Business Finance 321 Final Exam- Definitions

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Risk aversion definition

Assumes investors dislike risk and require higher rates of return to hold risker securities

Definition of inflation premium:

Avg expected inflation rate over the life of the loan

The type of risk associated with corporate bonds

"Credit risk"

Market Capitalization formula:

# of Shares of stock x Market price per share

Annual reports contain these four types of fin. statements:

Balance sheet, income statement, statement of cash flows, statement of stockholders' equity

Call provisions characteristics

Issuers must be willing to pay higher interest rate for callable bonds; must pay "call premium"when calling the bonds; Some have deferred call where bond is not callable for several years;

What does more debt tend to do to the WACC?

It reduces the WACC since after-tax cost of debt is lower than the cost of equity

What is rp in WACC?

It's the component cost of preferred stock where rp is the marginal cost of preferred stock

What is rs in WACC?

It's the cost of common equity where rs is the marginal cost of common equity using RE; re is the rate of return investors require on new eq. issued

What are the three primary sources that make up LT capital?

LT Debt, Preferred Stock, Common Eq.

Five major categories of ratios:

Liquidity (cash), asset management, debt management, profitability, market value

What are High Yield (Junk) bonds?

Lower rated bonds with greater default risk

What does a stock's risk include?

Market risk + diversifiable risk

RPM is defined as what?

Market risk premium-the premium require for bearing the risk of investing in the overall stock market= additional required return over the risk-free rate

When finding the weights in WACC (Wd, Wp, Wc), do we use book weights or market weights?

Market weights

Shareholder Primacy Model:

Maximize the interest of the owners (stockholders) by growing sales and profits to generate a higher stock price

What happens to ROA when debt increases?

ROA decreases because interest lowers NI; ROA= NI/Assets

Will the NPV of a project with the most cash flows coming in later years be severely reduced or increased as WACC increases?

Reduced, because a higher WACC has a greater impact on distant cash flows rather than near term cash flows

Sinking fund provision definition

Requires the issuer to retire a portion of the bonds each year

Maturity risk premium definition:

Risk of capital losses due to future changes in interest rates (price risk)

Factors impacting the interest rate to borrow money:

Risk of the borrower, length of time money is borrowed, collateral provided, type of debt (home, auto, etc.)

Reinvestment risk definition

Risk that a decline in interest rates will lead to a decline in income on a bond portfolio; the bondholder must reinvest at lower interest rates; high risk on ST bonds and callable bonds

Definition of default risk premium:

Risk that the borrower will default (i.e. not make payment)

Liquidity premium definition:

Risk that the security cannot be converted to cash on short notice at its fair value

Diversifiable risk definition:

Risk unique to a particular firm or industry; can be eliminated through diversification

Definition of primary market:

Sale of new additional shares of pubic companies

Financial goal of a business:

Shareholder wealth maximization (i.e.. maximizing stock price)

Should we focus on historical costs or new (marginal) costs?

Since cost of capital is used primarily to make decisions on new projects, we focus on today's marginal costs for the weighted avg cost

What effect does debt have on ROE and equity in general?

Since interest rates from debt lowers NI, debt lowers equity b/c ROE= NI/Equity

Is a portfolio's risk is smaller or larger than the average of the standard deviations of its individual assets?

Smaller

Type of risk associated with municipal bonds:

Some default risk

Coupon interest rate definition

Stated annual interest rate (generally fixed) paid by the issuer

Public corporations include which characteristics:

Stock publicly held by investors, "institutional investors" are large shareholders

Stakeholder Model purpose:

Strike a balance between profits and actions to benefit al stakeholders including stockholders, customers, etc.

What is the intrinsic value?

The "true" value of a company's stock as estimated by investors, analysts, etc.

What does NPV measure?

The project's contribution to shareholder wealth in dollars; if > 0, then accept the project

What is IRR?

The project's expected rate of return in %; rate that forces NPV to be 0.; same calc. as a bond's YTM

What is a Yield to Call (YTC)?

The rate of return on a bond if it is called before its maturity date

What is a yield to maturity (YTM)?

The rate of return that would actually be earned on a bond if it is held to maturity

Portfolio risk definition

The risk an investor would face if they held a group of stocks

Stand-alone risk definition

The risk an investor would face is they held only one stock

Price risk definition

The risk of decline in a bond's price due to an increase in interest rates; risk is higher on bonds with longer maturities

Default risk definition

The risk that the issuer will not make the payments is a key risk faced by bondholders

What does it mean if beta= 1?

The security is just as risky as the avg stock

What does it mean if beta is <1?

The security is less risky than avg

What does it mean if beta > 1?

The security is riskier than the avg

What is beta a measure of?

The stock's "market risk"; normally ranges from 0.5 to 1.5

Since solving for YTC and YTM are the same, what is the only difference between the time to call and the call premium?

The time to call is used for N and the call premium is FV

What is a perpetuity when it comes to preferred stock?

The value of a preferred stock

What does P stand for?

The value of a stock

What does the Discounted Dividend Model state?

The value of a stock equals the PV of the future dividends expected to be generated by the stock; hard to estimate all future dividends

What is the horizon or terminal value (TVn)?

The value of the FCF's after growth becoming constant based on a forecasted growth rate (g)

What do the w's and r's refer to in the WACC calculation?

The w's represent the firm's capital structure weights The r's represent the cost of each component

What does the expected rate of return of an investment portfolio equal?

The weighted avg of the expected returns of the portfolio's individual assets; NOT the riskiness

Expected Rate of Return Definition

The weighted avg of the probability of all the outcomes, representing the return expected from the stock investment

Why is new common equity more costly than common eq. from RE?

There are flotation costs associated with the new common eq.

What does a tighter or more peaked probability distribution curve mean?

There's a higher chance the actual rate of return on the stock will be close to the expected rate of return; tighter the distribution, the lower the risk

What is the purpose of bond ratings?

They are designed to reflect the probability of a bond issue going into default

What does it mean when investors are "risk averse"?

They like high returns and dislike high risk

What is the effect of low interest rates?

They stimulate foreign investment and consumer spending

What is the most important concept in finance?

Time Value of money: Also called discounted cash flow (DCF) analysis

Definition of secondary market:

Trading in outstanding shares of public companies

Four types of bonds:

Treasury bonds, corporate bonds, municipal bonds, foreign bonds

Name one use and two limitations of financial statements:

Use: ability to review and analyze fin. statements as well as accompanying footnotes; Limitations: managers use their own discretion (inconsistent) or how and when to record transactions; cash flow is more important than accounting income- modifications to fin. statements have to be made to accommodate this

Standard Deviation purpose:

Used as a measure of stand-alone risk; the smaller the SD, the tighter the probability distribution, the lower the risk that returns will vary

What is the discount rate used?

WACC or the weighted avg cost of capital

What is the Effective Annual rate (EFF%)?

also called equivalent annual rate (EAR)- annual Interest rate actually being earned

Types of risks associated with foreign bonds:

default risk and currency risk (exchange rate risk)

Warrant definition

long-term option to buy a stated number of shares of common stock at a specified price

What is the cost of debt in WACC?

rd(1-T) where rd is the marginal cost of debt capital

Three sections of balance sheet:

Assets, liabilities, stockholders' (owners') equity

What types of bonds are rated BBB or higher?

Investment-grade bonds

Correlation coefficient definition

A measure of the degree of correlation between two variables (stocks)

What is an Ordinary Annuity?

A payment at the end of a period

Steps in capital budgeting:

1. Est. cash flows 2. Determine the company's cost of capital (WACC) 3. Calc one or more decision criteria (see slide 11-4)

Who is are the top two and bottom two on a priority list when it comes to liquidation?

1. Secured creditors (collateralized bonds 2. Bankruptcy trustee costs 7. Preferred stock 8. Common stock

Federal taxes range from

15% to 35%

Federal and state typically used

40%

Typical average state tax

5%

Mortgage bonds definition

A bond backed by a pledge of specific assets as collateral

Bankruptcy definition:

A business has insufficient cash to meet its payment obligations, and thus becomes insolvent

Income Statement summarizes:

A company's financial results (revenue, expenses, NI) over a period of time (quarterly, (semi)annually, etc.)

Statement of cash flows summarizes:

A company's use of cash and receipts of cash over a period of time

Capital Asset Pricing Model (CAPM) definition

A financial model showing the relationship between risk and required returns when stocks are held in a portfolio

What is an amortized loan?

A load repaid in equal payments over its life where each payment consists of part interest and part principal

If IRR>WACC, should we accept or reject the project?

Accept, and vice versa if IRR<WACC; if both independent then accept both if both IRR> WACC=10%

Do stockholders focus on before-tax or after-tax capital costs?

After-tax cash flows

Private corporations include which characteristics:

Aka "closely held" corps, not publicly traded, stock owned by owners and managers

What is a nominal rate?

Aka annual percentage rate (APR0, quoted rate or stated rate; ignores compounding effects

Corporate valuation model is what?

Aka the free cash flow method i.e. the value of the entire firm equals the PV of its future free cash flows

Which stocks does a market risk impact?

All of them; can't be eliminated

Three reason financial analysts common size fin. statements:

Allows for comparisons of fin. statements b/c it eliminates size effects when comparing: 1. Results of one company to a competitor of diff. size 2. Results of same company of one year to the next 3. Results of the company compared to budget

Putable bond defintion

Allows holder to sell the bond back to the company prior to maturity

What is a periodic rate?

Amount of interest charged each period

What is a perpetuity?

An annuity that goes on forever

Proxy fight definition

An attempt by a group of stockholders to gain control of the company by controlling the voting shares

Debentures defintion

An unsecured bond i.e. no collateral

Does GAAP require items to be recorded at book value or market value?

Book value

Three ways to determine the cost of equity for RE, rs:

CAPM, Bond-Yield-Plus-Risk-Premium, or Dividend-Yield-plus Growth-Rate (DCF); CAPM is the most widely used

What is the cost of capital?

Calculated as the weighted avg of the various types of funds used over time by the firm

Common-Size balance sheets are calculated by:

Calculating individual items as a percent of total assets

Common-Size income statements are calculated by (See slide 4-15):

Calculating individual line items as a percent of sales

Dividends definition

Cash payment of company's earnings to shareholders

Statement of Stockholders' Equity summarizes:

Change in equity between the beginning and end of the period; shows how much of the earnings were retained rather than paid as dividends

Two main chapters of bankruptcy:

Chapter 11 Reorganization (business survives) and Chapter 7 Liquidation (worth more dead than alive)

Types of financial institutions:

Commercial and investment banks, pension funds, hedge fund, ETFs, Private eq. firms, college endowment funds, fin. service corps, life insurance companies

Definition of a classified stock

Common stock given a special designation such as Class A or Class B

Who analyzes fin. statements?

Company managers, banks/lenders, stockholders/investors, the SEC and IRS

What is benchmarking?

Comparing firm's performance to other firms in the same industry

Four key topic areas of finance:

Corporate finance, capital markets, investments, international finance

What is the real interest rate?

Current interest rate- Current inflation rate

Maturity date definition

Date bond principal is to be repaid

Does the call premium increase or decrease over time as bond approaches maturity?

Decreases

What is combining stocks into a portfolio to reduce risk called?

Diversification

Two sources of cash flow that the stock value derives from?

Dividends and capital gains

Coupon payment definition

Dollars of interest per payment

Examples of stock indexes:

Dow Jones Industrial Avg. (DJIA), S&P 500 Index, NASDAQ, Russell 2000 & 3000, MSCI EAFE

EBIT stands for:

Earnings before interest and taxes (aka Operating income)

EBITDA stands for:

Earnings before interest, taxes, depreciation and amortization

EBT stands for:

Earnings before taxes

Why is there a cost for RE?

Earnings can be reinvested or paid as dividends; there's an opportunity cost for the investor

Call provision definition

Gives issuer right to redeem the bonds early (ex. if interest rates decline)

Long term trends include:

Globalization of banking and commerce, more efficient and complex int'l financial markets, tech advancements

Convertible bond definition

Exchangeable for common stock of the issuer, at the bondholder's option

Expected Rate of return equals

Expected dividend yield + Expected growth rate or CGY

Par value definition

Face amount of the bond to be repaid at maturity

Four factors influencing interest rate levels:

Federal reserve policy, federal budget surplus or deficit, international factors, level of business activity (recessions)

What are flotation costs?

Fees paid to the investment banker

Balance sheet shows a company's:

Financial position at a specific point in time

The cash flow available AFTER the company has invested money is called:

Free cash flow

The "true value of a company is based on its:

Future cash flows AFTER taxes

What are flotation costs the highest and lowest for?

Highest- common eq.; Lowest-bond issuance

What is an amortization tables used for?

Home mortgages, auto loans, business loans, retirement plans, etc.

Premiums added to ST Treasury issuances:

IP

Premiums added to LT Treasury issuances:

IP and MRP

Premiums added to ST Corp. issuances:

IP, DRP, and LP

What determines the shape and slope of the yield curve?

IP, LP, DRP, MRP

Premiums added to LT Corp. issuances:

IP, MRP, DRP and LP

What is a discount bond and what occurs for a bond to become one?

If the market rate of interest is higher than the coupon rate, a bond's price will fall below its par value

What is a premium bond and what occurs for a bond to become one?

If the market rate of interest is lower than the coupon rate, the bond's price will increase above its par value.

Weaknesses of payback:

Ignores the time value of money, ignores cash flows after payback period

What's the difference between independent and mutually exclusive projects?

Independent projects' decisions are made separate from the others whereas with mutually exclusive projects, you only select one

Users of capital:

Individuals and institutions needing to raise funds to finance their investment opportunities and willing to pay a rate of return on the capital they borrow

Limitations to fin. ratio analysis

Industry avg may not be good; seasonal factors, historical values, and diff. accounting practices may distort ratios, "window dressing" may make ratios look better

Definition of IPO:

Initial public offering; initial sale of public stock by a private company; allows the company to raise money from outside investors

Suppliers of capital (money):

Institutions and individuals with "excess funds" that are saving money and looking for a rate of return on their investment

Why does rd only need adjustment in WACC?

Interest is tax deductible

What happens to interest and principal for each payment as time goes on?

Interest paid declines and principal paid increases

Indexed bond definition

Interest rate paid is based upon the rate of inflation

If a lower-rated bond carries a higher risk, what subsequently happens to the interest rate?

Interest rates also rise

Three factors affecting WACC:

Interest rates in the economy, level of stock prices in the market, tax rates

What does MIRR stand for?

Modified internal rate of return

Are short term interest rates more or less volatile than long term interest rates?

More volatile; they rise rapidly during booms and vice versa during recessions

Which method do we choose as the preferred method to make decisions to accept or reject? NPV or IRR

NPV

Two leading markets in the Stock Market:

NYSE (New York Stock Exchange), NASDAQ

Are EBITDA, EBIT, and EBT found in GAAP financial statements?

No

Are dividends on preferred stock or common stock tax deductible?

No

Treasury bond risks:

No risk of default

Does a change in WACC (cost of capital) impact the IRR?

No, because IRR is fixed for a set of cash flows. NPV does change however.

Statement of cash flows is split into three categories:

Operating activities, investing activities, and financing activities

What happens to P/E if growth and profitability are high and risk is low?

P/E is high

Value of a bond equals

PV of its FCF using the bond's market rate of interest (rd%)

What is an Annuity Due?

Payment at beginning of period (first payment is at time 0 on timeline

Income bond definition

Pays interest only when interest is earned by the issuer

Factors affecting bond ratings and default risk:

Potential labor problems, pension liabilities, provisions of the bond contract, financial performance, potential antitrust or product liabilities, accounting policy issues

Two types of corporations:

Private and public corporations

Impact of (well-off) financial. markets:

Promote economic growth, economies perform better, facilitation of the allocation of capital

Strengths of payback:

Provides an indication of a project's risk and liquidity

Takeover definiton

Purchasing the majority of outstanding stock in order to control the company

Risk premium (RP) definition

The Difference between the expected return on a risky asset vs. a less risky asset

What is the enterprise value?

The PV of all the firm's FCF's, the value of the entire company

rRF is what?

The Risk-Free Rate

DSO calculates what?

The average number of days after making a sale before receiving cash

What is re?

The common cost of new stock

What does g stand for?

The constant growth rate, also the stock price growth rate

What is the stock price?

The current price on the market and the PV of all expected future cash flows

What is the Yield Spread?

The gap between interest rates on different types of bonds

Capital gains definition

The growth in the price of the stock between time or purchase and time of sale

WACC is also known as what?

The hurdle rate; the rate that a specific project must exceed to be an acceptable project

What does MV of equity represent?

The market value of the common stock

Beta (b) is defined as what?

The measure of the risk of a specific stock held in a well-diversified portfolio and the extent to which the price of a stock goes up or down compared with the stock market (volatility)

What is the payback period?

The number of years required to recover a project's cost; calculated by adding project's cash inflows to its cost until cumulative cash flow turns positive;

What is an interest rate?

The price lenders receive and borrowers pay for debt capital (i.e.. loans)

What is another name for interest rates?

The price of debt

What is capital budgeting?

The process of analyzing projects and deciding which ones to include in the capital budget

Does YTM change or is it fixed?

YTM changes daily as interest rates change or as the market price of the bond changes

Do changes in inflation impact interest rates?

Yes

Is there a direct correlation between the amount of risk and return?

Yes, there's a direct correlation.

Relationship between Treasury and corporate issue yield curves

Yield curves for corp. securities are high due to greater default risk and liquidity premiums; The yield spread widens as corp. bond rating decreases (riskier the corp, the higher the yield curve)

What is a bond?

a LT debt instrument in which a borrower (issuer) agrees to make payments of principal and interest to the investors (bondholders)


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