a project at different measure becomes essential to take correct decisions

What advantage(s) does the discounted payback have over the ordinary payback?

The advantages of discounting cash flows are as followed: - it considers time value of money -The investment with negative Net Present Value is not accepted.

Which is bigger the bid price or the ask price?

The ask price, also known as the "offer" price, will almost always be higher than the bid price.

In general, what are bid and ask prices?

The bid price is what buyers are willing to pay for it. The ask price is what sellers are willing to take for it. If you are selling a stock, you are going to get the bid price, if you are buying a stock you are going to get the ask price.

What is the difference between a bond's clean price and its dirty price?

The clean price is the price of a coupon bond not including accrued interest payments A dirty price is a bond pricing quote, which refers to the cost of a bond that includes accrued interest based on the coupon rate. Bond price quotes between coupon payment dates reflect the accrued interest up to the day of the quote. In short, a dirty bond price includes accrued interest while a clean price does not.

How does NASDAQ differ from the NYSE?

The main difference between Nasdaq and NYSE is their markets. Nasdaq is a dealer's market, with participants trading through a dealer rather than directly with each other, while NYSE is an auction market, which enables individuals to transact between each other on an auction basis.

What is net present value rule?

The net present value rule is the idea that company managers and investors should only invest in projects or engage in transactions that have a positive net present value (NPV). They should avoid investing in projects that have a negative net present value. It is a logical outgrowth of net present value theory

In words, what is the payback period? The payback period rule?

The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to hit breakeven. It is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of the investment, the payback period is five years.

In general, what is the present value of an annuity of C dollars per period at a discount rate of r per period? The future value?

The present value of $C per period at a discount rate of "r" is C X{[1-(1+r)^t]/r}; The future value is C X {[(1+r)^t]-1/r}

In general, what is the present value of a perpetuity?

The present value of a perpetuity is Cash flow/Interest rate or yield

What is the stand-alone principle?

The principle that a company should decide whether or not to do a project based on the profitability of similar projects with the same risk.

What six components make up a bond's yield?

The real rate, expected future inflation, interest rate risk, default risk, tax-ability, and lack of liquidity

In general, what is the relationship between a stated interest rate an an effective interest rate? Which is more relevant for financial decisions?

The stated interest rate is APR which is used to determine the EAR that is effective annual rate. Effective annual rate is calculated as 1 plus APR rate which is raised to n which is a number of compounding in the year. EAR is the actual interest that is eared on investment which is earned on an investment and is, therefore, more relevant for decision making than APR.

What is the term structure of interest rates? What determines its shape?

The term structure of interest rate is the relationship between the short-term and long-term interest rates. Investors believe that the shape of the yield curve reflects the future expectation for interest rates of the entire market and monetary policy's circumstances. Long Term rates are higher than short term rates, the term structure is upward sloping. Short term rates are higher than long term rates, the term structure is downward sloping.

Does the value of a share of stock depend on how long you expect to keep it?

The value of a share does not depend upon the holding period of the investor. Things that matter are required returns to investors, dividends paid and growth rate in dividend.

How is depreciation calculated for fixed assets under current tax law? What effects do expected salvage value and estimated life have on the calculated depreciation deduction?

Under Modified ACRS Depreciation( MACRS) is that every asset is assigned to a particular class. An asset's class establishes its life for tax purposes. Once an asset's tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage. The expected salvage value( what we think the asset will be worth when we dispose of it) and the expected economic life( how long we expect the asset to be in service) are not explicitly considered in the calculation of depreciation.

Is it generally true that an advantage of the IRR rule over the NPV rule is that we dont need to know the required return to use the IRR rule?

Yes, IRR can estimate without the appropriate discount rate. For calculating IRR the required return is not required like that of NPV. As the name suggests it the minimum required rate of return for the project, because at IRR, NPV will be equal to zero. The projects required rate will be compared with IRR before making a decision of accepting or rejecting the project. Thus, for estimating IRR, an appropriate discount rate is not required.

What does the profitability index measure?

describes an index that represents the relationship between the costs and benefits of a proposed project

What is the Fisher Effect?

he Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.