EXAM 1 intro to finance - Lecture notes Study Guide PDF

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EXAM 1: FINANCE 3104 Chapter 1: An Introduction to the Foundations of Financial Management

The Goal of the Firm -

The fundamental goal of a business is to create value for the company’s owners, maximization of shareholder wealth Goal of the financial manager is to create wealth for the shareholders by making decisions that will maximize the price of the existing common stock

Five Principles that Form the Foundations of Finance 1. Cash Flow is what matters o Cash flow represents what money can be spent o Cash flow determines the value of a business o Incremental cash flow: the difference between the cash flows a company will produce both with and without the investment it is thinking about making 2. Money has a Time Value o Opportunity cost: the cost of making a choice in terms of the next best alternative that must be forgone 3. Risk Requires a Reward o Investors want a return that satisfies two requirements:  A return of delaying consumption  An additional return for taking on risk o The greater the risk, the greater the expected return 4. Market Prices are generally right o Efficient market: a market in which the prices of securities at any instant time fully reflect all publicly available information about the securities and their actual public values o Stock market prices are a useful barometer of the value of a firm  Managers can expect their company’s share prices to respond quickly to investor’s assessments of their decisions o Behavioral biases have an impact on our decisions 5. Conflicts of Interest Cause Agency Problems o Agency problem – problems and conflicts resulting from the separation of the management and ownership - The global financial crisis  Subprime loans  Mortgage back securities, securitization – process of packaging mortgages  Under water – homeowners owe more than the home is worth - Avoiding Financial Crisis - The Essential Elements of Ethics and Trust

The Role of Finance in Business - Finance is the study of how people and businesses evaluate investments and raise capital to fund them - The study of finance addresses: 1. Capital budgeting - What long-term investments should the firm undertake? o Capital budgeting is the decision making process with respect to investment in fixed assets 2. Capital structure decisions- how should the firm raise money to fund these investments? The firm’s funding choices are generally referred to as capital structure decisions o Capital structure decision is the decision making process with funding choices and the mix of long-term sources of funds

3. Working capital management- how can the firm best manage its cash flows as they arise in its day-today operations? o Working capital management is the management of the firm’s current assets and short term financing - Finance is the management and interpretation of information o Financial Markets: those institutions and procedures that facilitate transactions and all types of financial claims - The Role of the Financial Manager

The Legal Forms of Business Organization 1. Sole Proprietorships: a business owned by a single individual o Individual is responsibility for liabilities o Assumed-name certificate o Termination by death or choice o Absence of any form of legal business structure 2. Partnerships: an association of two or more individuals joining together as co-owners to operate a business for profit a. General Partnership: each partner is fully responsible for the liabilities incurred by the partnership i. Partnership agreement b. Limited Partnership: a partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership i. One partner has unlimited liability ii. Names of limited partner may not appear in the name of the firm iii. Limited partners may not participate in the management of the business 3. Corporation: an entity that legally functions separate and apart from its owners a. Can individually sue and be sued, purchase sell or own property, personnel are subject to criminal punishment for crimes b. Composed of owners who dictate its direction and policies c. Board of directors and corporate officers Organizational Form and Taxes: The Double Taxation on Dividends - Occurs when a corporation earns a profit, pays taxes on those profits, pays some of those profits back to shareholders in the form of dividends, and then the shareholders pay personal income taxes on those dividends o Disadvantage of corporations S-Corporations and Limited Liability Companies - S- Corporation: a corporation that because of specific qualifications, is taxed as though it were a partnership o Cannot be used for a joint venture between two corporations - Limited Liability Company: a cross between a partnership and a corporation under which the owners retain limited liability but the company is run and is taxed like a partnership o Corporations can be owners in an LLC o Operate under state laws o Cannot look too much like a corporation or it will be taxed like one

Finance and the Multinational Firm: The New Role

EXAM 1: FINANCE 3104 Chapter 2: The Financial Markets and Interest Rates Capital Markets: all institutions and procedures that facilitate transactions in long-term financial instruments

Financing of Business: The Movement of Funds Through the Economy -

Three ways to transfer Capital in the Economy 1. Direct transfer of funds a. Angel Investor: a wealthy private investor who provides capital for a business startup b. Venture Capitalist: an investment firm (or individual investor) that provides money to business start-ups 2. Indirect Transfer of Funds using an investment-banking firm a. Investment banking firm is a financial institution that helps companies raise capital, trades in securities, and provides advice on transactions such as mergers and acquisitions b. Syndicate – will buy the entire issue of securities from the firm that is in need of financial capital, the syndicate will then sell the securities at a higher price to the investing public than it paid for them 3. Indirect transfer using a financial intermediary a. Life insurance companies, mutual funds, and pension funds b. Collects the savings of individuals and issues its own securities in exchange for these savings. The intermediary then uses the funds collected from the individual savers to acquire the business firm’s direct securities such as stocks and bonds

Public Offerings versus Private Placements - Public offering: a security offering in which all investors have to opportunity to acquire a portion of the financial claims being sold o The process of acting as an intermediary between an issuer of a security and the investing public is called underwriting - Private Placement: a security offering limited to a small number of potential investors o Venture capital firm first raises money from institutional investors and high net worth individuals, then pools the funds and invests in start-ups and early-stage companies o Not very appealing to broader public markets due to:  Small absolute size  Very limited or nonexistent historical track record of operating results  Obscure growth prospects  Inability to sell the stock easily or quickly o Because of the high risk the venture capitalist will sit on the board Primary Markets versus Secondary Markets - Primary market: a market in which securities are offered for the first time for sale to potential investors - Initial Public Offering (IPO): the first time a company issues its stock to the public - Seasoned Equity Offering: the sale of additional stock by a company whose shares are already publicly traded - Secondary Market: a market in which currently outstanding securities are traded o SEC regulates the primary and secondary market The Money Market versus the Capital Market

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Money market: all institutions and procedures that facilitate transactions for short-term instruments issued by borrowers with very high credit ratings, short term = 1 year or less o U.S. treasury bills, various federal agency securities, bankers’ acceptances, negotiable certificates of deposit, commercial paper o Capital markets – long term financial instruments

Spot Markets versus Futures Markets - Spot market: cash market - Futures markets: markets in which you can buy or sell something at a future date Stock Exchanges: Organized Security Exchanges versus Over-the-Counter Markets, a Blurring Difference - Organized security exchanges: formal organizations that facilitate the trading of securities - Over-the-counter markets: all security markets except organized exchanges. The money market is an over the counter market. Most corporate bonds are also traded in the over-the-counter market. Organized Security Exchanges NYSE Over the Counter Markets o Many publicly held markets don’t meet the listing requirements of the organized stock exchanges or would rather be listed on NASDAQ Stock Exchange Benefits 1. Providing a continuous market a. Price volatility is reduced 2. Establishing and publicizing fair security prices a. Specific price of a security is determined in the manner of an auction, security prices are also widely publicized 3. Helping a business raise new capital a. Comparative values of securities offered in these markets are easily determined

Selling Securities to the Public -

Investment Banker: a financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds Underwriting: the purchase and subsequent resale of a new security issue at a satisfactory, profitable, price is assumed (underwritten) by the investment banker Underwriter’s Spread: the difference between the price the corporation raising money gets and the public offering of a security

Investment Banking Functions 1. Underwriting o Means assuming a risk, the risk of selling a security issued at a satisfactory price, a satisfactory price is one that generates a profit for the investment banking house o Syndicate: a group of investment bankers who contractually assists in the buying and selling of a new security issue o Procedure- managing investment banker and its syndicate will buy the security issue from the corporation in need of funds. The client is presented with a check from the managing house in exchange for the securities being issued. The syndicate owns the securities. 2. Distributing o Once the syndicate owns the new securities, it must get them into the hands of the ultimate investors o Distribution or selling function of investment banking 3. Advising

o Investment banker is an expert Distribution methods 1- Negotiated Purchase If all goes well, a method is negotiated for determining the price the investment banker and the syndicate will pay for securities. The negotiated purchase is the most prevalent method of securities distribution in the private sector, generally thought to be the most profitable technique according to investment bankers 2- Competitive Bid Purchase Several underwriting groups bid for the right to purchase the new issue from the corporation that is raising funds The investment banker willing to pay the greatest dollar amount per new security wins the competitive bid 1- Railroad issues 2- Public utility issues 3- State and municipal bond issues One issue is that the benefits from the advisory function are lost 3- Commission or Best-Efforts Basis Investment banker acts as an agent rather than a principle Securities are NOT underwritten, banker attempts to sell the issue in return for a fixed commission on each security sold Unsold securities are returned to corporation Issuing firm may be smaller Less costly to the issuer, successful sale not guaranteed 4- Privileged Subscription Privileged subscription: the process of marketing a new security issue to a select group of investors Target Markets: 1- Current stockholders 2- Employees 3- Customers of the firm Distributions directed at current stockholders are the most prevalent Rights offerings Investment banker may act only as a selling agent Standby agreement: obligates the investment banker to underwrite the securities that are not purchased by the privileged investors 5- Dutch Auction Dutch Auction: a method of issuing securities (common stock) by which investors place bids on indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares 6- Direct Sale Direct Sale: the sale of securities by a corporation to the investing public without the services of an investment banking firm Rare Private Debt Placements - Alternative to the sale of securities to the public through a privileged subscription

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Important investor groups: 1. Life insurance companies 2. State and local retirement finds 3. Private pension funds Advantages 1- Speed 2- Reduced costs 3- Financing flexibility Disadvantages 1- Interest costs 2- Restrictive covenants 3- The possibility of future SEC registration Flotation costs: the transaction costs incurred when a firm raises funds by issuing a particular type of security - Underwriters spread: difference between the gross and net proceeds from a given security issue expressed as a percent of the gross proceeds - Issuing costs: printing and engraving of certificates, legal fees, accounting fees, trustee fees, misc. components Regulation Aimed at Making the Goal of the Firm work: The Sarbanes- Oakley Act - Protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws and for other purposes

Rates of Return in Financial Markets Opportunity cost of fund: the next best rate of return available to the investor for a given level of risk Rates of Return over Long Periods - Common stocks have more risk ad produce higher average annual returns than long-term corporate bonds - Greater the risk the greater the expected returns Interest Rate Levels in Recent Periods - Nominal (or quoted) rate of interest: the interest rate paid on debt securities without an adjustment for any loss in purchasing power o Investors require a nominal rate of interest that exceeds the inflation rate or else their realized real return will be negative - Basis Point: one basis point is equal to 1/100th of 1 percent or 0.01 percent - Inflation premium: a premium to compensate for anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument - Default risk premium: the additional return required by investors to compensate them for the risk to default. It is calculated as the difference in rates between a U.S. treasury bond and a corporate bond of the same maturity and marketability - Maturity Risk Premium: the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes - Liquidity risk premium: the additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price

Interest Rate Determinants in a Nutshell Real risk-free interest rate: the required rate of return on a fixed-income security that has no risk in an economic environment of zero inflation Nominal interest rate =

real risk-free interest rate + inflation premium + default- risk premium + maturity-risk premium + liquidity-risk premium

Where… - Nominal interest rate: the quoted interest rate and is the interest rate paid on debt securities without an adjustment for any loss in purchasing power - Real risk free interest rate: the interest rate on a fixed income security that has no risk in an economic environment of zero inflation. The n0ominal interest rate less the inflation, default risk, maturity risk, and liquidity risk premiums - Inflation premium: a premium to compensate for anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument - Default risk premium: the additional return required by investors to compensate for the risk of default. It is calculated as the difference in rates between a U.S. treasury bond and a corporate bond of the same maturity and market ability - Maturity risk premium: the additional return required by investors in longer term securities to compensate them for the greater risk of price fluctuation on those securities caused by interest rate changes - Liquidity risk premium: the additional return required but investors for securities that cannot be quickly converted into cash at a reasonably predictable price Estimating Specific Interest Rate Returns Using Risk Premiums Risk-free interest rate = real risk-free interest rate +inflation premium OR Real risk free interest rate = risk-free interest rate – inflation premium Real ~ “after inflation adjusted” return The impact of inflation has been subtracted from the interest rate Real risk free: the return if there were no risk and no inflation Real and Nominal Rates of Interest - Real rate of interest: the nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment - Nominal rate of interest tells you how much money you will earn in interest Nominal Interest Rate = real rate of interest + inflation premium *practice Did You Get It? Page 40

1+ nominal interest rate = (1+ real rate of interest) (1+ rate of inflation) subtract inflation rate from nominal rate nominal interest rate = real rate of interest + rate of inflation + (real rate of interest) (rate of inflation) Inflation and Real Rates of Return: The Financial Analysts Approach Nominal interest rate – inflation rate = real interest rate -

Remember that the real rate on the corporate bonds is expected to be greater than that on long-term government bonds because of the default-risk premium placed on corporate securities

The Term Structure of Interest Rates Term structure of interest rates or yield curve: the relationship between interest rates and the term to maturity where the risk of default is held constant The term structure reflects observed rates or yields on similar securities, except for the length of time until maturity at a particular moment in time Shifts in the Term Structures of Interest Rates - Term structure changes over time as expectations change IMPORTANT: NOMINAL OR QUOTED RATE OF INTEREST

=

REAL RATE + OF INTEREST

INFLATION RATE

+

(REAL RATE (INFLATION OF INTEREST) x RATE)

What Explains the Shape of the Term Structure 1- Unbiased expectations theory Unbiased Expectations Theory: the shape of the term structure of interest rates is determined by an investor’s expectations about future interest rates Example: Second year investment, calculating interest needed Interest received in year 2 -----------------------------Investment made at beginning of year 2

2- Liquidity preference theory Liquidity Preference Theory: the theory that the shape of the term structure of interest rates is determined by an investor’s additional required interest rate in compensation for additional risks Risk premium – additional required interest rate – to compensate for the risk of changing future interest rates is nothing more than the maturity premium introduced earlier (what? No idea what that means lol) 3- Market segmentation theory Market Segmentation Theory: the theory that the shape of the term structure of interest rates implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity. This rate is independent of the demand and supply for securities having different maturities.

More moderate version of the theory - Allows investors to have strong maturity preferences, but also allows them to modify their feelings and preferences if significant yield changes occur...