Finance
Effective (or equivalent) annual rate
(EAR = EFF%): the annual rate of interest actually being earned, considering compounding.
Three Types of Mortgage Loans
-Interest Only -Amortized -Partially Amortized
Rate of Return
A higher rate of return means your money is "working harder" for you; don't have to invest as much yourself.
Three years ago you purchased 500 shares in the Kellogg Company, but yesterday you sold 200 those shares through your broker. This is: A secondary market transaction. A futures market transaction. A money market transaction. A primary market transaction. An over-the-counter market transaction.
A secondary market transaction.
Importance of Financial Markets
A well-functioning financial market helps match those two groups together so that capital moves efficiently. Need a variety of intermediaries willing to handle capital transfers of varying risk and time-horizon. Commercial banks prefer lower risk transactions Venture capital funds look for higher risk transactions Increases investment and economic growth Greater economic flexibility Ability to withstand changes/crises in the economy
Which of the following factors tend to encourage management to act in their stockholders' best interests? A reasonable compensation package sufficient to attract and retain able managers. Firing managers who do not perform well. Threat of a hostile takeover. Direct intervention by shareholders. All of the above encourage management to act in shareholders' best interests.
All of the above encourage management to act in shareholders' best interests.
Stockholder-Manager Conflicts
Also called Principal / Agent conflicts Stockholders (principals) hire managers (agents) to run the company Like most people, managers are naturally inclined to act in their own best interests 1. Risk-taking: Conservatism, Empire building 2. Perquisite consumption 3. Effort level Managerial compensation packages 1. Reward long run vs. short run thinking 2. Use of stock options Direct intervention by shareholders 1. CalPERS, TIAA-CREF The threat of firing The threat of takeover
Partially Amortized Mortgage Loan
Also known as a "balloon" mortgage. A "7/23 balloon" would be a 30-year mortgage where you make monthly payments for 7 years, then pay off the principal balance of the remaining 23 years, usually by refinancing.
Which of the following statements reflects the position of most people in business? Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. Whistleblowers are generally promoted more rapidly than other employees because of the courage it takes to blow the whistle.
Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Types of Multiple Cash Flow Streams
Annuity Perptuity Multiple, Uneven Cash Flows
Of the following statements, which is CORRECT? If H&R Block issues additional shares of common stock through an investment banker, this would be a secondary market transaction. As they are generally defined, money market transactions involve debt securities with maturities of less than one year. Only institutions, and not individuals, can engage in derivative market transactions. If you purchase 100 shares of Facebook stock from your friend Sam, this is an example of a primary market transaction. The NYSE is an example of an over-the-counter marke
As they are generally defined, money market transactions involve debt securities with maturities of less than one year.
Liquid Trading
Assets that are easy to trade Stocks of Fortune 500 companies, United States Treasury bonds, gold, silver, e.g. Can trade in large quantities without affecting the market price; easily converted into cash when needed
Dow Jones Industrial Average
Began in 1896; contained only 10 stocks at that time In 1928, 30 stocks were included in the Dow Price-weighted average - constructed by adding up the prices of the stocks in the Dow and dividing by a divisor to get the average Divisor was once 30 but has been adjusted to account for stock splits and periodic substitutions of stocks that comprise the index. Today the divisor is 0.14523396877348 (really a Multiplier!) Proctor & Gamble, Exxon Mobil, United Technologies have been in the Dow the longest. GE was removed and Walgreens joined Dow stocks are blue-chip industrial companies
Thinking about the financial markets, which of the following statements is CORRECT? The most important difference between spot markets versus futures markets is the maturity of the instruments that are traded. Spot market transactions involve securities that have maturities of less than one year, whereas futures markets transactions involve securities with maturities greater than one year. Capital market transactions involve only preferred stock or common stock. Both NASDAQ dealers and specialists on the NYSE hold inventories of stocks. Money market transactions only involve securities denominated in U.S. dollars. If General Electric were to issue new stock this year, this would be considered a secondary market transaction as the company already has stock outstanding.
Both NASDAQ dealers and specialists on the NYSE hold inventories of stocks.
Types of Financial Institutions/Intermediaries
Commercial banks and credit unions Investment banks Financial services corporations Pension funds Life insurance companies Mutual funds Exchange traded funds Hedge funds Venture capital and private equity companies
The Main Goal
Creating value for investors. Managers (agents) work on behalf of the shareholders (principals) Maximizing the share price is generally the best metric for maximizing shareholder value Maximizing revenues, earnings per share (EPS), market share, minimizing costs? In equilibrium, a stock's price should equal its "true" or intrinsic value.
Transfer of Capital
Direct transfers: from savers direct to individuals businesses. Usually small amounts, less common in developed markets, more common in less-developed markets Financial intermediaries: help move funds from parties with excess capital to parties needing capital -More common in developed economies Intermediaries help evaluate the risk of investments, provide funding, provide liquidity to the economy
Stock Market Recent Innovations
ECN: Electronic Communication Networks. Online trading system operating outside of exchanges like NYSE and NASDAQ Allow for "after-hours" trading Taking transaction volume from the exchanges NASDAQ, after going public, acquired several ECNs, Philadelphia Stock Exchange and 25% of the London Stock Exchange. NYSE bought by Intercontinental Exchange NYSE and NASDAQ compete against each other and against other market startups
Amortized Mortgage Loan
Each payment contains some principal and some interest. When you make the last payment, your balance hits zero and you own the asset in full. Car loans, mortgage loans, student loans, etc.
S&P 500 Index
Established in 1957; contains 500 stocks Measure of large-cap U.S. stock market performance Market-value weighted index (larger companies have greater influence) Most commonly used U.S. benchmark
Which of the following statements describes a primary market transaction? You sell 200 shares of Kroger stock on the NYSE through your broker. You buy 200 shares of Honda stock from your brother. The trade is not made through a broker; you just give him cash and he gives you the stock. Microsoft sells 2,000,000 shares of treasury stock to its employees when they exercise options that were granted in prior years. One financial institution buys 200,000 shares of BP stock from another institution. An investment banker arranges the transaction. Facebook issues 2,000,000 shares of new stock and sells them to the public through an investment banker.
Facebook issues 2,000,000 shares of new stock and sells them to the public through an investment banker.
Maximizing expected EPS will maximize shareholder value.
False
The acronym IPO stands for "independent public offering."
False
The chairperson of the board and the CEO are one and the same.
False
The primary financial objective of the firm is to maximize EPS.
False
Capital Markets
Financial Institutions or Intermediaries
Discounting
Finding the PV of a cash flow or series of cash flows
Maximizing the stock price on a specific target date will maximize shareholder value.
Flase
One of the following statements about issuing and owning securities is incorrect. Which statement is NOT CORRECT? When a corporation's shares are owned by a few individuals, we say that the firm is closely, or privately, held. Going public establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. It is possible for a firm to go public and yet not raise any additional new capital for the firm itself. The stock of publicly owned companies must generally be registered with and reported to a regulatory agency such as the SEC. When stock in a closely held corporation is offered to the public for the first time, the transaction is called going public, or an IPO, and the market for such stock is called the new issue, or IPO, market.
Going public establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares.
Which of the following statements about hedge funds is CORRECT? Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia. Hedge funds have more in common with investment banks than with any other type of financial institution. Hedge funds are not as highly regulated as most other types of financial institutions. The justification for this light regulation is that only the wealthiest investors invest in hedge funds, and they understand the risks. Hedge funds are extremely popular in Europe and Asia, but they are rarely used or made available in the United States. Hedge funds have more in common with commercial banks than with any other type of financial institution.
Hedge funds are not as highly regulated as most other types of financial institutions. The justification for this light regulation is that only the wealthiest investors invest in hedge funds, and they understand the risks.
When is Each Rate Used
INOM: Written into contracts, quoted by banks and brokers. Not used in calculations or shown on time lines. IPER: Used in calculations and shown on time lines. If M = 1, INOM = IPER = EAR. EAR: Used to compare returns on investments with different payments per year. Used in calculations when annuity payments don't match compounding periods.
Which of the following statements about legal and ethical issues is CORRECT? If a lower level person in a firm does something illegal, like "cooking the books," to understate costs and thereby artificially increase profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted. Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business. Ethics is not an important consideration in business and in business schools. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. There are many types of unethical business behavior. One example is when executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders.
If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted.
Which of the following statements about IPOs is CORRECT Sometimes, a company is forced to issue more shares than it wants to sell in an IPO because the share price is so low and demand is high. In a Dutch auction, investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day that the stock is offered to the public. The term "IPO" stands for Individual Purchase Order, and it is the price at which individual shares of a new company are offered for purchase. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.
In a Dutch auction, investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.
The Gabriel Corporation has asked you, a consultant, to recommend an action that is likely to reduce potential conflicts between stockholders and bondholders. Which action do you propose? The passage of laws that make it harder for hostile takeovers to succeed. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders). Compensating managers with more stock options and less cash income. The firm begins to use only long-term debt (e.g., debt that matures in 30 years or more) rather than debt that matures in less than one year. A government regulation that banned the use of convertible bonds.
Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders).
Imagine that you are the chairman of the board of a large corporation. Which of the following mechanisms do you think the board should choose to adopt to motivate top-level managers to act in the best interests of shareholders? Decrease the use of restrictive covenants in bond agreements. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock. Elect a board of directors that allows managers greater freedom of action. Take actions that reduce the possibility of a hostile takeover.
Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.
Interest Only Mortgage Loan
Interest is paid every period; principal is paid at expiration (if at all). Frequently used during the housing bubble. Most bonds are examples of interest-only loans, also.
Stock Prices and Intrinsic Value
Intrinsic value is a long-run concept. To the extent that investor perceptions are incorrect, a stock's price in the short run may deviate from its intrinsic value. Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run.
Why is it important to consider effective rates of return?
Investments with different compounding intervals provide different effective returns. To compare investments with different compounding intervals, you must look at their effective returns (EFF% or EAR). See how the effective return varies between investments with the same nominal rate, but different compounding intervals.
Reasons for Inefficiency
It is costly and/or risky for traders to take advantage of mispriced assets. Cognitive biases cause investors to make systematic mistakes that lead to inefficiencies. This is an area of research know as "behavioral finance." Behavioral finance borrows insights from psychology to better understand how irrational behavior can be sustained over time. Some examples include: Evaluating risks differently in up and down markets. Overconfidence leads to self-attribution bias and hindsight bias.
Will the FV of a lump sum be larger or smaller if compounded more often, holding the stated I% constant?
LARGER, as the more frequently compounding occurs, interest is earned on interest more often.
Cash Flow Types
Lump sum: single cash flow Ordinary annuity: a finite series of 2 or more cash flows of the same $ amount that occur in regular intervals "Ordinary" if cash flow is at the end of the period; "Annuity Due" if cash flow is at the beginning Perpetuity
Specialists at NYSE
Market makers match buyers and sellers. The specialist post bid and ask prices. If they cannot find a buyer for each seller, the specialists trades with them directly. Specialists have to maintain an orderly market: bid/ask prices can't get too far apart, and prices must change incrementally as the market changes (no big price jumps).
NASDAQ Composite Index
Measures the performance of all stocks listed on NASDAQ Approx. 3,300 companies are included in the index Generally considered an indicator of the Technology sector due to the large number of tech stocks that trade on NASDAQ Value-weighted index Apple, Google, Cisco Systems, Oracle are some of the securities in the index
Largest OTC Market
NASDAQ OMX National Association of Security Dealers Automated Quotation system
Largest Physical Market
NYSE New York Stock Exchange located on 11 Wall Street in Manhattan
You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this information by purchasing the stock?
No. If the market is efficient, this information will already have been incorporated into the company's stock price. So, it's probably too late for her to "capitalize" on the information.
She has read a number of newspaper articles about a huge IPO being carried out by a leading technology company. She wants to purchase as many shares in the IPO as possible and would even be willing to buy the shares in the open market immediately after the issue. What advice do you have for her?
Not all IPOs are well received. And, even if you are able to identify a "hot" issue, it is often difficult to purchase shares in the initial offering. These deals are generally oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers), and small investors find it hard, if not impossible, to get in on the ground floor. She can purchase the stock in the after-market, but evidence suggests that if you do not get in on the ground floor the average IPO under performs the overall market over the long run.
Types Of Secondary Markets
OTC market: No centralized location, traders linked electronically. NASDAQ, e.g. Also called a "dealer market". Physical stock market : Traders meet at a location and shout it out: NYSE, CBT, e.g. Also called an "auction market".
Types of Financial Markets
Physical assets vs. Financial assets (Corn/trucks/backhoes/real estate vs stocks/bonds) Spot vs. Futures (For purchase today or an agreement today for a purchase at a future date) Money vs. Capital (Transactions shorter than one year vs longer) Primary vs. Secondary (IPO/SEO vs. the rest of market trading) Private vs. Public
Which of the following is an example of a capital market instrument? Commercial paper. Preferred stock. Banker's acceptances. Money market mutual funds. U.S. Treasury bills.
Preferred stock.
A small investor has been reading about a "hot" IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?
Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading.
Converting APR to EAR
Remember that the APR is the quoted rate. (APR/m) is the periodic rate. m is the number of compounding periods per year Multiply this number by 100 to make a percentage EAR = [1 + (APR/m)]^m - 1
Secondary Markets
Sales between investors of already issued securities. This is what we generically refer to as the "stock market"
Stock Market Efficiency
Securities are normally in equilibrium and are "fairly priced." Market price = Intrinsic value Investors cannot "beat the market" except through good luck or better information. Highly Inefficient: small companies not followed by many analysts, not much contact with investors Highly Efficient: large companies followed by many analysts, good communication with investor
Which of the following is an example of securities traded in money markets? Common stocks. Long-term bonds. Foreign currencies. Consumer automobile loans. Short-term debt securities such as Treasury bills and commercial paper.
Short-term debt securities such as Treasury bills and commercial paper.
Stockholder-Debtholder Conflicts
Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk. Bondholders are particularly concerned about the use of additional debt. Bond covenants often use to protect bondholders
APR is not actually Annual
The APR is simply the periodic rate times the number of periods. 10% APR with monthly compounding only means the monthly rate is 10/12% per month, or .83333%/month. What is the effective annual rate? [(1.0083333)12]-1= 0.104713, or 10.4713%
NYSE v. NASDAQ
The NYSE has higher listing standards than NASDAQ. As a result, smaller companies generally start on NASDAQ and may move to the NYSE as they get more established. Exceptions: Apple, Microsoft and Starbucks are still on NASDAQ.
Which of the following statements about financial institutions and securities is CORRECT? Money markets are markets for long-term debt and common stocks. Money market mutual funds usually invest their money in a well-diversified portfolio of liquid common stocks. A liquid security is a security whose value is derived from the price of some other "underlying" asset. While the distinctions are becoming blurred, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties. The NYSE operates as an auction market, whereas NASDAQ is an example of a dealer market. Feedback: Correct. Commercial banks
The NYSE operates as an auction market, whereas NASDAQ is an example of a dealer market. Feedback: Correct. Commercial banks
Which of the following statements about financial markets is CORRECT? The New York Stock Exchange is an auction market, and it has a physical location. Home mortgage loans are traded in the money market. Capital markets deal only with common stocks and other equity securities. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties. If an investor sells shares of stock through a broker, then it would be a primary market transaction.
The New York Stock Exchange is an auction market, and it has a physical location.
Ask v. Bid Price
The ask is always higher than the bid; the difference is called the "spread" and is the primary way dealers and market makers make their money. (For the traders, it is a "transaction cost".)
Assume that you have analyzed the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following possible changes in the scenario would increase the calculated value of cash flows from an investment? The discount rate increases. The discount rate decreases. The total amount of cash flows remains the same, but more of the cash flows are received in the later years and less are received in the earlier years. The riskiness of the investment's cash flows increases. The cash flows are in the form of a deferred annuity, and they total $100,000. You learn that the annuity lasts for 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000.
The discount rate decreases.
Balancing Shareholder and Society Interests
The primary financial goal of management is shareholder wealth maximization, which translates to maximizing stock price. Value of any asset is present value of cash flow stream to owners. Most significant decisions are evaluated in terms of their financial consequences. Stock prices change over time as conditions change and as investors obtain new information about a company's prospects. Managers recognize that being socially responsible is not inconsistent with maximizing shareholder value.
If you sat on the board of directors of Tyng Corporation, which of the following actions would you recommend to reduce potential conflicts of interest between Tyng's stockholders and bondholders? Compensating managers with stock options. Abolishing the Securities and Exchange Commission. Financing risky projects with additional debt. The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions. The threat of hostile takeovers.
The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions.
You recently sold 100 shares of Facebook stock to your uncle. You had the certificates and gave them to him. In exchange, he wrote you a check. Which of the following best describes this transaction? This is an example of a primary market transaction. This is an example of an exchange of physical assets. This is an example of a derivative market transaction. This is an example of a money market transaction. This is an example of a direct transfer of capital.
This is an example of a direct transfer of capital.
Cash Flows and Rates
To properly compound and discount , the periodic cash flows need to be matched with the effective periodic rate. Up until now, our examples have involved annual cash flows with annual rates. Though we didn't say this at the time, that rate is known as the effective annual rate (EAR).
Which of the following statements about annuity calculations is CORRECT? It is impossible to get a negative number when you solve for I; you must have made a mistake. To solve for I, you must try different values for I until you find the one that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is a difficult procedure to do without a computer or financial calculator. If CF0 is positive and all the other CFs are negative, then you cannot solve for I. If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost.
To solve for I, you must try different values for I until you find the one that causes the PV of the positive CFs to equal the absolute value of the PV of the negative CFs. This is a difficult procedure to do without a computer or financial calculator.
A corporation is said to be publicly owned if its shares are held by the investing public, which may include individuals, other corporations, and institutional investors.
True
A financial intermediary is a corporation that takes funds from investors and then provides those funds to those who need capital. One example is a commercial bank, which takes in demand deposits and then uses that money to make long-term mortgage loans.
True
A stock is considered to be closely held if the corporation's shares are owned by a few individuals who are associated with the firm's management.
True
A stock's return can be broken out into its dividend yield (which might be zero) plus a capital gains yield (which could be positive, negative, or zero). These returns can be calculated for all of the stocks in the S&P 500. You can find an indicator of the "return on the market" by calculating the weighted average of those returns, using each stock's total market value.
True
Data from the Dow Jones Industrial Average, the S&P 500 Index, and the NASDAQ Composite Index give information about past stock returns.
True
Financial institutions are more diversified today than they were in the past, when federal separated investment banks, commercial banks, insurance companies, and other financial companies. Today, large financial services corporations offer services that they could not in the past.
True
Hedge funds are similar to mutual funds except that they are less regulated, have more flexibility regarding what they can buy, and restrict their investors to wealthy, sophisticated individuals and institutions.
True
Imagine that a firm's board of directors wants to maximize value for all of its stockholders in general, as opposed to some specific stockholders. A smart solution would be to design an executive compensation system that aims to build the firm's long-term value.
True
In most corporations, the CFO is outranked by the CEO.
True
The board of directors is the highest ranking body in a corporation. The members of the board are elected by the shareholders, and the chairperson of the board is the highest ranking member of the board. The CEO generally reports to the board and its chairperson, and the board generally has the authority to remove the CEO.
True
The equation used to find the annual rate of return on any given stock is the stock's dividend for the year plus the change in the stock's price during the year, divided by its beginning-of-year price. When applied to a large portfolio of stocks, like those in the S&P 500, the average of the returns on each stock can be used to find stock market returns for the year in question.
True
There are factors that influence stock price over which managers have virtually no control.
True
To find the annual rate of return on any given stock, add the stock's dividend for the year plus the change in the stock's price during the year, then divide by its beginning-of-year price.
True
Law of One Price
Two assets with the same cash flows must sell for the same price; no arbitrage
Calistoga Combines is a publicly-owned firm. In order to best serve shareholders, its' primary operating goal should be to: Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers. Minimize the firm's risks because most stockholders dislike risk. In turn, this will maximize the firm's stock price. Maximize the firm's expected EPS, which must also maximize the firm's price per share.
Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.
Stock Market Indexes
Used to show the performance of the stock market Difficult to determine which index best reflects market actions Three leading U.S. indexes: -Dow Jones Industrial Average -S&P 500 Index -NASDAQ Composite Index
Can the effective rate ever be equal to the nominal rate?
Yes, but only if annual compounding is used, i.e., if M = 1. If M > 1, EFF% will always be greater than the nominal rate.
Which of the following statements about the present value of an annuity is CORRECT? If you have a series of cash flows, each of which is positive, you can solve for I, where the solution value of I causes the PV of the cash flows to equal the cash flow at Time 0. To solve for I, you must identify the value of I that causes the PV of the positive CFs to equal the absolute value of the FV of the negative CFs. It is impossible to find the value of I without a computer or financial calculator. You can still solve for I, even if CF0 is positive and all the other CFs are negative. If you have a series of cash flows, and CF0 is negative but each of the following CFs is positive, you can solve for I, but only if the sum of the undiscounted cash flows exceeds the cost. It is impossible to get a negative number when you solve for I.
You can still solve for I, even if CF0 is positive and all the other CFs are negative.
Finding the Right Rate
You get monthly CFs and an APR with monthly compounding. Divide the APR by 12 to get the effective monthly rate, and match it with your monthly CFs. You have annual CFs and you are given an EAR (or simply told that the rate is x%--no mention of a compounding period). Use the effective annual rate with your annual CFs. Annual CFs and an APR. Even though APR stands for Annual Percentage Rate, you cannot just plug this number in to use with your annual CFs.
Financial Market
a place where individuals and organizations needing capital are brought together with those having a surplus of capital Individuals and businesses may want to borrow money and use that money for investment -Individuals: car loans, mortgages, student loans. -Businesses: loans or bonds Businesses may wish to sell ownership in their company (equity) in exchange for the cash needed to invest Savers/investors supply that cash, either directly or through an intermediary
The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize the stock price per share over the long run, which is the stock's intrinsic value. b. Maximize its expected EPS. c. Maximize its expected total corporate income. d. Minimize the chances of losses. e. Maximize the stock price on a specific target date.
a. Maximize the stock price per share over the long run, which is the stock's intrinsic value.
Which of the following is an example of a capital market instrument? a. Preferred stock. b. Banker's acceptances. c. U.S. Treasury bills. d. Money market mutual funds. e. Commercial paper.
a. Preferred stock.
Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders? a. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%. b. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. c. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval. d. The firm's founder, who is also president and chairman of the board, sells 90% of her shares. e. The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced.
a. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%.
You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction? a. This is an example of a direct transfer of capital. b. This is an example of a derivative market transaction. c. This is an example of a primary market transaction. d. This is an example of a money market transaction. e. This is an example of an exchange of physical assets.
a. This is an example of a direct transfer of capital
Financial Management
aka. Corporate Finance -What assets to buy (capital budgeting) -How to raise the capital to buy them (capital structure) -How to run the firm to maximize its value
Interest Rate
allows us to convert cash across time (also called the "discount rate", "cost of capital" or "required return" in various contexts) (1+r) is the "interest rate factor" 1/(1+r) is the "discount factor"
Periodic Rate
amount of interest charged each period, e.g. monthly or quarterly. IPER = INOM/M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding.
NASDAQ
an OTC/dealer market because investors do not directly interact to set prices Dealers aka Market Makers post their bid and ask prices for each stock they handle.
APR (Annual Percentage Rate)
annual rate that is quoted by law not actually a useful annual rate, despite its name. It uses simple, rather than compound, interest. simply the periodic rate times the number of periods.
With which of the following statements would most people in business agree? a. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. c. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. d. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. e. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation.
b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers? a. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold. b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover. c. Pay managers large cash salaries and give them no stock options. d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm's stock. e. Beef up the restrictive covenants in the firm's debt agreements.
b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.
Which of the following statements is NOT CORRECT? a. It is possible for a firm to go public and yet not raise any additional new capital for the firm itself. b. When a corporation's shares are owned by a few individuals, we say that the firm is "closely, or privately, held." c. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. d. The stock of publicly owned companies must generally be registered with and reported to a regulatory agency such as the SEC. e. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public, or an IPO," and the market for such stock is called the new issue or IPO market.
c. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares.
Which of the following statements is CORRECT? a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically. b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift. c. Capital market instruments include both long-term debt and common stocks. d. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors. e. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.
c. Capital market instruments include both long-term debt and common stocks.
Which of the following statements is CORRECT? a. The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders. b. Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. c. The threat of takeovers tends to reduce potential conflicts between stockholders and managers. d. One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. e. The threat of takeover generally increases potential conflicts between stockholders and managers.
c. The threat of takeovers tends to reduce potential conflicts between stockholders and managers.
Nominal Rate
called the quoted or stated rate. an annual rate that ignores compounding effects. Also called APR = "Annual" Percentage Rate INOM is stated in contracts: loans, credit cards, etc.
Annuity
cash flows are all the same amount, and spread out equally over a finite period of time. $1000 per year for 5 years, e.g.
Perpetuity
cash flows are same amount, over regular intervals, but forever.
Mutual Fund
corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units pool funds and thus reduce risks by diversification
Expected Return
correlated with the riskiness of the investment. A bank CD is very low risk Investing in the equity of startup companies is very risky
Which of the following statements is CORRECT? a. Home mortgage loans are traded in the money market. b. If an investor sells shares of stock through a broker, then it would be a primary market transaction. c. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties. d. The New York Stock Exchange is an auction market, and it has a physical location. e. Capital markets deal only with common stocks and other equity securities.
d. The New York Stock Exchange is an auction market, and it has a physical location.
Compounding
finding the FV of a cash flow or series of cash flows
Direct Costs
fines, lawsuits from externalities
Physical Location Exchanges
formal organizations having tangible, physical locations and trading in designated securities. exchanges for stocks, bonds, commodities, futures, and options auction markets with securities going to the highest bidder. Buyers and sellers place orders with their brokers who then execute those orders by matching buyers and sellers, although specialists assist in providing continuity to the markets.
Indirect Costs
inability to attract talent, boycotts
What does it mean for a market to be efficient?
investors can buy and sell stocks and be confident that they are getting good prices. If markets are inefficient, then investors will be afraid to invest, and this will lead to a poor allocation of capital and economic stagnation. market efficiency is clearly good.
Financial Services Corporation
large conglomerates that combine many different financial institutions within a single corporation. Most started in one area but have now diversified to cover most of the financial spectrum.
Electronic Dealer Based Market
made up of hundreds of brokers and dealers around the country who are connected electronically facilitates trading of securities that are not listed on a physical location exchange defined to include all facilities that are needed to conduct security transactions not made on the physical location exchanges. These facilities include (1) the relatively few dealers who hold inventories of these securities and who are said to make a market in these securities; (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a communication link between dealers and brokers. Dealers continuously post a price at which they are willing to buy the stock (the bid price) and a price at which they are willing to sell the stock (the ask price).
Actual Return
may be more or less than the expected return Investing in stocks/equities, or anything risky, can result in losses in some periods The lower the risk, the more likely the actual return will match the expected return
Initial Public Offering (IPO)
occurs when a company issues stock in the public market for the first time. "Going public" enables a company's owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market. Public companies are subject to additional regulations and reporting requirements. Getting shares in the primary market often results in a positive return when sold on the secondary market. Difficult to do if the IPO is "oversubscribed"
Private Equity Companies
organizations that operate much like hedge funds, but rather than buying some of the stock of a firm, private equity players buy and then manage entire firms Most of the money used to buy the target companies is borrowed
Investment Bank
organizations that underwrite and distribute new investment securities and help businesses obtain financing
Primary Market
original sales of securities, such as an IPO or SEO, a new bond issue, a Treasury auction, etc.
Illiquid Trading
real estate, fine art and other collectibles, stocks and bonds of many small companies If you need to sell these quickly to get cash, may be hard to find a buyer, may need to settle for a price below its "intrinsic" value.
Pension Fund
retirement plans funded by corporations or government agencies for their workers and are administered primarily by the trust departments of commercial banks or by life insurance companies invest primarily in bonds, stocks, mortgages, and real estate
Investments
security analysis, portfolio theory, mkt analysis, behavioral finance
Hedge Funds
similar to mutual funds because they accept money from savers and use the funds to buy various securities hedge funds are largely unregulated - stems from the fact that mutual funds typically target small investors, whereas hedge funds typically have large minimum investments (often exceeding $1 million) that are marketed primarily to institutions and individuals with high networths. received their name because they traditionally were used when an individual was trying to hedge risks.
Exchange Traded Funds
similar to regular mutual funds and are often operated by mutual fund companies buy a portfolio of stocks of a certain type—for example S&P 500—and then sell their own shares to the public
Bid Price
the price at which they are willing to buy a security from you
Ask Price
the price at which they are willing to sell a security to you
Finance
the study of how we allocate our assets over time in a risky world.
Present Value
today's value of money you expect to receive in the future Discount future cash flows (using the discount factor) to calculate the present value PV = FV / (1 + r)^t
Commercial Bank
traditional department stores of finance serving a variety of savers and borrowers Historically, they were the major institutions that handled checking accounts and through which the Federal Reserve System expanded or contracted the money supply. Today, several other institutions also provide checking services and significantly influence the money supply. providing an ever-widening range of services, including stock brokerage services and insurance.
Multiple Uneven Cash Flows
use the cash flow (CF) function
Future Value
value of today's money at some point in the future. Compound present cash flows (using the interest rate factor) to calculate the future value FV = PV(1 + r)^t
