RSM230 MIDTERM 1

why are bonds sometimes called DEBT INSTRUMENTS?

bc u are acting as the lender

how is BUYING a bond considered BOTH a loan and a sale?

It's a loan because you expect to be paid back with interest.

It's also a sale because the issuer is selling you a debt security.

who is issuer in a bond?

person taking the loan and promising to pay interest over time (give out debt security)

are bonds a liquid investment?

YES. can buy/sell very easily

if a bond is from a well-known issuer, how is its liquidity?

very good. bc it has a KNOWN credit risk

issuer of a bond

entity that issues the bond and borrows money (e.g., government, corporation)

what determines credit risk?

who the ISSUER is

government bonds are ___________ then corporate bonds

safer

corporate bonds have _______________ potential returns then gov. bonds

higher

issuer vs investor in BONDS

issuer: entity who sells the bond to raise money (ie. gov/company)

investor: entity who buys the bond to make money (via debt securities)

investor receives __________________ and ____________________ at maturity

interest payments (coupon) and face value (principle) at maturity

credit risk

default risk

in the real world, what are we most worried about when it comes to credit risk? why?

bankruptcy

- in the event of bankruptcy, the bond holders dont have to pay it all off (we might get some assets or smth)

usually, we think of gov. bonds as having close to _____ credit risk. (if the loan is in their own currency).

0

why do we think of gov. bonds as having close to 0 credit risk?

being the gov. has so much money, and it can raise taxes to make more money or just print more money

what is the average probability of default for bonds?

5% (we dont get 5% back)

If a bond has 0 credit risk, then it will remain....

close to fair market value

- the loan market value is FAIR (for short-term)

inflation reduces the ________ value of bond payments

real

how does inflation reduce the purchasing power of bond payments?

If inflation rises, bond values decrease because fixed payments become less valuable in real terms.

a bond must offer enough ____________ to compensate for both inflation and credit risk

yield (interest)

a bond must offer enough yield (interest) to compensate for both __________________ and ______________

inflation and credit risk

coupon is APPROXIMATELY equal to ....

YTM (Yield to Maturity) or Fair Market Interest Rate

share of stock

% ownership of the company

stockholders have a claim on ___________________ but no guaranteed return

future profits (cash flow)

2 ways companies raise capital

issue stocks or bonds

companies issue stocks to...

raise equity

companies issue bonds to...

borrow money

can both bonds and stocks be traded in the secondary market?

yes

are bonds or stocks riskier?

stocks

why are stocks riskier then bonds?

stocks depend on mkt conditions, while bonds provide FIXED INTEREST PAYMENTS (except in the event of default)

3 types of assets

real assets, financial assets, financial instruments (securities)

real assets

Physical, tangible assets like factories, machinery, real estate (used for production).

financial assets

Represent claims on cash flows, such as stocks, bonds, and loans.

financial instruments (securities)

Tradable assets like stocks and bonds, which represent ownership or debt.

new securities are issued in the __________ market

primary

2 types of primary markets

IPO (Initial Public Offering) and SEO (Seasoned Equity Offering)

IPO

Initial public offering, a corporation's first offer to sell shares to the public

SEO

Seasoned equity offering, any other sale of stock to public after IPO.

where are existing securities traded between investors?

secondary market

2 examples of secondary market

NYSE (New York Stock Exchange) or NASDAQ

stock exchange

a market for buying and selling stock

2 examples of stock exchange

NYSE, NASDAQ

are stock exchanges a primary or secondary market?

secondary

Index

- measurement of the performance of a specific group of stocks that represent a portion of the market.

S&P 500 and Dow Jones are examples of...

Index

Index is used to....

track and compare the overall performance of stocks, sectors, or the entire economy.

S&P 500

A stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

Dow Jones Industrial Average (DJIA)

The average price of 30 selected industrial stocks, used as a measure of general market trends

in a bond, who is the issuer?

entity that sells the bond (borrows money)

in a bond, who is the borrower?

the issuer is ALSO the borrower

3 types of stocks

direct ownership (individual stocks), mutual funds, Exchange Traded Funds (ETF)

Direct ownership (individual stocks)

buying shares of a specific company. ex) Tesla, Apple

Mutual funds

Professionally-managed fund pool of money to invest in multiple stocks (think Hetalmama and what he does)

how does a zero-coupon bond work?

instead of recieving interest, investors buy it at a DISCOUNT and recieve the full face value at maturity

give an example of a zero-coupon bond

a bond w a face value of $1000 might be sold for $800 today and redeemed for $1000 at maturity

analysts aim to estimate the ________________ of a company

value

_________________ aim to estimate the value of a company

analysts

the fair interest rate that determines bond prices is called____________

YIELD

Yield in bonds

ROI expected from a bond

what influences whether a bond is sold at par, premium or discount?

yield

with mutually exclusive projects, the project with the ___________ NPV should be taken

highest

How can excessive cost-cutting or excessive price hikes boost short-term profits but harm long-term growth?

For example, a company may cut R&D expenses to show higher earnings this year, but this could hurt innovation and competitiveness in the future.

current cash flow

money a company is generating NOW from operations

future cash flow

money a company may generate in the future from INVESTMENTS, INNOVATION, EXPANSION, and CUSTOMER RETENTION

What is a good strategy when balancing current and future cash flow?

Ensure that the firm doesn't sacrifice future financial health for short-term gains

the stock market values firms based on..

expected future earnings, not just current profits

- investors prefer companies with consistent growth and stability over time, rather then those that just have short bursts of high profit followed by declines

Market Cap

Total market value of a company's outstanding shares.

Arbitrage

The practice of buying and selling equivalent goods to take advantage of a price difference

__________________ is a way to take advantage of temporary mkt inefficiencies

Arbitrage

the price of the same stock/asset can differ between countries due to....

1. Time zones: Different trading hours (e.g., NYSE opens when Taiwan's market is closed).

2. Market efficiency: Information spreads at different speeds.

3. Exchange rates: Currency fluctuations can impact prices.

While both PV and FV give the same value, which formula do we usually use?

PV

Present Value (PV)

market value of a cash flow expected to be received in the future

"discounting to the present" means

taking present values

discount rate

rate of return that could be earned on similar alternative investments

2 other words for discount rate

hurdle rate and OC of Capital

perpetuity

series of payments that continue forever

annuity

series of payments that end on a specific date

PV is today's ____________________ of a cash flow expected to be received in the future

market value

taking present values is also known as...

discounting to the present

discount rate

rate that can be earned on similar alternative arrangements

hurdle rate

minimum acceptable rate of return (a project must generate to be considered worthwhile)

PV of a stream of future cash flows =

sum of the PV of each of the cash flows

valuation

determining the PV of an asset, company or investment

the project with the highest NPV is not necessarily the project with the highest return. T or F

T

Why do we look at incremental cash flows when budgeting?

to isolate the actual impact of a project on a firm's cash flows

is accounting income = cash flows?

NO

when do we use depreciation?

never (except for tax purposes)

when is the ONLY time we use depreciation?

for tax purposes

how does depreciation indirectly affect cash flow?

through taxes

economic depreciation of equipment formula

difference in what we bought vs what we sold it for

book value

accounting value

depreciation reduces the ________________________ of an asset over time

book value (accounting value)

do u ever include sunk costs?

NOPE

- Only include cash inflows + cash outflows that will occur as a result of undertaking the project

- Past expenditures are irrelevant to the decision

do u include OC in NPV analysis?

YES

Should OC be included in expenditures?

yes. this is an exception to the rule of only considering actual cash flow

should allocation and overhead costs be included in Cash Flow formula for "estimating cash flows"

NO. unless they are incremental

when should "allocation and overhead costs" be included in the "cash flow formula for estimating cash flows"?. GIVE EXAMPLE

when its incremental

Example:

A company rents an office for $10,000 per month, and this rent stays the same whether the project is undertaken or not → Do not include this in project costs.

If the project requires leasing an extra floor, increasing rent by $3,000 per month, this additional cost should be included.

should effects on other parts of the firm be included in "estimating cash flows"?

yes. ex) including a new product may cause erosion in the sales of an existing product. this should be included as a negative cash flow for introducing the new product.

When launching a profitable project, competitors may react by introducing similar products or services.

Even if the company chooses not to pursue the project, competitors may still enter the market, affecting profitability.

HOW SHOULD WE STRATEGICALLY PLAN FOR THIS?

Anticipate competitive behavior rather than assuming market conditions will remain unchanged.

should we ignore incremental losses?

NO. only ignore losses that are NOT incremental