Business Finance (Exam 1)

Capital Budgeting

how a firm decides to invest in projects

Capital Structure

how the firm decides to finance itself

Working Capital Management

how the firm manages its money on a day to day basis

Looking at the balance sheet, what are the assets for the working capital management?

1. Cash

2. Accounts Receivable

3. Inventory

Looking at the balance sheet, what are the liabilities for the working capital management?

1. Accounts Payable

2. Short-term debt

Looking at the balance sheet, what are the assets for the capital budgeting section?

1. Current assets

2. Long-term assets

3. Goodwill

Looking at the balance sheet, what are the liabilities for the capital budgeting section?

1. Current Liabilities

2. Long-term debt

3. Equity

What is the goal of financial management?

maximize current stock price of the company

The Agency Problem

the principle hires agents to act in their best interest… however, the agent may put their own interests first

Risks for larger companies

1. management team takes too little risks

2. making bad choices with short-term focus

What can companies due to ensure their executives are taking enough risks?

Golden parachute clause

What is the golden parachute clause

if a CEO is fired, they get a very large payout (reduces fear of being fired for taking risks)

What can companies due to ensure their executives are focusing on the long-term success of the business?

Award stock options

Stakeholder

any party that has financial interest in the company but is not a direct capital provider

Examples of stakeholders

1. employees

2. community

3. customers

4. suppliers

Shareholders

owners of a firm (both public and private companies)

Where do public companies trade shares

NYSE or NASDAQ

Primary Market

capital flows from investors to the issuing entity

Secondary Market

the transaction (cash flow) is between two investors (much larger than primary market)

What type of market is the NYSE?

Auction market

What type of market is the NASDAQ

Dealer Market

Simple Interest

accrues only on the principle invested

Compound Interest

accrues on the total account value

what is Time Value of Money used for?

determine what any amount of money is worth at any point in time

Discounting

bringing money back to the present value

Rule of 72

time it will take for an investment to double in value is roughly 72/r

What are the 3 criteria to determine if something is an annuity?

1. fixed payment

2. fixed interest rate

3. fixed time period

Ordinary Annuity

first cashflow is made at the end of the period

Annuity Due

first payment is made at the start of the period

Perpetuity

Allows us to find PV of a fixed cash flow, at a fixed rate of interest, forever (perpetual)

Annual Percentage Rate (APR)

Many financial assets/contracts are quoted as annual rate, but payment frequency is not annual

EAR is always _______ than APR because it is compounding

longer

Most loans are structured as _______

annuities

What are the 4 major types of loans?

1. Fully amortizing loans

2. Interest Only Loan

3. Pure Discount Loan

4. Balloon Payment

Fully Amortizing Loans

have fixed payments for fixed period of time at a fixed rate of interest - upon maturity of the loan, it is fully paid off

Examples of fully amortizing loans

car loans, student loans, most mortgages

Interest Only Loan

fixed payments each period, only covering interest accrued on the loan, final payment due is equal to amount originally borrowed

Example of interest only loan

bond

Pure Discount Loan

you receive some amount of money at present, make no interest payments, at maturity make large, single payment

example of pure discount loan

zero coupon bond

Balloon Payment

there is an amount borrowed at present, fixed payments are made, they may or may not cover interest accruing, as a result, at maturity, a payment is made covering the remaining balance

example of balloon payment

commercial mortgages

What is a bond

debt contract between the capital supplier and firm or government agency

What type of loan is a bond?

interest-only loan

what is another name for par value

face value

key components of par value

1. $1,000

2. repaid at maturity

3. total issued amount is broken down into smaller bonds

coupon interest rate is also called

stated interest rate

components of coupon interest rate

1. usually YTM at issue

2. contractional, does not change

3. multiply by par value to get coupon payment

Maturity

number of years until bond must be repaid

What type of payments are typically made for bonds

semi-annual payments

Yield to Maturity (YTM)

market required rate of return for bonds of similar risk and maturity

Components of YTM

1. market rate can and does change

2. discount rate used to value a bond

3. return if bond is held to maturity

4. usually = coupon rate at issue

5. quoted as an APR

Bond value

if we assume all cash flows can be reinvested at YTM, a bond can be valued as an interest-only payment

as interest rate increase, PV (bond prices) __________

decrease

When coupon rate = YTM…

Price = Par

When coupon rate < YTM… (also what is it called)

Price < Par (discount bond)

When coupon rate > YTM… (also what is it called)

Price > par (premium bond)

What is interest rate risk

when price of a bond changes due to interest rates

the longer the maturity, the higher/lower the interest rate risk

higher

the larger the coupon payment, the higher/lower the interest rate risk

lower

Reinvestment rate risk

uncertainty concerning rates at which cash flows can be reinvested

Which type of bond has more reinvestment rate risk? (short-term or long-term)

short-term

Which type of bond has more reinvestment rate risk? (high coupon rate bonds or low coupon rate bonds)

high coupon rate bond

What are coupon bonds also referred to as

deep discount bonds

Zero coupon bonds components

1. make no outside cash periodic interest payments (coupon rate = 0%)

2. entire YTM comes from difference between purchase price and par value (capital gain)

3. cannot sell for more than par value

what are examples of zero coupon bonds

treasury bills and U.S. Savings bonds

Quoted bond price

“clean” price - net of accrued interest

Invoice Price

“dirty” or “full” price - price actually paid (includes accrued interest)

Accrued interest

interest earned since last coupon payment is owed to bond seller at time of sale (amt earned, but not paid)

why does accrued interest occur?

because bonds trade daily, but interest is only paid semi-annually

Fisher Effect

relationship between real rates, nominal rates and inflation

Term Structure of Interest Rates

relationship between time to maturity and yields

Yield Curve (upward-sloping)

normal

Yield Curve (downward-sloping)

inverted

Factors affecting required return

1. default risk premium

2. taxability premium

3. liquidity premium

4. maturity premium

what is the concept of liquidity premium

bonds that have more frequent trading will generally have lower required returns

Longer term bonds will tend to have higher/lower required returns

higher

when is the only time a bond will sell at par

when YTM and coupon rate equal each other

for premium bonds, I/Y should be higher/lower than the coupon rate

lower