Business Finance 321 Final Exam- Definitions
Risk aversion definition
Assumes investors dislike risk and require higher rates of return to hold risker securities
Definition of inflation premium:
Avg expected inflation rate over the life of the loan
The type of risk associated with corporate bonds
"Credit risk"
Market Capitalization formula:
# of Shares of stock x Market price per share
Annual reports contain these four types of fin. statements:
Balance sheet, income statement, statement of cash flows, statement of stockholders' equity
Call provisions characteristics
Issuers must be willing to pay higher interest rate for callable bonds; must pay "call premium"when calling the bonds; Some have deferred call where bond is not callable for several years;
What does more debt tend to do to the WACC?
It reduces the WACC since after-tax cost of debt is lower than the cost of equity
What is rp in WACC?
It's the component cost of preferred stock where rp is the marginal cost of preferred stock
What is rs in WACC?
It's the cost of common equity where rs is the marginal cost of common equity using RE; re is the rate of return investors require on new eq. issued
What are the three primary sources that make up LT capital?
LT Debt, Preferred Stock, Common Eq.
Five major categories of ratios:
Liquidity (cash), asset management, debt management, profitability, market value
What are High Yield (Junk) bonds?
Lower rated bonds with greater default risk
What does a stock's risk include?
Market risk + diversifiable risk
RPM is defined as what?
Market risk premium-the premium require for bearing the risk of investing in the overall stock market= additional required return over the risk-free rate
When finding the weights in WACC (Wd, Wp, Wc), do we use book weights or market weights?
Market weights
Shareholder Primacy Model:
Maximize the interest of the owners (stockholders) by growing sales and profits to generate a higher stock price
What happens to ROA when debt increases?
ROA decreases because interest lowers NI; ROA= NI/Assets
Will the NPV of a project with the most cash flows coming in later years be severely reduced or increased as WACC increases?
Reduced, because a higher WACC has a greater impact on distant cash flows rather than near term cash flows
Sinking fund provision definition
Requires the issuer to retire a portion of the bonds each year
Maturity risk premium definition:
Risk of capital losses due to future changes in interest rates (price risk)
Factors impacting the interest rate to borrow money:
Risk of the borrower, length of time money is borrowed, collateral provided, type of debt (home, auto, etc.)
Reinvestment risk definition
Risk that a decline in interest rates will lead to a decline in income on a bond portfolio; the bondholder must reinvest at lower interest rates; high risk on ST bonds and callable bonds
Definition of default risk premium:
Risk that the borrower will default (i.e. not make payment)
Liquidity premium definition:
Risk that the security cannot be converted to cash on short notice at its fair value
Diversifiable risk definition:
Risk unique to a particular firm or industry; can be eliminated through diversification
Definition of primary market:
Sale of new additional shares of pubic companies
Financial goal of a business:
Shareholder wealth maximization (i.e.. maximizing stock price)
Should we focus on historical costs or new (marginal) costs?
Since cost of capital is used primarily to make decisions on new projects, we focus on today's marginal costs for the weighted avg cost
What effect does debt have on ROE and equity in general?
Since interest rates from debt lowers NI, debt lowers equity b/c ROE= NI/Equity
Is a portfolio's risk is smaller or larger than the average of the standard deviations of its individual assets?
Smaller
Type of risk associated with municipal bonds:
Some default risk
Coupon interest rate definition
Stated annual interest rate (generally fixed) paid by the issuer
Public corporations include which characteristics:
Stock publicly held by investors, "institutional investors" are large shareholders
Stakeholder Model purpose:
Strike a balance between profits and actions to benefit al stakeholders including stockholders, customers, etc.
What is the intrinsic value?
The "true" value of a company's stock as estimated by investors, analysts, etc.
What does NPV measure?
The project's contribution to shareholder wealth in dollars; if > 0, then accept the project
What is IRR?
The project's expected rate of return in %; rate that forces NPV to be 0.; same calc. as a bond's YTM
What is a Yield to Call (YTC)?
The rate of return on a bond if it is called before its maturity date
What is a yield to maturity (YTM)?
The rate of return that would actually be earned on a bond if it is held to maturity
Portfolio risk definition
The risk an investor would face if they held a group of stocks
Stand-alone risk definition
The risk an investor would face is they held only one stock
Price risk definition
The risk of decline in a bond's price due to an increase in interest rates; risk is higher on bonds with longer maturities
Default risk definition
The risk that the issuer will not make the payments is a key risk faced by bondholders
What does it mean if beta= 1?
The security is just as risky as the avg stock
What does it mean if beta is <1?
The security is less risky than avg
What does it mean if beta > 1?
The security is riskier than the avg
What is beta a measure of?
The stock's "market risk"; normally ranges from 0.5 to 1.5
Since solving for YTC and YTM are the same, what is the only difference between the time to call and the call premium?
The time to call is used for N and the call premium is FV
What is a perpetuity when it comes to preferred stock?
The value of a preferred stock
What does P stand for?
The value of a stock
What does the Discounted Dividend Model state?
The value of a stock equals the PV of the future dividends expected to be generated by the stock; hard to estimate all future dividends
What is the horizon or terminal value (TVn)?
The value of the FCF's after growth becoming constant based on a forecasted growth rate (g)
What do the w's and r's refer to in the WACC calculation?
The w's represent the firm's capital structure weights The r's represent the cost of each component
What does the expected rate of return of an investment portfolio equal?
The weighted avg of the expected returns of the portfolio's individual assets; NOT the riskiness
Expected Rate of Return Definition
The weighted avg of the probability of all the outcomes, representing the return expected from the stock investment
Why is new common equity more costly than common eq. from RE?
There are flotation costs associated with the new common eq.
What does a tighter or more peaked probability distribution curve mean?
There's a higher chance the actual rate of return on the stock will be close to the expected rate of return; tighter the distribution, the lower the risk
What is the purpose of bond ratings?
They are designed to reflect the probability of a bond issue going into default
What does it mean when investors are "risk averse"?
They like high returns and dislike high risk
What is the effect of low interest rates?
They stimulate foreign investment and consumer spending
What is the most important concept in finance?
Time Value of money: Also called discounted cash flow (DCF) analysis
Definition of secondary market:
Trading in outstanding shares of public companies
Four types of bonds:
Treasury bonds, corporate bonds, municipal bonds, foreign bonds
Name one use and two limitations of financial statements:
Use: ability to review and analyze fin. statements as well as accompanying footnotes; Limitations: managers use their own discretion (inconsistent) or how and when to record transactions; cash flow is more important than accounting income- modifications to fin. statements have to be made to accommodate this
Standard Deviation purpose:
Used as a measure of stand-alone risk; the smaller the SD, the tighter the probability distribution, the lower the risk that returns will vary
What is the discount rate used?
WACC or the weighted avg cost of capital
What is the Effective Annual rate (EFF%)?
also called equivalent annual rate (EAR)- annual Interest rate actually being earned
Types of risks associated with foreign bonds:
default risk and currency risk (exchange rate risk)
Warrant definition
long-term option to buy a stated number of shares of common stock at a specified price
What is the cost of debt in WACC?
rd(1-T) where rd is the marginal cost of debt capital
Three sections of balance sheet:
Assets, liabilities, stockholders' (owners') equity
What types of bonds are rated BBB or higher?
Investment-grade bonds
Correlation coefficient definition
A measure of the degree of correlation between two variables (stocks)
What is an Ordinary Annuity?
A payment at the end of a period
Steps in capital budgeting:
1. Est. cash flows 2. Determine the company's cost of capital (WACC) 3. Calc one or more decision criteria (see slide 11-4)
Who is are the top two and bottom two on a priority list when it comes to liquidation?
1. Secured creditors (collateralized bonds 2. Bankruptcy trustee costs 7. Preferred stock 8. Common stock
Federal taxes range from
15% to 35%
Federal and state typically used
40%
Typical average state tax
5%
Mortgage bonds definition
A bond backed by a pledge of specific assets as collateral
Bankruptcy definition:
A business has insufficient cash to meet its payment obligations, and thus becomes insolvent
Income Statement summarizes:
A company's financial results (revenue, expenses, NI) over a period of time (quarterly, (semi)annually, etc.)
Statement of cash flows summarizes:
A company's use of cash and receipts of cash over a period of time
Capital Asset Pricing Model (CAPM) definition
A financial model showing the relationship between risk and required returns when stocks are held in a portfolio
What is an amortized loan?
A load repaid in equal payments over its life where each payment consists of part interest and part principal
If IRR>WACC, should we accept or reject the project?
Accept, and vice versa if IRR<WACC; if both independent then accept both if both IRR> WACC=10%
Do stockholders focus on before-tax or after-tax capital costs?
After-tax cash flows
Private corporations include which characteristics:
Aka "closely held" corps, not publicly traded, stock owned by owners and managers
What is a nominal rate?
Aka annual percentage rate (APR0, quoted rate or stated rate; ignores compounding effects
Corporate valuation model is what?
Aka the free cash flow method i.e. the value of the entire firm equals the PV of its future free cash flows
Which stocks does a market risk impact?
All of them; can't be eliminated
Three reason financial analysts common size fin. statements:
Allows for comparisons of fin. statements b/c it eliminates size effects when comparing: 1. Results of one company to a competitor of diff. size 2. Results of same company of one year to the next 3. Results of the company compared to budget
Putable bond defintion
Allows holder to sell the bond back to the company prior to maturity
What is a periodic rate?
Amount of interest charged each period
What is a perpetuity?
An annuity that goes on forever
Proxy fight definition
An attempt by a group of stockholders to gain control of the company by controlling the voting shares
Debentures defintion
An unsecured bond i.e. no collateral
Does GAAP require items to be recorded at book value or market value?
Book value
Three ways to determine the cost of equity for RE, rs:
CAPM, Bond-Yield-Plus-Risk-Premium, or Dividend-Yield-plus Growth-Rate (DCF); CAPM is the most widely used
What is the cost of capital?
Calculated as the weighted avg of the various types of funds used over time by the firm
Common-Size balance sheets are calculated by:
Calculating individual items as a percent of total assets
Common-Size income statements are calculated by (See slide 4-15):
Calculating individual line items as a percent of sales
Dividends definition
Cash payment of company's earnings to shareholders
Statement of Stockholders' Equity summarizes:
Change in equity between the beginning and end of the period; shows how much of the earnings were retained rather than paid as dividends
Two main chapters of bankruptcy:
Chapter 11 Reorganization (business survives) and Chapter 7 Liquidation (worth more dead than alive)
Types of financial institutions:
Commercial and investment banks, pension funds, hedge fund, ETFs, Private eq. firms, college endowment funds, fin. service corps, life insurance companies
Definition of a classified stock
Common stock given a special designation such as Class A or Class B
Who analyzes fin. statements?
Company managers, banks/lenders, stockholders/investors, the SEC and IRS
What is benchmarking?
Comparing firm's performance to other firms in the same industry
Four key topic areas of finance:
Corporate finance, capital markets, investments, international finance
What is the real interest rate?
Current interest rate- Current inflation rate
Maturity date definition
Date bond principal is to be repaid
Does the call premium increase or decrease over time as bond approaches maturity?
Decreases
What is combining stocks into a portfolio to reduce risk called?
Diversification
Two sources of cash flow that the stock value derives from?
Dividends and capital gains
Coupon payment definition
Dollars of interest per payment
Examples of stock indexes:
Dow Jones Industrial Avg. (DJIA), S&P 500 Index, NASDAQ, Russell 2000 & 3000, MSCI EAFE
EBIT stands for:
Earnings before interest and taxes (aka Operating income)
EBITDA stands for:
Earnings before interest, taxes, depreciation and amortization
EBT stands for:
Earnings before taxes
Why is there a cost for RE?
Earnings can be reinvested or paid as dividends; there's an opportunity cost for the investor
Call provision definition
Gives issuer right to redeem the bonds early (ex. if interest rates decline)
Long term trends include:
Globalization of banking and commerce, more efficient and complex int'l financial markets, tech advancements
Convertible bond definition
Exchangeable for common stock of the issuer, at the bondholder's option
Expected Rate of return equals
Expected dividend yield + Expected growth rate or CGY
Par value definition
Face amount of the bond to be repaid at maturity
Four factors influencing interest rate levels:
Federal reserve policy, federal budget surplus or deficit, international factors, level of business activity (recessions)
What are flotation costs?
Fees paid to the investment banker
Balance sheet shows a company's:
Financial position at a specific point in time
The cash flow available AFTER the company has invested money is called:
Free cash flow
The "true value of a company is based on its:
Future cash flows AFTER taxes
What are flotation costs the highest and lowest for?
Highest- common eq.; Lowest-bond issuance
What is an amortization tables used for?
Home mortgages, auto loans, business loans, retirement plans, etc.
Premiums added to ST Treasury issuances:
IP
Premiums added to LT Treasury issuances:
IP and MRP
Premiums added to ST Corp. issuances:
IP, DRP, and LP
What determines the shape and slope of the yield curve?
IP, LP, DRP, MRP
Premiums added to LT Corp. issuances:
IP, MRP, DRP and LP
What is a discount bond and what occurs for a bond to become one?
If the market rate of interest is higher than the coupon rate, a bond's price will fall below its par value
What is a premium bond and what occurs for a bond to become one?
If the market rate of interest is lower than the coupon rate, the bond's price will increase above its par value.
Weaknesses of payback:
Ignores the time value of money, ignores cash flows after payback period
What's the difference between independent and mutually exclusive projects?
Independent projects' decisions are made separate from the others whereas with mutually exclusive projects, you only select one
Users of capital:
Individuals and institutions needing to raise funds to finance their investment opportunities and willing to pay a rate of return on the capital they borrow
Limitations to fin. ratio analysis
Industry avg may not be good; seasonal factors, historical values, and diff. accounting practices may distort ratios, "window dressing" may make ratios look better
Definition of IPO:
Initial public offering; initial sale of public stock by a private company; allows the company to raise money from outside investors
Suppliers of capital (money):
Institutions and individuals with "excess funds" that are saving money and looking for a rate of return on their investment
Why does rd only need adjustment in WACC?
Interest is tax deductible
What happens to interest and principal for each payment as time goes on?
Interest paid declines and principal paid increases
Indexed bond definition
Interest rate paid is based upon the rate of inflation
If a lower-rated bond carries a higher risk, what subsequently happens to the interest rate?
Interest rates also rise
Three factors affecting WACC:
Interest rates in the economy, level of stock prices in the market, tax rates
What does MIRR stand for?
Modified internal rate of return
Are short term interest rates more or less volatile than long term interest rates?
More volatile; they rise rapidly during booms and vice versa during recessions
Which method do we choose as the preferred method to make decisions to accept or reject? NPV or IRR
NPV
Two leading markets in the Stock Market:
NYSE (New York Stock Exchange), NASDAQ
Are EBITDA, EBIT, and EBT found in GAAP financial statements?
No
Are dividends on preferred stock or common stock tax deductible?
No
Treasury bond risks:
No risk of default
Does a change in WACC (cost of capital) impact the IRR?
No, because IRR is fixed for a set of cash flows. NPV does change however.
Statement of cash flows is split into three categories:
Operating activities, investing activities, and financing activities
What happens to P/E if growth and profitability are high and risk is low?
P/E is high
Value of a bond equals
PV of its FCF using the bond's market rate of interest (rd%)
What is an Annuity Due?
Payment at beginning of period (first payment is at time 0 on timeline
Income bond definition
Pays interest only when interest is earned by the issuer
Factors affecting bond ratings and default risk:
Potential labor problems, pension liabilities, provisions of the bond contract, financial performance, potential antitrust or product liabilities, accounting policy issues
Two types of corporations:
Private and public corporations
Impact of (well-off) financial. markets:
Promote economic growth, economies perform better, facilitation of the allocation of capital
Strengths of payback:
Provides an indication of a project's risk and liquidity
Takeover definiton
Purchasing the majority of outstanding stock in order to control the company
Risk premium (RP) definition
The Difference between the expected return on a risky asset vs. a less risky asset
What is the enterprise value?
The PV of all the firm's FCF's, the value of the entire company
rRF is what?
The Risk-Free Rate
DSO calculates what?
The average number of days after making a sale before receiving cash
What is re?
The common cost of new stock
What does g stand for?
The constant growth rate, also the stock price growth rate
What is the stock price?
The current price on the market and the PV of all expected future cash flows
What is the Yield Spread?
The gap between interest rates on different types of bonds
Capital gains definition
The growth in the price of the stock between time or purchase and time of sale
WACC is also known as what?
The hurdle rate; the rate that a specific project must exceed to be an acceptable project
What does MV of equity represent?
The market value of the common stock
Beta (b) is defined as what?
The measure of the risk of a specific stock held in a well-diversified portfolio and the extent to which the price of a stock goes up or down compared with the stock market (volatility)
What is the payback period?
The number of years required to recover a project's cost; calculated by adding project's cash inflows to its cost until cumulative cash flow turns positive;
What is an interest rate?
The price lenders receive and borrowers pay for debt capital (i.e.. loans)
What is another name for interest rates?
The price of debt
What is capital budgeting?
The process of analyzing projects and deciding which ones to include in the capital budget
Does YTM change or is it fixed?
YTM changes daily as interest rates change or as the market price of the bond changes
Do changes in inflation impact interest rates?
Yes
Is there a direct correlation between the amount of risk and return?
Yes, there's a direct correlation.
Relationship between Treasury and corporate issue yield curves
Yield curves for corp. securities are high due to greater default risk and liquidity premiums; The yield spread widens as corp. bond rating decreases (riskier the corp, the higher the yield curve)
What is a bond?
a LT debt instrument in which a borrower (issuer) agrees to make payments of principal and interest to the investors (bondholders)