FINN 3043 Exam #1 Review Questions

Describe the role of capital markets from the firm's and investors' perspectives.

Firms see the capital market as a source of external finance for long-term projects. Put another way, they sell new bonds and stock to raise funds to build factories, launch marketing campaigns, and expand into new markets. Investors, in contrast, see the capital market as a savings vehicle for long-term needs like retirement.

What is the primary economic principle used in managerial finance?

The primary economic principal used in managerial finance is marginal cost-benefit analysis. Marginal cost-benefit analysis is the tenet that managers should base financial decisions on the marginal benefits and costs associated with some action.

What is the real rate of interest?

The real rate of interest is the rate of return on an investment measured not in dollars, but in the increase in purchasing power that the investment provides. It measures the rate of increase in purchasing power.

What is the term structure of interest rates, and how is it related to the yield curve?

The term structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. The yield curve illustrate this relationship.

What are the three main types of decisions that financial managers make?

The three main types of decisions that financial managers make are investment, financing, and working capital decisions.

Why does the trade-off between risk and return exists?

The trade-off between risk and return exists because shareholders are risk adverse. Shareholders will only accept large swings in a firm's cash flows on if compensated over time with higher average cash flows.

For corporations, how are the marginal and average tax rates related?

They are related because the average tax rate does not equal the marginal tax rate because tax rates change with income levels.

Briefly describe the following theories of the general shape of the yield curve: expectations theory

Under the expectations theory of the term structure of interest rates, the shape of the yield curve solely reflects investor expectations about future short-term interest rates. So, an upward sloping curve means investors expect short-term rates to rise.

Describe an underwriting syndicate.

Underwriting syndicate: a group of other banks formed by the originating investment bank to share the financial risk associated with underwriting new securities.

What four ways do VCs use to organize their businesses?

Venture capitalists (VCs) are organized as (1) limited partnerships (most common), (2) small business investment companies (SBICs), (3) financial funds, and (4) corporate funds.

Define agency problems and describe how they give rise to agency costs.

Agency problems arise when managers place personal goals ahead of their duty to shareholders to maximize stock price. The attendant costs are called agency costs. Agency costs can be implicit or explicit; either way they reduce shareholder wealth.

How are corporate owners rewarded for the risks they take?

Corporate owners are rewarded for the risks they take through compensation, specifically dividends and capital gains from increases in the price of their shares.

What is the difference between an angel investor (angel) and a venture capitalist (VC)?

"Angels" are usually wealthy individuals who fund promising start-ups in return for a slice of firm equity. Venture capitalists, in contrast, are businesses that pool contributions from individuals (often institutional investors like university endowments and pension funds) and invest those funds in promising start-ups.

For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward sloping, (b) upward sloping, and (c) flat?

(a) downward sloping: Investors expect short-term interest rates to fall. (b) upward sloping: Investors expect short-term interest rates to rise. (c) flat: Investors expect future short-term interest rates to roughly equal current short-term rates.

What are the debt specific risk premium components?

- Default risk: The risk the issuer will not pay contractual interest or principal as scheduled. - Contractual provisions: The risk provisions in the indenture will be invoked and materially affecting the bond's attractiveness (like the firm calling the bonds when interest rates fall).

List and briefly describe the potential issuer- and issue-related risk components that are embodied in the risk premium.

- Maturity (interest rate) risk: The risk interest rates will rise and cause price of the debt instrument to fall; price volatility increases with instrument's maturity. - Liquidity risk: The risk the instrument cannot be converted to cash quickly without a significant loss. - Tax treatment: Debt instruments are subject to differing tax treatment by federal, state, and local governments; for example, interest state and local government debt is exempt from federal taxes. Tax exemption reduces nominal rate of interest (because investors care about after-tax returns).

Explain why corporation face a double taxation problem.

Corporation income is taxed at the firm level (via corporate income tax paid of firm's profits) and then again at the personal level (via dividends or capital gains enjoyed by shareholders)

What role do financial markets play in our economy?

Financial markets facilitate direct interaction of suppliers and demanders of funds.

What general procedure must a private firm follow to go public via an initial public offering (IPO)?

1.) Obtain approval from its current shareholders, the investors who own its privately issued stock 2.) Company's auditors and lawyers must certify that all the company's financial documents are as accurate as possible 3.) Company hires investment bank willing to facilitate the offering 4.) Company files a registration statement with the SEC § Prospectus: a portion of a security registration statement that describes the key aspects of the issue, the issuer, and its management and financial position § Red herring: a preliminary prospectus made available to prospective investors during the waiting period between the registration statement's filing with the SEC and its approval 5.) After SEC approves registration statement, the investment community can begin analyzing the company's prospects 6.) Company must observe a quiet period during which the law places restrictions on what company officials may say about the company § Purpose: Make sure that all potential investors have access to the same information about the company and that no one is privy to any unpublished data that might confer an unfair advantage 7.) Investment bank and company executives promote the company's stock offering through a roadshow (a series presentation to potential investors around the globe) and gauge demand and pricing for stock 8.) After the investment bank sets terms and prices, the issue, the SEC must approve the offering

What are financial institutions?

A financial institution is an intermediary that channels the savings of individuals, businesses, and governments into loans or investments.

What is a mortgage backed security?

A mortgage backed security is a security that represent claims on the cash flows generated by a pool of mortgages.

What is private placement versus a public offering?

A private placement is the sale of a new security directly to an investor or a small group of sophisticated investors (such as insurance companies and pension funds). A public offering, in contrast, is the sale of newly issued stock or bonds to the public at large.

Differentiate between the real rate of interest and the nominal rate of interest.

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal interest raterefers to the interest rate before taking inflation into account.

What are the major differences between and finance with respect to emphasis on cash flows and decision making?

Accountants do NOT focus on cash flows, they mainly focus on collecting and presenting financial data. Also, the operate on an accrual basis. Financial managers focus on cash flows. Also, they evaluate accounting statements, develop additional data and make their decisions based on the associated risk and return.

Explain how a firm's corporate governance structure can help avoid agency problems.

Agency problems in a firm can be reduced with a properly constructed and followed corporate-governance structure. Such a structure will feature checks and balances that reduce management's interest in and ability to deviate from shareholder-wealth maximization. Like all corporate decisions, reducing agency costs is subject to marginal benefit-marginal cost analysis. In other words, the firm should invest in policies to align the incentives of management and shareholders as long as the marginal benefits exceed the marginal costs.

How can the firm structure management compensation to minimize agency problems?

Firms most commonly try to mitigate agency problems by linking pay to metrics connected with shareholder wealth. Incentive plans tie compensation to share price.

What are broker markets?

Broker markets are the securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities.

Describe the role of commercial banks within the financial market environment.

Commercial banks are institutions that provides savers with a secure place to invest their funds and that offer loans to individual and business borrowers. Also, they transform the deposits of net savers into loans to net borrowers.

How do VCs structure and price their deals?

Deal structure allocates responsibilities between the start-up and VC and may include constraints on the firm to enhance its chance of success and mitigate VC risk. Pricing depends on the (1) value of the start-up, (2) perceived risk of its business operations, and (3) amount of funding needed.

What are dealer markets?

Dealer markets are the markets in which the buyer and seller are not brought together directly, but instead have their orders executed by securities dealers who "make markets" in the given security.

What relationship exists between financial institutions and financial markets?

Financial institutions actively participate in the financial markets as both suppliers and demanders of funds.

Describe the role they play within the financial market environment.

Financial institutions transform loans and investments into forms savers prefer to hold (such as deposits) or help net borrowers issue debt and equity instruments tailored to saver preferences.

Why must financial managers consider risk as well as return when they evaluate a decision alternative or action?

Financial manager consider risk as well as return when they evaluate a decision alternative or action because they affect share price differently. Risk and return are determinants of share price, which represents the wealth of the firm's owners.

What are primary and secondary markets?

In primary markets, debt and equity instruments are sold the first time—a direct exchange between the firm or government issuing securities and the purchasers. In secondary markets, previous issued securities are traded subsequent times; the original issuers receive no new funds.

If managers do not act in the best interests of shareholders, what role might incentives play in explaining that behavior?

Incentives play a huge role if a manager does not act in the best interest of the shareholder. Compensation is closely linked to a firm's stock price.

What role do institutional investors play in shareholder activism?

Institutions typically hold large quantities of shares in many corporations. Because of their large stakes, these investors actively monitor management and vote their shares for the benefit of all shareholders.

What role does an investment bank play in public offering?

Investment bank: financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions · Responsible for promoting the stock and facilitating the sale of the company's IPO shares

Describe the role of investment banks within the financial market environment.

Investment banks are institutions that instruct companies on the best vehicles for raising capital, advise them on mergers/restructuring, and engage in trading and market-making to support their consulting function.

Why is it important that managers recognize that a trade-off exists between risk and return?

It's important the managers recognize that a trade-off exists between risk and return because shareholders prefer higher cash flows, but dislike inconsistency in cash flows.

Which form do the largest businesses typically take and why?

Large businesses or firms typically take the form of corporations due to limited liability and they can raise capital by selling stock.

How do marker forces-- both shareholder activism and the threat of takeover-- prevent or minimize the agency problem?

Large institutional investors reduce agency problems by using their voting clout to elect new directors that will make the changes in policies and personnel necessary to get underperforming stock to its highest possible price. The threat of hostile takeover can also keep management focused on shareholders.

Is maximizing shareholder wealth inconsistent with having concern for the welfare of a firm's other stakeholders?

Maximizing shareholder's wealth does NOT mean that managers should ignore the interests of everyone connected to a firm who is not a shareholder. Firms with satisfied employees, customers, and suppliers tend to produce higher (or less risky) cash flows for their shareholders compared with companies that neglect non-owner stakeholders. That said, customers prefer lower prices for firm output, firm employees prefer higher wages, and firm suppliers prefer higher prices for the input goods and services they provide. So actions that produce the highest price of the firm's stock cannot simultaneously maximize customer, employee, and supplier satisfaction.

Why do you think that so many pieces of important legislation related to financial markets and institutions were passed during the Great Depression?

Much of the U.S. framework for financial and financial- institution regulation stems from the First New Deal (1933-34). This framework addressed specific factors thought to have caused the slump. To protect depositors from losses in bank failures, the Banking Act of 1933 created federal deposit insurance. To prevent failures in the first place, the Act also barred commercial banks from security underwriting, which was thought to pose dangerous additional risks. To head off fraudulent investment schemes like those preceding the stock-market crash of 1929, the Securities Act of 1933 and Securities Exchange Act of 1934 forced companies wishing to issue public securities to disclose information about their financial condition.

For what three main reasons is profit maximization potentially inconsistent with wealth maximization?

Profit maximization is potentially inconsistent with wealth maximization because of timing, cash flows, and risk.

What is risk?

Risk is the chance that actual outcomes may differ from those expected.

What is securitization, and how does it facilitate investment in real estate assets?

Securitization is the process of pooling mortgages or other types of loans and then selling claims or securities against that pool in the secondary market.

Describe the role of the shadow banking system within the financial market environment.

Shadow banking systems are a group of institutions that engage in lending activities, much like traditional banks, but they do not accept deposits and therefore are not subject to the same regulations as traditional banks.

What do falling home prices create an incentive for homeowners to default on their mortgages even if they can afford to make the monthly payments?

Some homeowners (borrowers) recognized that the value of their house was less than the amount they owed on their mortgages, so they walked away and let lenders repossess their homes

Describe the roles of, and the relationships among, the major parties in a corporation: stockholders, board of directors, and managers.

Stockholders are the owners of a corporation and they elect the board of directors. The board of directors is responsible for guiding corporate affairs and setting general policy. The CEO reports to the board of directors and they oversee day-to-day operations.

What is the "normal" shape of the yield curve?

The "normal" shape of the yield curve is upward sloping.

What different aspects of financial markets do the Securities Act of 1933 and the Securities Exchange Act of 1934 regulate?

The Securities Act of 1933 focused on the primary market, compelling sellers of new securities provide reasonably accurate portrayals of their firms to prospective investors. The Securities Exchange Act of 1934, in contrast, regulated trading in secondary markets; forcing publicly traded companies to keep investors informed about firm condition on an ongoing basis. Also, it created the SEC.

Discuss how one measures achievement of the firm's goals.

The best way to measure's one achievement of the firm's goal of maximizing shareholder's wealth is the share price. Mangers are instructed to take actions that increase the firm's share price.

What is the capital market?

The capital market is a market that enables suppliers and demanders of long-term funds to make transaction.

How are capital, broker, and dealer markets different?

The difference, in short, between broker and dealer markets turns on whether traders or dealers provide the liquidity. Another difference is the technical point that deals with the way trades are executed.

What is the efficient market hypothesis?

The efficient market hypothesis is the theory describing the behavior of a market in which (1) securities are in equilibrium, (2) security prices fully reflect all available information and react swiftly to new information, and (3) because stocks are fully and fairly priced, investors need not waste time looking for misplaced securities.

What is the goal of the firm, and therefore, of managers and employees?

The goal of the firm should be to maximize the wealth of the owners and managers/employees should only take actions that they expect will increase the shareholder's wealth.

Who are the key customers of financial institutions?

The key customers of financial institutions are individuals, businesses and government.

Briefly describe the following theories of the general shape of the yield curve: liquidity preference theory

The liquidity-preference theory assumes investors prefer short- to long-term debt instruments because short-term debt is more liquid and less risky (i.e., suffer lower capital losses when interest rates rise). The general preference for short maturities means investors will demand a premium to hold longer- term debt instruments. This risk premium will produce an upward sloping yield curve even if investors expect no changes in interest rates.

What is the Eurocurrency market?

The market consisting of all the world's currencies that are banked outside their countries of origin; international equivalent of the domestic money market.

Briefly describe the following theories of the general shape of the yield curve: market segmentation theory

The market-segmentation theory assumes the market for short- and long-term debt instruments is distinct, with demand and supply determining the interest rate in each market. Under the market- segmentation theory, long-term interest rates exceed short-term rates when demand for long-term instruments is stronger than for demand for short-term instruments (and/or supply of long-term debt is relatively weaker than demand for short-term debt).

What is the money market?

The money market is a market where investors trade highly liquid securities with maturities of 1 year or less.

Which legal form of business organization is most common?

The most common legal form of business organization is sole proprietorships.

Who are net suppliers, and who are net demanders of funds?

The net suppliers are individuals. The net demanders are businesses and governments.

What basic risk is associated with mortgage-backed securities?

The primary MBS risk is credit risk, the chance homeowners will not make monthly principal and interest payments as stipulated in their mortgage contracts.

Why does a crisis in the financial sector spill over into other industries?

§ Banks began to tighten their lending standards and dramatically reduce the quantity of loans they made § Corporations and businesses began to hoard cash and cut back on expenditures because they no longer relied on the money market as a source of short-term funding § GDP declined, lost 8 million jobs, unemployment rate reached 10% § In response to the Great Recession, Congress passed on $862 million stimulus package in an attempt to revive the economy and the Federal Reserve pushed short term interest rate close to 0% § Recovery was very slow

How do rising home prices contribute to low mortgage delinquencies?

§ When house prices are rising, the gap between what homes are worth and what borrowers own on their mortgages widens § Lenders began to relax their standards for borrowers, which led to tremendous growth in a category of loans called subprime mortgages o Both lenders and borrowers assumed that rising home prices would allow refinancing of their loans if they had difficult making payments · Refinancing no longer became an option, so delinquency rates and foreclosures began to climb