Fundies Exams

What is Finance?

The uses and sources of assets with a focus on valuation of those assets

Investment Decisions

About the use of funds or about the asset side of the balance sheet

Financing decisions

About the sources of funds or liabilities side of the balance sheet

Real Assets

Produce goods and services

Financial Assets

Claims to cashflows generated by real assets

What is a corporation?

A business that is organized as a separate legal entity and run by managers but owned by shareholders

Advantages/Disadvantages of Corporation

+ Managers/ownership are easily exchanged

+ Access to capital

- Agency problems

- Double taxation

Book Value

According to the “books” prepared by accountants under US GAAP (backward looking)

*Does not account for many internally created intangible assets 

Market Value

According to the price at which investors are trading the firm on the market (forward looking)

Perpetuity

A stream of future cashflows where all cashflows are equal size, occur at regular intervals, and continue forever

Annuity

Stream of future cashflows of equal size, occur at regular intervals, but are finite in time

Interest rate risk

Risk that bond prices change because the interest rates change (investors want lower rates, corps want higher rates)

Bond and Interest rate relationship

Bond prices stand in an inverse relationship to interest rates

Interest Rate Bond comparison

If interest rate = coupon rate, sells at par

If interest rate > coupon rate, sells at discount

If interest rate < coupon rate, sells at premium

Yield to Maturity

The interest rate at which the present value of a bond’s coupon payments and face value are equal to the bond price

Current Yield

The annual coupon payment divided by price (does not account for capital gains)

Yield Curve

A graph that plots the relationship between the yield to maturity and time to maturity

Default Risk

Treasury bonds are always backed but corporation bonds may default on their obligations

Primary Market

Place where new shares are issued (IPO)

Secondary Market

Place where existing shares are bought and sold by investors

Price and Intrinsic Value

In an efficiently working capital market, a firms stock price is equal to its intrinsic value

Efficient Market Hypothesis

An efficient capital market is a market in which prices reflect all available information

If markets are efficient, new information leads to…

an immediate and full price change

Why should markets be efficient?

Competition among investors to make superior return drives prices to intrinsic value

Why should markets be inefficient?

Prices may deviate from intrinsic value because people are not always rational

Forms of Market Efficiency

1. Weak form - prices reflect all information about past price and changes

2. Semi-Strong Form (most realistic) - prices reflect all publicly available information

3. Strong Form - prices reflect all information including that of insiders

Capital Budgeting

Investment decisions are also called capital budgeting decisions

Sources of Incremental After Tax Cashflow

1. Capital Investments - required initial investment

2. Operations - projects incremental revenues minus tax

3. Changes in net Working Capital - addition of initial NPV

Stock Market Indices

Used to see how publicly traded companies are doing overall in the economy

Examples of Stock Market Indices

S&P 500, DOW, Russell 2000

Market Risk Premium

The return of stocks over and above the returns of US T-Bills compensating investors for risk

Diversification

Investment strategy where you combine two or more stocks into a portfolio in order to reduce risk

Correlation

Diversification does not work when returns are perfectly positively correlated. Works best when perfectly negatively correlated.

Risk

Market Risk - Cannot be diversified away

Firm Risk - Can be diversified away

Market Risk

Result of economy wide sources of risk that affect the overall stock market

Firm Risk

Result of sources that only affect the specific firm