Principles of Finance Exam 1 - UARK (Kefu Wu)

What was the Gramm-Leach-Bliley Act of 1999?

- It promoted competition in U.S. banking. - It allowed business combinations between commercial banks, investment banks, & insurance companies and thus permits these institutions to compete in markets in a wider range of activities.

Bob Young, a management trainee at a large New York-based bank, is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3%, and consumer prices have been rising steadily at a 2% rate for several years. What should Bob's estimate of the real rate be?

1%

What are the 3 financial institutions?

1) Commercial Banks 2) Investment Banks 3) Shadow Banking System

What are the 3 Theories to explain shapes of yield curves?

1) Expectations Theory 2) Liquidity Preference Theory 3) Market Segmentation Theory

What are financial managers' key decisions? (4)

1) Financing 2) Investment 3) Capital Budgeting 4) Working Capital

What are the 3 types of Yield Curves?

1) Normal (upward sloping) 2) Flat 3) Inverted (downward sloping)

What are major forms of firm owners' income?

1) Ordinary Income: the income coming from business operations (i.e. wages, salaries, & dividend distributions) 2) Capital Gain: the income coming from proceeds of selling the firm's assets, including physical assets & financial securities.

What are 2 major ways for a firm to raise capital?

1) Private Placement 2) Public Offering

The major functions of the FDIC are?

1) Provides deposit insurance to individuals who held it in a bank that failed. 2) Examines banks on a regular basis to ensure that their operations are "safe & sound".

What are 3 organizational forms? What are their major differences?

1) Sole Proprietorship - unlimited liability, taxed on proprietor's personal tax return. 2) Partnership - unlimited liability for owners and may have to cover debts of other partners. Taxed on partners' personal tax return. 3) Corporation - limited liability, double taxation on firm and on individual

When VCs invest in a target company, a legal agreement clearly defines the deal structure and pricing. What does that entail?

1) The agreement will specify a guidance of the target company's operation strategy, and a timeline to go IPO. 2) The agreement will specify an explicit exit strategy fot the VC that defines when and how the VC must be repaid, in what prices. 3) VCs will require MORE equity ownership and pay LESS for the riskier and less developed firms.

What are Principles of managerial decisions? (5)

1) Time Value of Money 2) Risk-Return Tradeoff 3) "Cash is King" 4) Competitive Financial Market 5) Incentive

What is the Over-the-Counter Market?

A financial market where smaller, unlisted securities are traded. The total trading volumes in this market are small.

Underwriting Syndicate

A group of investment banks formed by the originating investment bank to share the investment opportunities as well as financial risks associated with underwriting new securities.

Generally, an increase in risk of a security will result in ________.

A higher return or interest rate

Selling Group

A large number of brokerage firms that join the originating investment banker(s); each accepts responsibility for selling a certain portion of a new security issue on a commission basis.

What is a Capital Market & what securities are traded w/in that market?

A long-term financial market in which traded securities have maturities of more than 1yr, or without maturity. Securities: 1) Long-term govt. securities (i.e. treasury notes (T-notes) or treasury bonds (T-bonds)). 2) Corporate bonds 3) Corporate preferred stocks & common stocks 4) Financial derivatives

What are Securitization of mortgage loans and morgage-backed securities?

A process of pooling mortgages of other types of loans to be a financial package or product and then selling claims/securities against that pool in the secondary market. These kinds of securities are mortgage-backed securities that represent claims on the cash flows generated by the pool of mortgages

What is a Money Market & what securities are traded in that market?

A short-term financial market, in which only highly liquid, marketable securities that are 1yr or less than 1yr maturities are being traded. Securities: 1) Treasury Bills (T-Bills) 2) Commercial paper 3) Negotiable certificates of deposit (CD)

The Gramm-Leach-Bliley Act of 1999 ________.

Allows business combinations between commercial banks, investment banks, and insurance companies

What is Purchasing Power Parity (PPP)?

An economic theory explaining the fundamental determination of foreign exchange rates. States that exchange rates will make the prices of g&s the same in all countries according to currencies' real purchasing power.

Expected inflation rates (i)

An expectation rate in prices rising of most g&s in an specified period of time

What are the differences between Broker Markets & Dealer Markets?

Both broker & dealer markets are secondary markets bc they trade for pre-owned securities. The differences are... Broker Market: has a trading floor. Brokers bring buyers & sellers together to make a transaction, but brokers do not buy/sell securities themselves. Brokers charge transaction fees (commission) for each completed transaction. ------Think of real estate agents selling houses! Dealer Market: Doesn't have a physical marketplace/trading floor. Dealers provide liquidity for security to buyers & sellers by either buying or selling securities from/to investors; therefore they play a role as "market makers". Dealers charge 1/2 of the bid/asking price + transaction fees (commission) for each completed transaction. So, transaction costs in dealer markets are higher than in broker markets.

How do you solve the Principal-Agent Problem?

By corporate governance... such as laws, rules & processes. Internally, some firms may offer stock options and/or restricted stocks as a sort of compensation to managers which link managers' performance/benefits directly to the firm's stock prices & therefore align managers' interests with the interests of the owners.

Which of the following provides savers with a secure place to invest funds and offer both individuals and companies loans to finance investments?

Commercial banks

What is a risk-premium for an underline non-government security?

Corporate issued securities are NOT risk-free. For investors, in order to compensate the risk for underline security (j), a risk premium (RP_j) should be added to a benchmark risk-free rate (Rf), and form a rate of required return for that security j: r_j = Rf + RP_j

When Country A has lower inflation than Country B

Country A's currency should appreciate against Country B's currency.

The ________ rate of interest is the rate that balances the supply of savings and the demand for investment funds in financial markets.

Equilibrium

What is the Expectations Theory?

Expectation could cause any shape of a yield curve

T/F? The term initial public offering (IPO) describes a transaction in which a firm sells securities directly to an investor or to a small group of investors.

FALSE

What is the difference between Finance and Accounting in terms of business transactions?

Financial Managers focus on actual Cash Flows, whereas Accountants focus on Accrual Basis.

Why do financial professions and economists want to study yield curve?

For financial managers, in comparison of costs for long-term funds or short-term funds, yield curve may affect the firm's financing decisions. Yield curve is a good predictor of future economy. A positive slope predicts an economic growth/boom; whereas a negative slope foreshadows a recession.

What is the President/CEO responsible for?

Fully in charge of overall business

More ________ and _______interest rates would tend to decrease the value of a country's currency relative to other currencies.

Imports; lower

What is the Bretton-Woods International Monetary System?

In other words... Gold can be exchanged for US dollars which promoted trade after WW11. º In 1944, allied countries signed agreement that established a Pegged Exchange Rate System for all member countries. º US gov. said that ppl could use dollars to redeem gold from Fed Reserve Banks. ----- USSR, China, & other communist countries not included. º Eliminated risks of foreign exchange rates in international trade markets. º 1970 US gov. declared that U.S. Fed Reserve Banks will no longer be obligated to redeem gold for US dollars. = collapse of B-W.I.M.S.

What is IPO (Initial Public Offering)?

Initial Public Offering (IPO): a firm goes public by issuing its common stock to public investors in a primary capital market. After the IPO, the firm's stocks become outstanding, listed in stock exchanges, and will be traded in secondary markets.

Which of the following assist companies in raising capital, advise firms on major transactions such as mergers or financial restructuring, and engage in trading and market-making activities?

Investment Banks

Suppose the Expectations Theory holds. If the yield curve is flat, this means that ________.

Investors do not expect interest rates to change in the future.

What is the Liquidity Preference Theory?

It claims that the long-term yield is higher than the short-term yield, causing an upward sloping yield curve

What is an equilibrium rate of interest?

It is the general market interest rate & is determined by the interaction of total supply and total demand of funds in financial markets.

What are the Board of Directors responsible for?

Making strategic decisions

What is the primary principle that Finance adopted from Economics?

Marginal Cost - Marginal Benefit Analysis. Wise financial systems must achieve MB > MC!!

What is the Market Segmentation Theory?

Market for loans is segmented on the basis of maturity, and the supply of & demand for loans within each segment determine its prevailing interest rate, thus determining the shape of the yield curve

What is the goal of a firm?

Maximize shareholder wealth

What is the difference between Money Markets & Capital Markets?

Money Market: short-term, 1yr or less maturities. Capital Market: Long-term, more than 1yr or no maturity.

What are subprime mortgages?

Mortgage loans made to borrowers with lower incomes and poor credit histories as compared to "prime" borrowers, therefore having much higher delinquency or default risks.

Should the firm maximize Stakeholders' Welfare?

No. Stakeholders are difficult to be ranked, therefore, their welfare can't be maximized.

Should the firm or financial managers set the goal to maximize profit?

No. It ignores 3 important factors: 1) Timing 2) Cash flows 3) Risk

What is the difference between Primary Markets & Secondary Markets?

Primary Market: is for a firm to issue/sell its stocks in order to raise equity financing. The stocks are purchased by investors for the first time in the market. The process is the so-called Initial Public Offering (IPO). ---- (kinda like buying clothes brand-spankin' new but for stocks) Secondary Market: is a financial market where investors trade for pre-owned securities. ---- (kinda like secondhand/hand-me-down clothes but for stocks)

The ________ market is where securities are initially issued and the ________ market is where pre-owned securities (not new issues) are traded.

Primary; secondary

What is Private Placement?

Raising funds by selling the firm's new securities directly to an investor or a group of investors through its own business network.

What are risk-free securities?

Securities with NO default risk. The interest rates offered by those securities are a benchmark of rate return in the absence of risk. In the US, government securities are regarded as "risk-free"

What is a different view of the school of Behavioral Finance opposing the Efficient Market Hypothesis?

Stock prices can change from their true values for extended periods, which may lead to predictable patterns in stock prices. Some evidence indicates that stocks performed poorly in the past displayed a predictable tendency to rebound, making investors aware of a pattern-profit opportunity.

The key securities traded in the capital markets are ________.

Stocks and bonds

T/F? The Securities Act of 1933 focuses on regulating the sale of securities in the primary market, whereas the 1934 Act deals with the regulations governing the transactions in the secondary market.

TRUE

T/F? The components of risk premium for an underline corporate bond includes business risk, financial risk, interest rate risk, liquidity risk, and tax risk.

TRUE

T/F? The nominal interest rate on a risk-free investment is approximately equal to the sum of the real rate of interest plus an inflation premium.

TRUE

What does the theory of the Efficient Market Hypothesis claim? What implication does it suggest?

That at any point in time, security prices fully reflect all information available about the firm & its securities. Suggests that: -- Securities are typically in equilibrium; they are fairly priced. -- Bc the market reaches equilibrium & securities are fairly priced, investors cannot easily find misplaced securities; therefore, investors cannot make systematic gains in such a market.

Nominal Interest Rates (r)

The actual rate of interest charged by the supplier of funds and paid by the demander of funds.

What is Public Offering?

The sale of either stocks or bonds to the general public conducted by financial institutions through capital market, typically a primary market.

Underwriting

The securities purchased by investment banks from an issuing corporation at an agreed-on (discount) price.

If the JPY/USD exchange rate goes from 117.453 to 118.543

The yen has depreciated relative to the dollar, and the dollar has appreciated relative to the yen.

What are financial institutions?

There are fund demanders and fund suppliers in the economy. Generally, individuals are fund suppliers & firms are fund demanders. Financial institutions are intermediaries that channel the savings of individuals, businesses, & governments into loans or investments to fund demanders.

What do investment banks do?

They assist companies in raising capital, advise firms on major transactions & business issues, and engage in security trading & market-making activities.

What do shadow banking systems do?

They engage in lending activities, but do not accept deposits and therefore they're not subject to the same regulations with which traditional institutions (i.e. commercial banks) must comply.

What do commercial banks do?

They receive deopsits and make commercial laws

Which of the following is an example of marketable securities?

U.S. Treasury Bills

Although no investment is truly risk free, ______ are generally viewed as the closest thing we can come to in the real world to a risk-free investment.

U.S. Treasury securities

What is the CFO responsible for?

Under CEO, in charge of overall financial management

What is the Controller responsible for?

Under CFO, Cheif accountant, responsible for accounting activities, tax management, and cost control

What is the Treasurer responsible for?

Under CFO, manages cash, pension plans, as well as key risks.

When an investment bank buys new securities from a firm and takes on the responsibility of reselling those securities to the public it is engaged in ________.

Underwriting

What are venture capital and venture capitalists (VC's)

Venture Capital: is an equity financing provided by a firm that specializes in financing young, rapidly growing firms. Venture Capitalists: are formal business entities that take in private equity capital from many individual invests & make private equity investment decisions on their behalf. Usually, these investments are very HIGH-RISK

Principal-Agent Problem

When the agent (worker or manager) doesn't act in the best interest of the principal (owner).

Do ethics of the firm affect its share prices?

Yes

How do you calculate marginal tax & total tax payment due with a progressive taxation framework?

You calculate tax payments for each applicable taxable income bracket w/ the marginal tax rate of that bracket, then add them up together.

Prospectus

a security registration statement submitted to the SEC & potential investors, which describe key aspects of the issue

Who are winners & who are losers due to changes in exchange rates?

a) Buyer or seller of a currency? ºººº if you want to buy a currency, you want a cheap/weak currency. ºººº if you want to sell a currency, you want an expensive/strong currency

What are major factors that influence foreign exchange rates & how?

a) Trade Flows ºººº If Country A has a trade deficit w/ Country B (i.e. imports exceeds exports) then Country A's currency should be depreciated relative to Country B's currency, then Country B's currency should be appreciated & vice versa. b) Inflation Rates ºººº If Country A has a higher inflation rate than Country B, then Country A's currency should be depreciated relative to Country B's currency, then Country B's currency should be appreciated & vice versa. c) Interest Rates ºººº If Country A has lower interest rates that Country B, then Country A's currency should be depreciated relative to Country B's currency, then Country B's currency should be appreciated & vice versa.

IPO offer price

the price a which the issuing firm sells its securities to public investors.

Real Interest Rate (r*)

the rate of return on an investment measured not in dollars, but in the purchasing power that the investment provides.

Firms that require funds from external sources can obtain them ________.

through financial institutions

What were the major measures of the Glass-Steagall Act of 1933?

º prohibited institutions from engaging in activities of high-risk business, thereby effectively separating commercial banks from investment banks. º Established Federal Deposit Insurance Corporation (FDIC).