Finance Chapters 11-15

what is capital mix determined by?

-Considering present capital structure -Ascertaining if current position is optimal

a shelf registration allows

-a firm to take advantage of market conditions -a from to issue additional securities without SEC approval

shortcomings of payback method

-ignores the time value of money -ignores cash flows after the payback period -shorter payback period does not always mean a more desirable investment

preferred stock is usually issued by companies that have what characteristics?

-low prices for their common stock - a high debt to equity ratio

Explain Correlation Coefficients

A numerical value that identifies the strength of the relationship between variables. -1 to 1 linear relationship -1 = negative, no meaning +1 = positive, things go in the same directions. +1 is the strongest relationship

the reinvestment rate for projects measured with IRR is

All inflows from the investment can be reinvested at IRR.

what do we use for risk on stock?

Beta

what is the actual measurement of risk?

Beta

what is used rather than earnings in capital budgeting decisions?

Cash flow

in capital budgeting decisions, emphasis is on what?

Cash flows rather than earnings

what adds up to weighted average cost of capital?

Debt, preferred stock, common equity.

the reinvestment rate for projects measured with NPV is?

Equal to discount rate

what happens in secondary trading?

Funds flow between investors

Users of Capital in U.S.

Government - Lender Corporations- Lender Households- Borrower

Example of a bond with risk free rate

Government bonds

explain federal government agency bonds and provide two examples of who offers them

Government bonds are issues at low rates with mature dates - Freddie mac -Sally Mae

highly correlated investments move

In the same direction during good and bad times.

low cost debt may . . .

Increase overall risk of the firm, may eventually make all forms of financing more expensive.

time increases/decreases risk?

Increases

how to find cost of debt?

Kd= Y(1-T)

Capital Rationing

Limit set on the amount of funds available for investment

Reinvestment assumption of NPV

Makes a more conservative assumption that each inflow can be reinvested at Cost of capital or discount rate

NASDAQ

National Association of Securities Dealers Automated Quotations

NYSE

New York Stock Exchange

depreciation is what?

Noncash expenditure that is added back to profit

follow on equity offer

Offering more stock later after IPO

sources of capital for common stock equity?

Purchaser of new shares - external source Retained earnings - internal source

Corporate Restructuring

Radical change to an organization's internal and external relationships. selling off parts of the company.

who controls the markets?

SEC

what set up the markets we know today?

Securities act of 1933

money market

Securities with a maturity of less than one year. Treasury Bills and Commercial Paper

the portfolio effect

The impact of a given investment on the overall risk-return composition of the firm. A firm must consider not only the individual investment characteristics of a project but also how the project relates to the entire portfolio of undertakings.

what are the four primary roles of investment bankers? (describe each)

Underwriter - contracting to buy securities from corporation Market maker - engage in buying and selling of securities to ensure a liquid market Advisor - advise of types of securities and when to sell Agency functions - link buyer and seller as a broker

Investment banker functions

Underwriter, Market maker, advisor, agency function.

If IRR is the same as discount rate, what would NPV of project be?

Zero

what is an investment banker?

a financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds

decision tree

a graph of decisions and their possible consequences; it is used to create a plan to reach a goal

net present value profile

a graphical representation of the relationship between an investment's NPVs and various discount rates

liquid market

a market in which stock can be bought and sold fairly easily through an organized exchange

Shelf Registration

a procedure that allows firms to file one registration statement for several issues of the same security

market makers

act as the stabilizing influence, wont let price drop. This is legal for a short period of time when it initially comes to the market. "stabilization period"

what is the reinvestment assumption of IRR

all inflows from a given investment can be reinvested at IRR

what can a replacement decision be analyzed by?

analysis of both old and new machines and incremental analysis of cash flow of old and new machines.

ECN's have transformed security markets by

automatically matching buy and sell orders at a lower cost

what does financial capital consist of?

bonds, preferred stock, common equity.

when you issue stocks and bonds you are entering the

capital market

how can risk be reduced?

combining risky assets with low risk or negatively correlated assets.

high risk

completely new market

how to find tax deductible gain or loss on on old asset?

compute book value compared with sale price

simulation models

computerized models that can be tested under different scenarios to identify acceptable solutions to problems

what does payback method consider and fail to consider?

considers liquidity but fails to consider time value of money.

the investment banker is the link between who

corporations in need of funds and investor

who do retained earnings belong to?

current stockholders- paid as dividends or reinvested in the firm.

reduce weighted average costs has to do with the weight of what?

debt and equity

Optimal Capital Structure

desire to achieve minimum overall cost of capital

where do the treasury, government agencies, and corporations raise funds?

domestic capital markets

why do we adjust discount rate higher than capital?

economic changes, policy changes, technology changes.

ECNs

electronic communication networks

advantages of payback method?

emphasizes liquidity and ease of use.

standard deviation isn't helpful if

expected values differ

when does accurate forecasting become more difficult?

farther out in time

what are reasons for capital rationing?

fear of too much growth hesitation to use external sources of financing

what securities are available in the capital market?

federal Government, government agencies, state governments, local municipalities

how do you raise money?

go to the capital market and issue stocks and bonds

larger standard deviation means

greater risk

What is the NYSE?

has designated markets on floor, is not all electronic.

the further down the line the securities are sold the

higher the potential profit

Negatively correlated investments move

in opposite directions and are a greater risk reduction

How is risk measured?

in terms of losses and uncertainty

difference in NYSE and NASDAQ

in the NYSE each trade is made on the floor and NASDAQ can be done online without the need of physical trading

What is the cost of debt?

interest rate at which company raises new capital

what are some examples of market influencers

interest rates, exchange rates, economic growth

Who are intermediaries?

investment bankers

What is the NASDAQ?

largest electronic stock market in the U.S. - the National Association of Securities Dealers Automated Quotation System The NASDAQ Composite Index measures all domestic and international stocks listed on The NASDAQ, which number over 3,000.

after shares have started trading the investment banker will do what?

make a market in the security to ensure a liquid market?

what is the NPV reinvestment assumption?

makes a more conservative assumption that each inflow can be reinvested at equally higher rate.

to reduce risk you add together what types of investments

negatively correlated to current investments

what is the often preferred investment selection method?

net present value

what are preferred methods of capital budgeting?

net present value and internal rate of return

moderate risk

new equipment

why do many investment decisions occur?

new technology

what are the three methods for evaluating capital expenditures?

payback internal rate of return net present value

risk averse

prefer to avoid risk, expect higher value of return for risky investments.

for a project to be potentially accepted

profitability must equal or exceed cost of capital

money raised by sale is usually invested in

real capital of firm, long term productive assets of plant and equipment.

example of low or no risk

repair of old machinery

explain underwriting spread along with participants

represents total compensation for all participants in the distribution process.

investors are

risk averse

what are simulation models driven by

sales forecast

what is a capital market?

securities greater than a year such as bonds, common stock, and preferred stock.

what is a capital market made up of?

securities that have a life of one year or longer

What did the Glass-Steagall Act do?

separated commercial banking from investment banking

what do we use for risk on projects?

standard deviation

when creating a stock/bond ratio you want to keep

standards the same across the board

what securities are tax exempt

state and local

Who owns the company?

stockholders, common stock

According to the efficient market hypothesis, if the stock price includes all information, both public, and private it is said to be

strong form efficient

security markets exist to aid

the allocation of capital among households, corporations, and governments.

payback method

the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows

Internal Rate of Return (IRR)

the discount rate that makes the NPV of an investment zero

how is private placement of equity different from a public offering?

the equity is purchased directly by the investor and it cannot be resold in the public security markets

the larger the coefficient

the greater the risk

lower distribution process means

the higher the price for shares

What is opportunity cost?

the loss of potential gain from other alternatives when one alternative is chosen.

Net Present Value

the present value of current and future benefits minus the present value of current and future costs

Capital Budgeting

the process of planning and managing a firm's long-term investment decisions.

risk premium

the rate of return that financial investors require to hold risky assets minus the rate of return on safe assets

target stock/bond ratio?

the ratio of percentage of stocks and bonds to raise funds.

what contributed to the worldwide demand for capital?

the reduction in telecommunication costs

Net Present Value (NPV)

the sum of the present values of expected future cash flows from an investment, minus the cost of that investment

leverage

the use of borrowed money to supplement existing funds for purposes of investment

what does it mean to be correlated?

to move together

Managing investment banker wants to share risk

true

Investment banker

underwrites new issues of securities for corporations, states, and municipalities

higher standard deviation cash flows are created by

unexpected events

define risk in terms of what?

variability

what makes something so risky?

variability

return has to exceed

weighted average cost of capital

yield to maturity indicates

what firms must pay on before tax basis

What is the cost of capital?

what is costs to get money, weighted average cost of source of financing to the firm.

why do foreign investors invest in US stock?

will continue to prosper and politically stable

internally generated sources of funds come through two primary sources what are they?

working capital and sale of assets