Finance 300

present value interest factor

PVIF(r,t) Assuming strictly positive interest rates, a number less than one that transforms a larger future value into an equivalent smaller present value

Evaluate the following statement: Managers should not focus on the current stock market value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. - If this is correct, then the statement is false.

What are the primary disadvantages and advantages of the corporate form of Organization?

Primary Disadvantage: - double taxation to shareholders of distributed earnings and dividends. Advantages: - limited liability, - ease of transferability, - ability to raise capital - unlimited life.

Compound annual growth rate (CAGR)

The annual rate of return that generates an ending balance from a beginning balance if the one reinvests the profits at the end of each year

Time Value of Money (TVM)

The concept that economic agents have preferences over when money is paid or received due to opportunity costs

Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire the outstanding stock. Your company's management begins to fight this bid. Is management acting in shareholders best interests?

The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country?

The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions

simple interest

The interest an investment earns on the original principal only. - growl linearly

interest-on-interest

The interest earned on prior interest payments becoming principal - grown exponentially - becomes a larger portion of the future value as time passes

periodic interest rate (r)

The interest rate defined in a contract that specifically states how much interest is earned or paid over an interval of time

Compounding

The process of reinvesting earnings to generate interest-on-interest on an investment or debt - the process of determining the FV of an investment

pure discount loan

The simplest possible loan that involves two cash flows. Initially, the principal changes hands then the borrower pays back the principal and interest with a single payment at a later date. Also known as a zero-coupon bond. Examples: - Savings bonds - Treasury bills

Present Value (PV)

The value of a cash flow that occurs earlier than the future value

future value (FV)

The value of a cash flow that occurs later than the present value. - both lenders and borrowers can never know FV of a loan with certainty

What goal should always motivate the actions of the firm's financial manager?

To maximize the current market value (share price) of the equity of the firm (whether it's publicly traded or not).

Are agency problems more or less severe in companies who own most of the stick in public corporations?

We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions' deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control.

European Style

a bond that makes a single coupon payment each year = coupon rate x face value

American-Style Bond

a bond that makes coupon payments every six months - the amount equals half the coupon rate times the face value

discount bond

a bond whose price is less than its face value because its coupon rate is less than the yields on similar bonds - a discount bond's price will, on average, rise as the time to maturity shortens

debenture

a bond with collateral - all US Treasury bonds are debentures

Annuity Due

a finite stream of identical reoccurring payments whose payments occur at the beginning of each period Example: - rent and lease payments lender would prefer an annuity due borrower would prefer ordinary annuity

ordinary annuty

a finite stream of identical reoccurring payments whose payments occur at the end of each period Example: - car loans - mortgages

inflation

a general increase in prices with a corresponding reduction in the purchasing power of money - ex. something that costs $1 today might cost $1.50 next year

perpetuity

a infinite stream of cash flows that are paid or received with regular frequency - in general, the word perpetuity refers to a stream where all the cash flows are the same - also called level perpetuity or constant perpetuity To apply the perpetuity formula, you must assume the periodic rate is constant forever.

bond

a long-term standardized debt instrument that may trade in secondary markets

effective rate

a low-frequency rate that is equivalent to a high-frequency rate Example: an effective annual rate of 12.682503% (low frequency) is the same as 1% per month (high-frequency)

Loan amortization schedule

a payment-by-payment table that shows the balance, interest and principal paid per payment, and the resulting ending balance for an amortized loan, such as a mortgage or car loan - as time passes, the proportion of an amortized loan payment that goes to interest declines. - repayment of the principal increases over time

Call Feature

a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date - typically makes the investment less desirable because the issued will only repurchase the bond if it is to its advantage (if interest rates decline)

lump sum

a single amount of money at a particular time

discounted cash flow (DCF)

a valuation method that gets the value of an investment's expected cash flows at a single point of time and adds them up - the overall approach to getting the value today of a project's future cash flows

economic good

all else equal, something that makes economic agents better off - profits - leisure time - money Getting more of an economic good compensates us for getting more of an economic bad

economic bad

all else equal, something that makes economic agents worse off - ex. pollution - risk - crime assume that the greater the unpleasantness of risk (economic bad), the greater the expected return (economic good) to make them happier

growing annuity

an annuity whose payments grow at a constant rate per period for the length of the contract

fixed income

another term for bonds

Important Relationship III

as PV increases, interest rate decreases When the price for a given future lump sum increases, the implied rate of return falls.

In response to the Sarbanes-Oxley Act, many small firms in the US have opted to "go dark" and delist their stock. Why might a company choose this route? What are the costs of "going dark"?

because of the costs of compliance. - The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firm's profits. - A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market.

Bearer bonds

bonds where the person holding the paper bond receives the bonds cash flows (steal them)

Periodic Rate

defines over what interval of time interest is earned and when it is paid Example - credit card which charges 1.5% per month - the person who charges purchases on the card will pay 1.5% on the balance outstanding at the beginning of the month as interest at the end of the month. Critical because it determines how frequently interest-on-interest is earned or paid on a contract.

discounting

determining the present value of an expected future cash flow using the discount rate

default

failure on the part of the bond issuer to fulfill the terms of the indenture, often by failing to make a coupon payment or pay the face value

consistent

in TMV calculations involving the fundamental equation of finance, you must define both the periodic rate and the number of periods over the same unit of time. - start with the rate and then determine the number of periods between the lump sums

Continuously compounding interest

interest paid constantly, and immediately begins earning interest on itself

Laplante's Second rule of finance

interest rates have no meaning unless you know over what interval of time interest is paid or received - 1% per day/hour/month/year? (assume interest rates are strictly positive)

pension fund

investment pools that pay for employee retirement benefits. Employers, whether private sector or government, provide the money for the fund, though in some cases employees may contribute as well. Federal laws provide specific guidelines for plan fiduciaries to protect the pension assets, thus plan managers pursue constrained investment strategies in the best interests of the beneficiaries.

Laplante's First rule of finance

money has no meaning unless a business or individual known exactly when they will pay or receive cash in a transaction

mutual fund

pool money from small investors, then pursue a wide range of investment strategies, usually enabling the investors to diversify easily. - Since many mutual fund investors are unsophisticated, the SEC acts in the public interest to regulate mutual funds and enforce rigorous public disclosures. For example, SEC regulation restricts mutual fund strategies and requires quarterly public disclosure of equity positions. Mutual funds - charge relatively low fees for their investment services (some charge no fees) In summary, mutual funds pool the resources of a large number of small backers, charge small fees, and adopt relatively constrained investment strategies due to SEC regulation.

Hedge Fund

pool money from sophisticated investors, known as accredited investors, then pursue a wide range of investment strategies chasing alpha, unusually large returns. - Typically, investors can only withdraw their money once per year, known as the lock-up period. - The SEC does not heavily regulate hedge funds because, from its point of view, accredited investors should know what they are getting themselves into. - typical hedge fund has a two and twenty fee structure, a two percent annual management fee plus 20% of overall profits. In summary, hedge funds pool the resources of a small number of wealthy backers, charge large fees, and adopt relatively unconstrained investment strategies due to limited regulation.

bond ratings

predictions by rating agencies as to the likelihood a bond issuer will default - the big three agencies are Moody's, Standard & Poors, and Fitch - Ratings o BBB and above are investment-grade debt - Ratings of BB and below are speculative-grade debt (non-investment grade, junk, or high-yield fixed income)

Is an IPO a primary market transaction or a secondary market transaction?

primary market transaction (IPO= initial public offering)

preferred stock

stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights - typically, finance companies issue preferred stock and pay a level quarterly dividend

liquidity

the ability to buy or sell an asset at its full market value - there is an inverse relationship between liquidity and bid-ask spreads - US Treasury bonds are highly liquid, trading in very deep OTC markets while with small bid-ask spreads - municipals are illiquid with large bid-ask spreads - corporates fall in between munis and treasutrys

interest rate risk premium

the additional compensation bondholders require for the increased price risk of bonds with longer times to maturity

current yield

the annual coupons / bond's price - the portion of a bondholder's total return due to the receipt of regular cash flows, the coupons

Capital Gains Yield

the annual percentage change in a bond's price - the portion of a bondholder's total return due to a change in the bond's value

Bond issuer

the borrower on one side of a bond issue

convexity

the curvature of a bond's price response due to changes in yields

maturity date

the date specified in the indenture on which the issuer pays the principal amount of the bond, thus paying off the loan

Net present value (NPV)

the difference between the present value of cash inflows and the present value of cash outflows

Annual Percentage Rate (APR)

the federally required interest rate that a lender must reveal to a borrower on a loan contract - must be an annual rate - only reveals simple interest paid on debt - interest rate of 6% with monthly compounding ('with' typically indicates APR) APR= r x m r = periodic rate m = number of compounding periods in a year Measure of the simple interest earned or paid on a loan - crucially misses interest-on-interest. - Since economic agents care about interest-on-interest, the APR can be of limited value to individuals trying to make informed decisions. - The value of the APR is that it can be used as an input to find periodic rates and Effective Annual Rates

discount rate

the interest rate used to calculate the equivalent present value of an investments expected cash flown at a single point of time and adds them up

Coupon payment

the interest-only payment the bondholders receive regularly - the coupon rate x face value = total interest paid annually - if European style, coupon payments are annual - if American: semiannual

bondholder

the lender on one side of a bond issue

number of periods (t)

the number of periods between the two lump sums and is consistent with the periodic rate

Coupon rate

the percentage of the face value paid out annually as interest only

expected value

the probability-weighted average of the possible state - contingent outcomes - in minds of lender or borrower, it is the average or typical outcome, with errors on either side of it once the future value reveals the truth - For risky assets, the future value is a random variable, so we think in terms of its expected value.

cost of capital

the rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders - The opportunity cost of capital is an interest rate, just like the required return.

Fisher Effect

the relationship between nominal interest rates, real interest rates, and expected inflation

inverted yield curve

the situation where long-term treasury's have lower yields than short term bonds - uncommon and result from expectations that inflation or productivity will be much lower in the future

bonds issued

the total number of bonds issued - the number of bonds issued times the face value of the total amount of the loan - as the bonds issued increases, so does the probability of default

opportunity cost

the value of what is foregone by choosing one alternative over another Example: receivables/payable - getting cash today or waiting 90 days to collect it (receivables) - waiting 90 days means forgoing 3 months of interest it could earn if it makes a cash sale today - payable: firm would rather pay later than today to earn as much interest as possible interest rate represents an opportunity cost - if you invest your scarce cash in one asset, you forgo the return you could have gotten from another asset - when entering a loan, for forgo the interest rate you could have paid to another lender - must think about the next best choice with similar risk

indenture

the written agreement between the bond issuer and the bondholders detailing the terms of the debt issue

Percentage Format

used to input interest rates when solving TVM calculations with a financial calculator. - twelve percent is 12% in percentage form

credit risk

(default risk) - the uncertainty about a bond issuer's ability to make all required payments

face value

(par value) the principal amount of a bond repaid at the end of the term - typically $1000 but could be anything

Interest rate risk

(price risk) the risk that a bond's price will change in unexpected ways due to unanticipated changes in interest rates - all else equal, bonds with longer times to maturity have more interest rate risk than bonds with shorter times to maturity - all else equal, bonds with smaller coupon payments have more price risk than bonds with large coupons

What are the three types of financing management decisions and relevant business transaction

1. Capital budgeting - deciding whether to expand a manufacturing plant 2. capital structure - deciding whether to issue new equity and use the proceeds to retire outstanding debt 3. working capital management - modifying the firm's credit collection policy with its customers).

In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?

1. The treasurer's office 2. the controller's office The controller's office handles cost and financial accounting, tax management, and management information systems. The treasurer's office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the treasury group's functions.

Lease

A contract that allows a party to temporarily rent an asset for a fixed period under a set of prespecified conditions. - can differ from rent in the case of large capital assets because GAAP may require the lessor (renter) to book the asset and the lease on its balance sheet.

Call Provision

A feature of some bonds that gives the issuer the right to prepay the debt - since issuers will only exercise the call provision when interest rates fall, it imposes reinvestment risk on the bondholders - US Treasurys do not have call provisions, but Munis and Corporates may

Amortized Loan

A loan that has identical payments throughout the contract - payments are applied first towards reducing the interest balance, and any remaining sum towards the principal balance - as a consequence, the proportion of each payment that pays interest decreases while the proportion applied to the principal increases throughout the loan

Effective Annual Rate (EAR)

A rate which reflects all of the simple and compound interest an economic agent will pay or receive over the course of a year. - takes differing periodic rates and/or compounding frequencies into account - allows individuals to compare different loans or investments (not always possible when using APR) - the maximum EAR occurs when the number of compounding periods per year is infinite also known as the Annual Percentage Yield or APY. - always expressed as annual interest rate EAR = all interest earned/paid on $1 invested/borrowed = (i + r)^m -1 EAR = (1+APR/m)^m - 1 As the compounding frequency increases, the EAR increases at a decreasing rate.

Treasury Bill

A short-term debt obligation issued and backed by the U.S. government with a maturity of less than one year. Treasury bills are the least risky asset on planet earth.

Basis Points (BPS)

A unit that is equal to 1/100th of 1%. 1.23% is 123 basis points or 123 bps

random variable

A variable which is the product of a random process. Random variables must have two or possible outcomes that one does not know in advance of their realization A loan's future cash flows are random variables, ranging between zero and full payment - parties weigh the possible outcomes and their associated probabilities to arrive at their expected values

Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? (employee safety, the environment)

An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are noneconomic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: "A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?"

Important Relationship II

As the interest rate increases, PV decreases A future lump sum of cash becomes less valuable to you when the opportunity costs of waiting for it rise.

Important Relationship 1

As time increases, PV decreases The longer you must wait for a future, the less valuable it is today because of the ever-increasing opportunity costs you bear while waiting

Corporates

Bonds issued by corporations that often have 20 year maturities, but may extend to 100 years - have default risk because corporations must generate cash for the contractually obligated payments through unforced sales of goods and services to their customers

What are the four primary disadvantages of the sole proprietorship and partnership forms if business organization? And benefits compared to corporate form

Disadvantages: - unlimited liability, - limited life, - difficulty in transferring ownership, - difficulty in raising capital funds Advantages: - simpler, - less regulation, - the owners are also the managers, - sometimes personal tax rates are better than corporate tax rates.

Rule of 72

Divide seventy-two by an interest to approximate the time to double one's money. - approximation can have large errors - the error increases when you use a rate progressively lower than 8%

closing costs

Expenses separate from the purchase price that buyers and sellers normally incur to complete a real estate transaction. Examples include appraisal fees, title searches and insurance, loan processing fees (a.k.a. origination fees) by the bank, and many more. Closing costs run somewhere between 2% and 5% of the purchase price.

For simple interest contracts only

FV = PV (1+r x t) total interest = PV x r x t

Fundamental Equation of Finance

FV = PV(1+r)^t simply a growth formula where the interest rate is the growth rate.

Future value interest factor for an annuity

FVIFA(r,t) Assuming strictly positive interest rates, a number greater than one that transforms a smaller present value into an equivalent larger future value

Subsidized Stafford Student Loans

Financial aid for college students where interest does not accrue until repayment begins - The subsidy is the present value (on the day the loan is made) of the interest that would have accrued up until the time it actually begins to accrue

Critiques to top managers' compensation in US

How much is too much? Who is worth more, Mark Parker or LeBron James? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, that is, stock price increases in excess of general market increases.

What does it mean when we say the New York stock exchange is an auction market? What kind of market is NASDAQ?

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter.

Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm's management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. - Management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

compound interest

Interest earned on both the initial principal and the reinvested interest earned in prior periods. includes both simple interest and interest-on-interest In a compound interest contract, the principal upon which interest is calculated grows through time.

decimal form

Interest rates expressed as a percentage must be converted into decimal form when using mathematical formulas or Excel spreadsheets for TVM calculations. - twelve percent is 0.12 in decimal form