finance final

indirect financing

involves financial institutions that are intermediaries between savers and borrowers.

intermediary

is an institution that acts as a middleman, providing services to those with funds to invest and those who need fund

bootstrapping

involves using personal savings, selling personal assets, borrowing against assets, using credit cards, and taking on personal loans to raise capital.

mutually exclusive projects

projects where choosing one project precludes the adoption of other projects. Managers must rank these projects by some criteria and select the best project

retention ratio

proportion of earnings (Net Income) that is retained and reinvested in the company

The stock price of Baskett Co. is $73. Investors require a return of 10.5 percent on similar stocks. If the company plans to pay a dividend of $4.25 next year, what growth rate is expected for the company's stock price?

.105 = $4.25/$73 + g .105 = .058 +g g = .105 - .058 = .047

Burkhardt Corp. pays a constant $13.50 dividend on its stock. The company will maintain this dividend for the next 9 years and will then cease paying dividends forever. If the required return on this stock is 9.2 percent, what is the current share price?

1. Enter 9 2. Press N 3. Enter 9.2 4. Press I/YR 5. Enter -13.50 6. Press PMT 7. Enter 0 8. Press FV 9. Solve by pressing PV, which gives a present value of $80.28

commercial bank

A financial intermediary that serves as an interface with savers and borrowers. These banks accept deposits from savers that offer safety and a rate of return. They then lend these funds out to individuals and businesses who need to borrow. Banks make a profit by lending out funds at an interest rate that is higher than the rate they pay to their depositors.

discount

A bond sells at a discount when its market price is less than its face value. This occurs when the coupon rate is less than the current YTM.

premium

A bond sells at a premium when its market price is greater than its face value. This occurs when the coupon rate is greater than the current YTM.

debenture

A bond that is not secured by an underlying asset.

interest only bond

A bond that makes regular periodic interest payments and pays the entire principal upon maturity.

discount bond

A bond that pays no interest and has a 0% coupon rate! At maturity it pays the face value plus accumulated interest

stock buybacks

A company can buy back its shares from the stockholders. This gives the shareholders a (hopefully) capital gain and cash, It also reduces the number of shares outstanding

divisible projects

A company may take on a portion of a project and get proportional benefits from the project

privately held company

A company that raises capital by selling their securities directly to investors rather than the general public.

levered firm

A company that uses both debt and equity in its capital structure.

unlevered firm

A company that uses only equity in its capital structure.

stock buyback

A corporation goes into the secondary market and buys back its own stock, thus giving cash to its shareholders.

inflation

A decrease in the purchasing power of a unit of a currency.

common stock

A financial security that represents ownership in a company: the right to all residual cash flows after the claims of the company's stakeholders have been satisfied. Common shareholders control the company through their election of the board of director

pure play firm

A firm concentrated in a particular industry or operation.

amortized loan

A loan with a scheduled number of equal payments, with each payment including both interest payments and a partial payment on the amount on the loan's principal.

dealer

A market maker that maintains an inventory and stands ready to buy and sell at any time. The dealer makes a profit through the spread: by buying an asset at one price and selling the asset at a higher price

SEO

A new public stock issued after the company's stock has been previously issued publically. Also called a seasoned new issue.

bond

A security representing the long-term debt of a company

convertible bonds

A type of bond that can be exchanged for common stock offered by the bond-issuing company. This feature provides the stable income and fixed payment of debt, but also allows the bondholder to share in a company's growth and profitability.

preferred stock

A type of stock whose holders are given certain priority over common shareholders in the payment of dividends. Usually the dividend rate is fixed at the time of issue and no voting rights are given.

economic interdependencies

Adopting a project would change the cash flows in other parts of the company

broker

An entity that brings security buyers and sellers together but does not maintain an inventory. The broker makes a profit via a commission paid for services rendered in facilitating the trade

deflation

An increase in the purchasing power of a unit of a currency.

capital gain

An increase in the value of an asset over its purchase price

real interest rate

An interest rate reflecting the real change in purchasing power of a currency.

nominal interest rate

An interest rate that is not adjusted for inflation.

secondary market transaction

An investor holding a publicly traded security sells the security to another investor. The company issuing the security is not part of this transaction. Once issued, these securities are traded among investors

rights offer

An offer that gives a current shareholder the opportunity to maintain a proportionate interest in the company before shares are offered to the public.

break-even analysis

Analysis of the level of sales at which a project would earn zero profit: At the break-even point revenues exactly equal costs.

collateral

Assets that are pledged as security for payment of debt.

investment grade bonds

Bonds rated to have a relatively low probability of default and are acceptable to prudent investors such as pension funds.

Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $5.3 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $7.4 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $26.5 million to build, and the site requires $1.32 million for an access road to a major highway. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?

Cash flow = $7,400,000 + 26,500,000 + 1,320,000 Cash flow = $35,220,000

operating cash flows

Cash flows received from the operating of the capital budgeting project

primary market transaction

Corporations and other organizations, with the assistance of investment banks, create financial securities and issue them to the investing public. This is how companies raise capital.

publicly traded corporations

Corporations who fulfill registration and reporting requirements and are authorized to sell financial securities to the general public.

sunk costs

Costs that have already been incurred. As such they would not be affected by the capital budgeting decision and are thus not incremental cash flow

Halestorm Corporation's common stock has a beta of 1.15. If the risk-free rate is 3.6 percent and the expected return on the market is 11 percent, what is the company's cost of equity capital?

E(R) = 0.36 + 1.15(.11 - .036) = .1211 or 12.11 %

For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 9 percent, should the firm accept this project? What if the required return was 21 percent?

Enter all cash flows using Initial cash flow: -168,500 Cash flow 1: $86,000 Cash flow 2: $91,000 Cash flow 3: $53,000 To get the NPV at 21%, just enter 21, press the I/YR button, then downshift and NPV

common stock

Equity claims held by the "residual owners" of the firm who are the last to receive any distribution of earnings or assets

initial cash flows

Expenditures that are undertaken to obtain assets and begin a capital budgeting project

hard rationing

Funds are not available and managers must choose the best set of projects given their capital constraints.

regulatory requirements project

Governments regulate economic activity to protect society from harmful effects. The most cost-effective way to handle toxic waste from a production process is to dump it into Lake Lady Bird. These projects are undertaken because they are required.

What is the profitability index for the following set of cash flows if the relevant discount rate is 10 percent? What if the discount rate is 15 percent? If it is 22 percent?

Initial cash flow: $0 Press CFJ Cash flow 1: $15,800 Press CFJ Cash flow 2: $13,600 Press CFJ Cash flow 3: $8,300 Press CFJ Inter 10 Press I/YR Press downshift Press PRC/NPV At the 10% discount rate the present value of the project's cash flows is $31,839.22. We need only divide this by the initial investment to get the PI. = $31,839.22/$27,500 = 1.158

A firm evaluates all of its projects by applying the IRR rule. If the required return is 11 percent, should the firm accept the following project?

Initial cash flow: -168,500 Cash flow 1: $86,000 Cash flow 2: $91,000 Cash flow 3: $53,000 To get IRR press downshift Then CST/IRR

financial markets

Markets in which financial securities are issued and traded.

soft rationing

Limits on investments are made by managers for better control of the firm

You find a zero coupon bond with a par value of $10,000 and 17 years to maturity. If the yield to maturity on this bond is 4.9 percent, what is the price of the bond? Assume semiannual compounding periods

N = 34 semiannual periods I/YR = semiannual discount rate of 2.45% PMT = 0 FV = The par value of the bond = $1,000 (Bonds are generally priced at $1,000) PV = Price of $4,391.30.

What price would a newly issued 10-year bond, paying interest annually, with a 10 percent coupon bond sell for? Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond now? The YTM?

N = 8 I/YR = 8 PV = $1,114.93 PMT = $100 FV = $1,000

exchanges

Organized public markets where companies list their securities for trading by investors. These listed securities must adhere to securities laws and regulations to be traded on these public markets. The exchanges provide a legal platform to ensure that the commitments made by participants are realized. Exchanges are generally organized as profit-seeking companies

Gilmore, Inc., just paid a dividend of $2.35 per share on its stock. The dividends are expected to grow at a constant rate of 4.1 percent per year, indefinitely. If investors require a return of 10.4 percent on this stock, what is the current price? What will the price be in three years? In 15 years?

P3 =P0(1 +g)3 P3 = $38.83(1 + .041)3 P3= $43.81

call provision

Part of a bond indenture that allows the issuer to buy back the bond under certain conditions.

protective covenant

Part of the indenture that protects bondholders by limiting certain actions a company might otherwise take.

the next dividend payment by Dizzle, Inc., will be $2.48 per share. The dividends are anticipated to maintain a growth rate of 4.5 percent forever. If the stock currently sells for $39.85 per share, what is the required return?

R=$2.48/$39.85 + .045 = 0.0622 + 0.045 = .1072

The Giuntoli Co. just issued a dividend of $2.55 per share on its common stock. The company is expected to maintain a constant 5 percent growth rate in its dividends indefinitely. If the stock sells for $43 a share, what is the company's cost of equity?

R=$2.55(1.05)/ $43 + 0.5

ackne Corp. has an issue of preferred stock with a $4.20 stated dividend that just sold for $93 per share. What is the bank's cost of preferred stock?

Rp = $4.20/$93 = .045, or 4.5%

corporate social responsibility project

The ExxonMobil project is an example of corporations contributing to society. While the corporation's function in society is to efficiently produce goods and services, corporations are expected to be good citizens. These projects do help society, and also enhance the reputation of the company.

principal value

The amount borrowed and the amount bondholders should receive when the bond matures. The face value of bonds is generally set at $1,000 per bond.

free cash flow

The amount of cash generated by a company that is available to distribute to the firm's creditors and owners

coupon payment

The amount of regular, per-period interest payments promised by the company issuing the bond.

coupon rate

The annual stated rate of interest paid on the bond. This rate is set when the bond is issued and does not change. This rate will set up the cash flows of the bond's time line.

balance sheet model of the firm

The assets of the firm must be supported by the firm obtaining financing (borrowing or issue equity). The accounting balance sheet follows the cost principle and records asset and claims at their historic costs when added to the balance sheet

YTM

The current opportunity cost on all bonds of equivalent risk and maturity. It is the rate required by market participants to invest in the bond. The yield will change with changes in economic conditions and the risk of the bond. This is the discount rate that will be used to discount the bond's cash flows to determine its economic value

financial leverage

The degree to which a firm uses debt in its capital structure. As interest payments are generally fixed, the more a firm uses debt, the more its net income will change with a change in sales.

inflation premium

The extra rate of return required by investors to compensate them for the loss of purchasing power of the currency.

maturity

The length time the bond will exist and when the bond should repay the principal to the bondholder. o

interest rate risk

The market price of a bond varies inversely with the current required rate of return.

erosion

The negative effect where adopting the project would decrease the cash flows from existing operations

earnings per share

The net income of the company divided by the number of shares. This states the income of the company on a per-share basis, which is useful when we're evaluating the price of a single share of stock

IPO

The original sale of a company's securities to the public. Also called an unseasoned new issue.

synergy

The positive effect where adopting the project would increase the cash flows from existing operation.

opportunity cost

The rate the bondholders expect to earn given the risk of the bond. It is the opportunity cost of the bond in that it is the rate of return the investor should earn on other similar bonds.

default risk

The risk that a bond issuer may not honor the provisions of the bond indenture, causing a loss in value of the bond.

investment horizon

The time period that the investor plans to hold the stock.

operating leverage

The use of fixed operating costs to magnify an increase in sales into a larger percent increase in operating profit and NOI.

WACC

The weighted average cost of a firm's common equity, preferred stock, and debt. Used as the discount rate for capital budgeting decisions.

institutional investors

These organizations pool large sums of money and invest those sums in securities, real property securities, and other investment assets. Their role in the economy is to act as highly specialized investors on behalf of others.

cost reduction project

These projects focus on reducing costs. Outsourcing of business functions or production, improving supply chains, employing machine learning lead to lower costs and thus higher income

revenue enhancing project

These projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign.

crowdfunding

Websites in which companies needing capital post information about their company and invite individuals to invest. Crowdfunding bypasses the traditional financial intermediaries such as investment banks and commercial banks.

indenture

Written agreement between the corporate debt issuer and the lender. Sets forth maturity date, interest rate, and other terms.

OTC markets

are not centralized trading places but rather systems by which dealers can offer to buy and sell securities among themselves and to their customers.

speculative bonds, junk bonds

bonds rated to have a higher probability of default. These bonds would be attractive to investors who have a high tolerance for risk, but would not be held by companies with fiduciary obligations, such as pension funds.

payback

calculates the amount of time it takes for a project to "payback" its initial investment. The shorter the payback period the quicker the company gets its initial investment back and begins to see profit. Managers set the maximum payback period they will accept. Projects with payback periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected.

investment bank

is a financial intermediary who perms a variety of services including aiding in the sale of securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individuals and institutional clients, and trading for their own account. In the following example Nathan works with an investment bank to create, price, and sell these new bonds

Bargeron Corporation has a target capital structure of 75 percent common stock, 5 percent preferred stock, and 20 percent debt. Its cost of equity is 10.9 percent, the cost of preferred stock is 7.1 percent, and the pretax cost of debt is 5.8 percent. The relevant tax rate is 21 percent. What is the company's WACC?

capital structure: :75% common stock :Equity cost of capital: 10.9% :5% preferred stock :Preferred cost of capital: 7.1% :20% debt :Pre-tax debt cost of capital: 5.8% :Corporate tax rate: 21% Bargeron' s WACC is thus: WACC = .75(.1090) + .05(.071) + .20(.058)(1 - .21) WACC = .094, or 9.4%

terminal cash flows

cash flows incurred in closing down a capital budgeting project.

capital spending

cash that must be invested in the project's capital assets

capital spending

cash that must be invested in the project's capital assets to produce the projected operating cash flow!

indivisible projects

company may adopt a project in its entirety or not, but cannot take a portion of a project.

venture capital

develop businesses into viable, profitable companies through their investment of capital that more traditional investors may not make.

direct expenditures

directly connected with obtaining the capital asset.

net present value

dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable.

operating cash flow

earnings before interest plus depreciation minus taxes. And, its important to remember that these cash flows have not yet occurred--we estimate what they would be if the project were to be adopted

market value

economic value: the present value of the promised payments taken at the bond's opportunity cost.

capital expenses

involve obtaining the major productive asset: a company will pay a substantial amount today to obtain the equipment, technology or other resource and will use this asset as part of the production process over several years.

direct financing

involves companies issuing financial securities through the financial markets to expand and build their operations.

preferred stock

form of equity that has preference over common stock in the payment of dividends. Preferred shareholders receive dividends before common shareholders. Preferred stock dividends are generally fixed and do not have voting rights in the corporation.

capital budgeting process

formal way for managers to guide their capital expenditure decisions.. This process consists of six steps or phases.

clientele effect

holds that some investors prefer companies with steady dividend payments, while other investors prefer growth in the stock price rather than the income from dividends.

bank loan

indirect financing where the company borrows funds from a bank, which gets those funds from savers. These claims are not traded in the financial markets

economic balance sheet

looks at assets and claims, but uses current market values.

economically independent projects

making one choice is independent of other choices. Managers can accept all projects that are wealth-increasing.

efficient market

market in which the price of the asset reflects its economic value

additions to net working capital

nvestments in the project's short-term assets.

ICFAT

periodic cash outflows and inflows that occur if, and only if, an investment project is accepted. Incremental cash flow focus on the project, not the company as a whole

average accounting return

rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR. If the project earns more than this specified rate, it is accepted. If the ARR is less, the project will be rejected. While useful for some purposes the AAR is not based on future cash flows, and does not use the opportunity cost. It is thus of limited use in making decisions about the future.

internal rate of return

rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost. They should only accept the project if it earns (IRR) more that should be expected (RRR) given other projects of equivalent risk

return on equity

rate of return that shareholders get on their investment in the corporation

price/earnings ratio

ratio of the stock price divided by the company's Earnings per Share (EPS).

profitability index

ratio that calculates the relative wealth created per dollar invested.. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications

dividends

regular payments to the shareholders that generally represent a distribution of profit. These payments are not guaranteed: the Board of Directors will declare—issue a dividend—only if they believe the company has enough cash or profits.

indirect expenditures

result from our decision to purchase the asset, should also be included at the project's inception.

operating expenses

short term expenses where the benefits are enjoyed in the same period as the expense are incurred.

cost of capital

the minimum rate of return required by investores to undertake a capital budgeting project

leverage

the use of fixed costs to magnify changes in rates of return

pure play method

uses a publicly traded firm's rate of return as the discount rate for a capital budgeting project that has the same operating characteristics as the pure-play firm.

capital rationing

where funds are limited to a fixed dollar amount and must be allocated among competing projects. Managers need a method of ranking projects, or portfolio of projects, by their desirability and selecting the higher ranked projects until funds are fully committed.