BA323 MEGASET

What is the main goal of the corporation?

To make capital gains for shareholders. Maximize value of the firm.

Who ultimately owns the corporation? What is the relationship between

shareholders, the board of directors, and management?

Shareholders ultimately own the corporation. Management (managers) are naturally inclined to act in their own interests but that may not be in the best interests of shareholders. The board of directors - elected by the shareholders - can oversee managerial behavior through corporate governance.

What are the 3 most important management positions?

CEO, COO, CFO

What is the Sarbanes-Oxley legislation? Why was it passed?

Sarbanes-Oxley was passed in 2002 as a result of the Enron and Worldcom scandals. It makes corporate management legally responsible for the accuracy of their financial statements.

What is the major disadvantages and advantages of corporations compared to other forms of business organizations?

Advantages: Ease of raising money (BIGGEST ADVANTAGE), Unlimited life, Easy transfer of ownership, and limited liability (you can only lose what you've invested).

Disadvantages: Double taxation and cost of setup and report filing.

What is a stock's intrinsic value? In an efficient market, will a stock's price equal

the stock's intrinsic value?

A stock's intrinsic ("true") value is the value the investor inherently believes the stock to possess, i.e. the 'correct price'. In an efficient market a stock's price should equal it's intrinsic value.

Why do shareholders have a conflict of interest with managers?

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders).

What is corporate governance?

The system of governing a company that aligns the interests of shareholders and managers together.

What are various strategies for aligning the interests of shareholders and management?

Stock instead of cash. Long vesting periods. Stronger oversight by board or outside investors.

Change in CEO Compensation starting in the 1980s?

Movement away from salaries to stock options to foster growth, innovation and risk-taking.

Why is it a good idea for CEO compensation to track an overall market index like the S&P 500?

To align interests of shareholder and management. Expect CEO compensation to track S&P 500; as opposed to a bond-market which would discourage risks.

What is the bondholder-stockholder conflict? Do bondholders prefer safer or risky corporate investments?

Bondholders prefer safe, secure investments while stockholders prefer riskier business maneuvers for possible greater capital gains.

What is the difference between shareholder theory and stakeholder theory?

Shareholder Theory = Maximize capital gains for shareholders.

Stakeholder Theory = consider other objectives such as the impact on employees, suppliers and the environment.

What are the three ways that capital is transferred between savers and

borrowers?

- Direct transfers: Business sells its stocks or bonds directly to

savers without going through any financial

institution

- Investment Banks/Underwriters: Transfers that go through an investment bank

such as Goldman Sachs or Morgan Stanley. Companies sells stock or bonds to the

underwriter, which is then sold by the

investment bank to savers. Underwriters are taking on risk. Also called primary market transactions

- Financial Intermediaries (Banks): Loans made through a financial intermediary

such as a bank, insurance company, or a mutual

fund. The intermediary obtains funds from savers in

exchange for securities

Why do most companies use underwriters to raise capital instead of using direct transfers? What purpose do investment banks serve in the underwriting process?

Most companies use underwriters instead of direct transfers because of the ability to raise much larger amounts of capital. In the underwriting process the investment banks are taking on a share of risk.

Describe the capital allocation process and what role the suppliers of capital plays and the role that the users of capital play. Why is the financial system often described as the circulatory system of the economy?

- In a well-functioning economy, capital flows

efficiently from those who supply capital to

those who demand it.

- Suppliers of capital: individuals and institutions

with "excess funds." These groups are saving

money and looking for a rate of return on their

investment.

- Demanders or users of capital: individuals and

institutions who need to raise funds to finance

their investment opportunities. These groups

are willing to pay a rate of return on the capital

they borrow.

(i.e. money is moving, it isn't just sitting in Scrooge McDucks Money Bin)

What is the main difference between private and public markets?

- Private Markets- transactions are negotiated

directly between two or more parties.

• Bank loans, private debt placements

• Unique negotiations, not traded

- Public Markets - Standardized contracts

traded on organized exchanges

• Multiple instances of the same contract

• Much more liquid than private market

• Example: shares of a stock

The derivative market exceeds 700 trillion. What type of derivative is most common?

*Interest rate derivatives.

Difference between primary and secondary market transactions?

- Primary Markets - Markets in which

corporations raise new capital

• Example: Investment bank gives money to company

- Secondary Markets - An already existing

security is traded among investors

• Involves no direct inflow of funds to the

corporation

• However, the existence of secondary markets is

crucial for well functioning primary markets

What is an IPO? Why do companies go public?

IPO = Initial Public Offering. "Going public" enables a company's owners to raise capital from a wide variety of outside

investors. Once issued, the stock trades in the secondary market.

On average, do IPOs make or lose money over time? Why is it so important for private equity funds to invest in a large number of IPOs?

Most IPO's lose money, thus it is important for private equity funds to invest in a large number to offset losses in hope for the next Google/Facebook/Amazon, etc.

What is behavioral finance? Know the four behavioral biases discussed in class.

Cognitive biases that cause investors to make systematic

mistakes that lead to inefficiencies. This is an area

of research know as "behavioral finance."

• Over-optimism/overconfidence - investors are

more optimistic about expected future returns than

they should be

• Prospect Theory - care more about losses than

gains

• Anchoring - Care about the first piece of information

that you see too much

• Herding - Investors have a tendency to revise their initial forecasts to be closer to the average forecast

What is the We Company's business model?

Buy and buildout large amounts of real-estate assets to subsequently rent/lease. "But we're more a like a tech company bruh because we rent/lease out to cool/hip millenials"

Why does We need to raise capital?

Because they aren't making a profit yet! They need funds to become 'too big to fail'.

How does We illustrate how the IPO process works?

WE needs capital and Softbank is the underwriter, however Softbank is only offering to fiance some of the IPO.

Hedge funds and derivatives: Hedge funds often use derivatives to increase risk.

Hedge fund is a management company that takes money from individuals and tries to make XYZ more money from it! Then they give a share back.

(100 year bond example from Argentina)

What are Quarterly Earnings Reports? Why do investors care about them so much?

Stocks report earnings four times a year

- Crucial report

• Results can move stock prices by 3%-15%+

• Apple: 4% move results in a $40 billion change in

market cap!

- Investors and analysis pay close attention to the

company's cash, profits, and investment

decisions

•What are the four parts of an annual report?

Balance sheet

• Provides a snapshot of a firm's financial position

at one point in time.

Income statement

• Summarizes a firm's revenues and expenses over

a given period of time.

Statement of cash flows

• Reports the impact of a firm's activities on cash

flows over a given period of time.

Statement of stockholders' equity

• Shows how much of the firm's earnings were

retained, rather than paid out as dividends.

What is the most important report that a corporation issues?

The Annual Report

What are the four factors that affect the level of interest rates?

*Production opportunities: The investment opportunities in productive

assets

*Time preferences for consumption (are people saving money?): The preference of consumers for current consumption as opposed to saving for future

consumption

*Risk: The chance that investment will provide a low or negative rate of return

*Expected Inflation: Amount by which prices increase over time

• What is the nominal vs real interest rate?

The nominal interest rate is just that...the rate of interest. The real interest rate is the nominal rate minus the expected rate of inflation. Nominal is generally larger. If the risk-free rate increases generally speaking the interest rate will go up*.

Why is the inflation rate and interest rates so highly correlated?

Because to slow inflation (too much money in the market) the Fed will increase interest rates to deter borrowing and thus limit cash flow. It's a balancing act.

What are the *five determinants of interest rates* and four premiums that investors received for holding interest-paying securities

*Inflation premium: A premium equal to the expected inflation that investors add to the real risk-free rate of return

*Default risk premium: The difference between the interest rates on a US Treasury bond and a corporate bond of equal maturity and

marketability

*Liquidity premium: Premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice

*Maturity risk premium: A premium that reflects interest rate risk

**Know what premiums that different types of bonds have**

Treasury Short-Term Bonds: Inflation Premium

Treasury Long-Term Bonds: Inflation Premium & Maturity Risk Premium

Corporate Short-Term Bonds: Inflation Premium, Default-Risk Premium, & Liquidity Premium.

Corporate Long-Term Bonds: Inflation Premium Liquidity Premium, Maturity Risk Premium & Default Risk Premium.

Which bonds have higher interest rates?

Corporate, or more specifically long-term corporates.

*What are the three types of term structures?

Upward slopping (investors are confident about the economy); downward slopping (investors are pessimistic about the economy, i.e. expect recession)

What does an upward sloping and downward sloping yield curve suggest about the future state of the economy?

An upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future

Will BBB+ bonds have a higher or lower interest rate than AA- bonds?

Higher! Because they're riskier.

What is pure expectations theory?

The pure expectations theory contends that the

shape of the yield curve depends on investors'

expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice versa. Thus, the yield curve can slope up, down,

or even bow.

What is a key assumption of the pure expectations theory?

Assumes that the maturity risk premium is zero.

Current Assets include?

cash, marketable securities, accounts receivable, and inventories

Current Liabilities include?

liabilities due within a short time, usually within a year

Proprietorship

an unincorporated business owned by one individual

Partnership

An unincorporated business owned by two or more persons.

Corporation

A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability

Advantages of Proprietorship/Partnerships

Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages of Proprietorship/Partnerships

Difficult to raise capital

Unlimited liability

Limited life

Advantages of a corporation

Unlimited life

Easy transfer of ownership

Limited liability

Ease of raising capital

Disadvantages of a corporation

Double taxation

Cost of setup and filing reports.

Types of Corporations

C Corporation

S Corporation

Limited Liability Company (LLC)

Limited Liability Partnership (LLP)

Determinants of Intrinsic Values and Stock Prices

Managers' ultimate goal

Maximize shareholder wealth - maximizing stock price

Avoid actions that reduce intrinsic value

Equilibrium

a stock's price should equal its "true" or intrinsic value

Stockholders

receive more of the upside if the project succeeds

more likely to prefer riskier projects

Bondholders/Debtholders

receive fixed payments

more interested in limiting risk

attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers' actions

Components of a Financial System

Financial institutions

Financial instruments

Financial markets

Financial markets provide channels through which financial institutions trade financial instruments

Financial institutions

Commercial banks, mutual funds, investment banks, securities firms etc.

Risk management.

Financial instruments

Bank loans, mortgage, bonds, money market securities, derivatives.

Financial markets

Money markets, bond markets, mortgage markets, foreign exchange markets, derivative markets.

Suppliers of capital

individuals and institutions with "excess funds." These groups are saving money and looking for a rate of return on their investment.

Demanders or users of capital

individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow

Market

a venue where goods and services are exchanged

Financial Market

a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds.

Types of Financial Markets

Physical assets vs. Financial assets

Spot vs. Future

Money vs. Capital

Primary vs. Secondary

Public vs. Private

Money Markets

markets that trade debt securities with maturities of one year or less (e.g., U.S. Treasury bills)

little or no risk of capital loss, but low return

Capital Markets

markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year

substantial risk of capital loss, but higher promised/expected return

Primary Markets

markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds)

Secondary Markets

- markets where existing financial instruments are traded among investors (e.g., exchange traded: NYSE and over-the-counter: NASDAQ)

- Add liquidity for both buyers and sellers of financial instruments

Aid in price discovery

- Help corporations determine cost of debt/equity - provide benchmark to evaluate performance

IPO info

- "Going public" enables a company's owners to raise capital from a wide variety of outside investors. Once issued, the stock trades in the secondary market

- occurs when a company issues stock in the public market for the first time

- subject to additional regulations and reporting requirements

Highly Inefficient

Small companies not followed by many analysts. Not much contact with investors.

highly efficient

Large companies followed by many analysts. Good communications with investors

Annuity

An asset that pays a fixed sum each year for a specified number of years.

Perpetuity

Financial concept in which a cash flow is theoretically received forever.

Nominal Rate

- also called the quoted or stated rate. An annual rate that ignores compounding effects

- Written into contracts, quoted by banks and brokers.

- Not used in calculations or shown on timelines

Periodic Rate

- amount of interest charged each period, e.g. monthly or quarterly

- Used in calculations and shown on timelines

Effective Return Rate

Used to compare returns on investments with different payments per year. Used in calculations when annuity payments don't match compounding periods

Bond

A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

Par Value

face amount of the bond, which is paid at maturity (assume $1,000 if not specified)

Coupon Payment

specified amount of interest paid each period (assume semiannual frequency if not specified

Coupon Interest Rate

stated interest rate (generally fixed) paid by the issuer. Multiply by par value to get dollar payment of interest (i.e., coupon payment)

Maturity Date

years until the bond must be repaid

Issue Date

when the bond was issued

Yield to Maturity

rate of return earned on a bond held until maturity (also called the "promised yield").

Zero Coupon Bond

bonds that pay zero coupons

Convertible Bond

may be exchanged for common stock of the firm, at the holder's option

Warrant

long-term option to buy a stated number of shares of common stock at a specified price.

Callable Bond

allows issuer to buy back the bond prior to maturity

Putable Bond

allows holder to sell the bond back to the company prior to maturity

Sinking Fund

- Provision to pay off a loan over its life rather than all at maturity.

- Similar to amortization on a term loan.

- Reduces risk to investor, shortens average maturity.

Bankruptcy

For large organizations, reorganization occurs more frequently than liquidation, particularly in those instances where the business is worth more "alive than dead."

Default Risk

- investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return.

- Influenced by the issuer's financial strength and the terms of the bond contract.

Risk Aversion

assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities

Risk Premium

the difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities.

Market Risk

portion of a security's stand-alone risk that cannot be eliminated through diversification

Diversifiable Risk

portion of a security's stand-alone risk that can be eliminated through proper diversification

Stand Alone Risk

Market risk + Diversifiable risk