Topic 1: Overview of Finance

The ask price of stock A is $56.75 while the bid price for stock A is $56.71. What is the bid ask spread?

.04 56.75-56.71 = 0.04

Suppose you bought a stock for $45 one year ago. Today the stock is currently priced at $47.42. If the stock does not pay a dividend, what is the percentage return for this stock? (ANSWER IN DECIMAL FORM.)

.0538 (47.42-45)/45 = 0.0538 or 5.38%

Suppose you bought a stock for $101.44 one year ago. Today the stock is currently priced at $109.54. If the stock does not pay a dividend, what is the percentage return for this stock? (ANSWER IN DECIMAL FORM)

.0799 (109.54-101.44)/101.44 = 0.0799 or 7.99%

Suppose you bought a stock for $19.84 one year ago. Today the stock is currently priced at $18.45. The stock recently paid a $3.50 dividend, what is the percentage return for this stock? (ANSWER IN DECIMAL FORM)

.1064 (18.45-19.84+3.50)/19.84 = 0.1064 or 10.64%

Suppose you bought a stock for $22.10 one year ago. Today the stock is currently priced at $22.08. The stock recently paid a $4 dividend, what is the percentage return for this stock? (ANSWER IN DECIMAL FORM)

.1801 (22.08-22.10 + 4)/22.10 = 0.1801 or 18.01%

The ask price of stock A is $215.54 while the bid price for stock A is $215.14. What is the bid ask spread?

.40 215.54-215.14 = 0.40

Suppose you bought a stock for $45 one year ago. Today the stock is currently priced at $47.42. If the stock does not pay a dividend, what is the dollar return for this stock?

2.42 47.42-45 = 2.42

Suppose you bought a stock for $22.10 one year ago. Today the stock is currently priced at $22.08. The stock recently paid a $4 dividend, what is the dollar return for this stock?

3.98 22.08-22.10 + 4 = 3.98

Suppose you bought a stock for $101.44 one year ago. Today the stock is currently priced at $109.54. If the stock does not pay a dividend, what is the dollar return for this stock?

8.10 109.54-101.44 = 8.10

To understand how the primary market works, we need to understand what a syndicate is

A syndicate is a group that is temporarily formed to handle a bond or stock issue. Syndicates are generally made up of large investment banks or other types of institutional investors. These large investment banks that make up a syndicate might also be the underwriters of the security issue. An underwriter has the responsibility of determining the value of the security and then, in some cases, the underwriter will purchase all of the securities from the issuer and then sell them to other investors.

What issue(s) are associated with the firm goal to maximize shareholder value?

Agency costs and potential unethical behavior

Which of the following is an example of firm capital?

Cash

What are the two ways a syndicate can place a bond?

Competitive sale or negotiated sale

What are the three important areas of finance discussed in this section?

Corporate Finance, Investments, and Banking/financial institutions

When dealers have to compete with one another, transaction costs will generally ___________.

Decrease

dollar returns

Dollar Returns=Pt−Pt−1+CFtDollar Returns=Pt−Pt−1+CFt In this equation, P t is the sold price, P t-1 is the bought price, and CF t is the cash flow (coupons for bonds; dividends for stocks).

Maximizing shareholder value ethically can improve society generally by:

Employing additional workers. Creating growth and leading to increased production by other firms. Increasing the profitability of other firms because of increased consumption.

An IPO is a seasoned equity offering.

False

Corporate finance is devoted to understanding various types of financial instruments.

False

Economics is a subfield of Finance

False

Secondary markets are where securities are initially offered to the public.

False

Trading on the NYSE is executed without a specialist (i.e., a market maker).

False

While competitive sales allow underwriters to submit bids to purchase bonds, negotiated sales do not.

False

Stocks that are listed on dealer markets generally have a single dealer for each stock.

False Stocks that are listed on dealer markets generally have multiple dealers for each stock.

A Treasury bond is a debt instrument issued by corporations.

False A Treasury bond is a debt instrument issued by governments.

A stock is a debt instrument issued by corporations.

False A stock represents ownership in a company

Agency costs are commonly mitigated by increasing management compensation.

False Agency costs are not commonly mitigated by increasing management compensation.

An example of agency costs is increased costs incurred because of higher levels of production.

False An example of agency costs is not increased costs incurred because of higher levels of production.

Dealer markets have a physical location.

False Auction markets have a physical location. Dealer markets do not.

Efficient markets are those in which prices are volatile.

False Efficient markets are those in which prices reflect all relevant information.

Efficient markets will often have mispriced securities.

False Efficient markets will often have mispriced securities.

A market order to sell a stock would execute at the current ask price.

False False. The order would execute at the current bid price.

A limit order to buy a stock at $101.55 would execute at the current ask price.

False False. The order would execute when the ask price is at or below $101.55.

Firms that are maximizing shareholder value will generally see stability in the firm's stock price.

False Firms that are maximizing shareholder value will generally see increases in the firm's stock price.

Firms with low unexpected earnings usually exhibit large positive returns on the earnings announcement day.

False Firms with low unexpected earnings usually exhibit large negative returns on the earnings announcement day.

Inefficient markets are those in which prices will respond quickly to new information.

False Inefficient markets are those in which prices will respond slowly to information.

Nasdaq is an example of an auction market.

False Nasdaq is an example of a dealer market.

Privately-held companies and publicly traded companies will always maximize shareholder value in the same way. TrueFalse

False Privately-held companies and publicly traded companies will always maximize shareholder value in the same way.

The NYSE specialist will charge a higher price to sellers of the stock and a lower price to the buyer of the stock.

False The NYSE specialist will charge a lower price to sellers of the stock and a higher price to the buyer of the stock.

Banks make money when interest rates they charge to borrowers are less than interest rates they pay depositors.

False. Banks make money when interest rates they charge to borrowers are MORE than interest rates they pay depositors.

NASDAQ is the world's largest secondary financial market.

False. The NYSE is the world's largest secondary financial market.

Which of the following is not an example of firm capital?

Financial markets

What are ways firms can maximize shareholder value?

Hire new employees to improve production and the profitability. Invest in new research and development that will be profitable. Invest capital into projects that will improve the profitability of the firm.

If providing liquidity becomes more risky, then dealers will __________ the spread.

Increase the spread

If the price of a particular stock begins to heavily fluctuate, then the specialist will __________ the spread.

Increase the spread

What is a way firms can maximize shareholder value?

Invest in new machinery that will be profitable.

Corporate Bonds

Just as the U.S. government might need to borrow money to cover costs or investments in new projects, firms also borrow from the public. Consider Google, the Internet giant, worth more than $300 billion as of 2013. Google might be looking to invest another $50 billion in low-orbiting satellites; however, because of its size, the company cannot walk into a local bank hoping for a $50-billion loan. Instead, Google will likely issue bonds with a face value of $1,000 that make one or two annual coupon payments a year and might be paid back over a 20-year period. If Google were to go bankrupt, then as part of the bankruptcy, those who hold Google's bonds will have access to the company's assets when they are liquidated.

What are the two types of orders that are used by investors?

Market Orders and Limit Orders

There are several different types of orders used by investors, but we will focus on the two most common types: market orders and limit orders.

Market orders are time sensitive while limit orders are price sensitive. Recall our example in the previous section about a $100 stock. If an investor submitted a market order to buy the $100 stock, the execution price would be at the current ask price which, in our example, was $100.03. However, the investor could instead submit a limit order to buy at a price of $100.00. In this case, the order would not execute until the specialist was willing to lower the ask price to $100.00 or a different investor submitted a limit sell order with a price of $100.00. If the latter were to occur, the limit sell order at $100 and the limit buy order at $100 would cross and execute without the specialist quoting different ask or bid prices. Much of the trading that occurs on the NYSE (and many other markets) is accomplished because limit buy orders and limit sell orders cross and execute.

The goal of the firm is to ___________ shareholder value.

Maximize

Stocks

Most finance students have heard of the many legends of those that have made or lost billions of dollars by investing in stocks. Before we can have that discussion, we need to become familiar with what a stock is. A stock is a share of ownership in a company. If Google did not want to borrow money from bondholders to finance the $50-billion low-orbiting satellite project, Google could sell shares of ownership in the company. Investors might be willing to buy shares of ownership in Google because they believe that this satellite project will be extremely profitable. Google will use the proceeds from the sale of these shares to fund the project. If Google were to fail, shareholders claim rank below those of bondholders when claiming the assets of the firm.

A stock is a share of ______________ in a particular company.

Ownership

percentage returns

Percentage returns are calculated by simply dividing the dollar returns by the price of the security at time t-1, or the previous time period. Percentage Returns=(Pt−Pt−1Pt−1+CFtPt−1)×100

Which of the following best explains the role of prices?

Prices convey information. Prices affect the distribution of income. Prices affect incentives.

Primary financial markets are markets where issuers place new securities with investors.

Primary financial markets are markets where issuers place new securities with investors.

A high-quality customer just purchased $500,000 worth of product from your company. The contract calls for immediate delivery of the product with a cash payment of $300,000 today and $200,000 to be paid in 60 days. The expense associated with the product is $300,000, of which $100,000 has not been paid to your supplier. Under an accrual based accounting system, you will most likely report which of these?

Revenues of 500,000 and expenses of 300,000

The goal of the firm is to maximize ___________ value.

Shareholder

market efficiency

The degree to which prices in a market reflect all available information.

Corporate Finance

The first area is corporate finance, which focuses on financial decision making by a firm's management.

Investments

The second area is investments. This area is devoted to understanding the various types of financial instruments—such as stocks, bonds, etc.—and how to value these instruments.

Banking or Financial Institution

The third area is banking. Almost everyone taking this course will have already visited a bank and will understand that banks make money by paying depositors a smaller interest rate than the interest rate they charge to borrowers.

The primary market for stock issuance works in a similar way to the bond primary market. However, some terminology is different. A firm that is going public (or selling shares of ownership for the first time) is going to perform an initial public offering (IPO).

These IPOs are sometimes called new equity offerings. However, much of the underwriting occurs in a similar manner, which we have discussed above.

Treasury Securities

Treasury securities are generally bonds that are issued by the U.S. government. The U.S. government is constantly investing in various projects that range from national defense to freeway improvements. When tax revenues fall short of covering these and other governmental costs, the U.S. Treasury will issue bonds. These bonds are effectively loans provided by the public to the government and will vary in length. Some of these bonds are as short as 60-day loans, while other bonds are loans that are paid over a 30-year period.

A bond is a debt instrument issued by corporations or governments.

True

A bond is similar to a loan.

True

A limit order to buy a stock at $101.55 would execute when the ask price is at or below $101.55.

True

A market order to buy a stock would execute at the current ask price.

True

A syndicate is a group of investors that is temporarily formed to handle the issuance of new bonds.

True

Agency costs are commonly mitigated by compensating management with company stock.

True

Agency costs are costs that are incurred when management does not act in the best interest of shareholders.

True

An IPO is where a company goes public or sells shares to the public for the first time.

True

An IPO occurs on the primary market.

True

An example of agency costs is a firm's decision to invest in a project because management enjoys working on the project.

True

An example of agency costs is management spending company money on unprofitable goods and services.

True

Auction markets have a physical location.

True

Capital is defined as a financial asset.

True

Companies can raise capital by issuing bonds or stocks.

True

Companies should always maximize shareholder value.

True

Corporate finance focuses on the decision making by the management of the firm.

True

Firms that are maximizing shareholder value will generally see increases in the firm's stock price.

True

Firms try to mitigate agency costs by aligning managers' interests with shareholders' interests.

True

Firms with high unexpected earnings usually exhibit large positive returns on the earnings announcement day.

True

In an efficient market, new information will move prices almost immediately.

True

In an inefficient market, prices will slowly respond to new information.

True

Inefficient markets will often have mispriced securities.

True

Markets are where prices are determined.

True

NYSE daily trading volume has increased over the last 50 years.

True

Ownership

True

Some high frequency traders provide liquidity to the rest of the market.

True

Stock represents ownership in a particular company.

True

Stocks and bonds are two types of financial instruments.

True

Syndicates are generally made up of investment banks and other institutional investors.

True

The NYSE specialist has an objective to provide liquidity to the market.

True

The bid-ask spread is compensation to the specialist for providing liquidity to the market.

True

The goal of the firm is to maximize shareholder value.

True

Without financial markets, exchange would become more costly.

True

Because in an efficient market all available information is built into the price of a stock - investment patterns and trends to "get rich quickly" are not easily discernable and it is difficult to predict the price

True In an efficient market, prices are not predictable.

Take, for example, a company that has recently announced unexpectedly strong earnings.

Upon the announcement, an efficient market will bid up the stock price of the company to fully reflect the strong earnings. Another example might be a company that has recently been named as a defendant in a class-action lawsuit. Upon the announcement of this class-action lawsuit, if stock prices take months to reflect this information, this might be evidence of market inefficiency. The purpose of discussing the price response to new information is based on the idea that as firms make sound, profitable decisions, their stock price (in an efficient market) should increase in relation to the firm's profitability. In the next section, we will discuss this in more detail.

Because the specialist faces risk

in holding an inventory of a stock that is fluctuating in price, the specialist will charge a slightly higher ask (or offer) price to those that want to buy and will be willing to pay a slightly lower bid price to those that want to sell.

Which type of bond placement - competitive sale or negotiated sale - requires a more thorough interview process?

negotiated sale

A stock is a share of ______________ in a particular company.

ownership

The matching principle in accrual accounting requires that_________.

revenues be recognized when the earnings process is complete and matches expenses to revenues recognized

In the previous section, we have discussed two large secondary financial markets: the NYSE and NASDAQ. The NYSE has a single individual with the title of

specialist A market maker on the New York Stock Exchange that holds an inventory of securities and acts as a liquidity provider to those that wish to buy and sell. , who provides liquidity. That is, the specialist is hired by the NYSE to provide a "fair and orderly" market, meaning the specialist is to hold an inventory of a particular stock and must be willing to buy from those that wish to sell and sell to those that wish to buy.

Think about cases when a firm releases a new product or announces the acquisition of another competing company. These decisions will undoubtedly affect the stock price of the firm. The goal of the firm is

therefore, to maximize shareholder value. This is usually accomplished by profitable decision-making by management, investing capital into projects that will increase the firm's stock price, and avoiding those investments that cost more money than they bring in.

Market orders are __________ sensitive while limit orders are _____________ sensitive.

time, price