Business Finance Chapter 7 & 8 Review

Common Stock

Ownership shares in a publicly held corporation.

Initial Public Offering (IPO)

First offering of stock to the general public.

Primary Offerings

The corporation sells shares in the firm.

Primary Market

Market for the sale of new securities by corporations.

Secondary market

Market in which previously issued securities are traded among investors.

P/E ratio

Ratio of stock price to earnings per share. Calculated as Price per share/Earnings per share

Book value

Net worth of the firm according to the balance sheet.

Liquidation value

Net proceeds that could be realized by selling the firm’s assets and paying off its creditors.

Extra earning power, intangible assets, and value of future investments

What are the three factors that going-concern refers to?

Intrinsic Value

Present value of future cash payoffs from a stock or other security. Calculated as (DIV₁+P₁)/(1+r).

Expected return

=(DIV1+P1-P0)/P0

Expected rate of return

=(DIV₁)/P₀ + (P₁-P₀)/P₀

Dividend discount model

Discounted cash-flow model that states that today’s stock price equals the present value of all expected future dividends. Calculated as ·       = (DIV₁)/(1+r) + (DIV₂)/(1+r)^2+(DIV₃)/(1+r)^3+ … + (DIV_t)/(1+r)^t.

Constant-growth dividend discount model.

Version of the dividend discount model in which expected dividends grow at a constant rate. ·       R = (DIV₁)/P₀ + g or =dividend yield+ growth rate

Sustainable growth rate

The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant.

Payout ratio

Fraction of earnings paid out as dividends

Plowback ratio

Fraction of earnings retained by the firm.

Present value of its growth opportunities

Net present value of a firm’s future investments.

Free Cash Flow

Cash flow available for distribution to investors after firm pays for new investments or additions to working capital.

Efficient Market

Market in which prices reflect all available information

Bubbles

Every now and again investors seem to be caught up in a speculative frenzy, and asset prices then reach levels that (at least with hindsight) cannot easily be justified by the outlook for profits and dividends.

Attitudes toward risk (people don’t like losses), Beliefs about Probabilities (Investors are usually overconfident), Sentiment (Efficient markets bring to mind absolutely rational investors on the lookout for every possible profit opportunity.

3 attitudes to risk, probabilities, and the economy

Opportunity cost of capital

The minimum acceptable rate of return on capital investment is set by the investment opportunities available to shareholders in financial markets.

Net present value (NPV)

Present value of cash flows minus investment.

True

True or False: A risky dollar is worth less than a safe one.

NPV rule

Invest in any project that has a positive NPV when its cash flows are discounted at the opportunity cost of capital.

Rate of return rule

Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

Profitability Index

Ratio of a project’s NPV to the initial investment.

Capital Rationing

Limit set on the amount of funds available for investment.

Soft rationing

Capital rationing is not imposed by investors. Instead, the limits are imposed by top management.

Hard rationing

Suppose that you are the manager of a state-owned enterprise, where you do not have the freedom to raise new capital. In that case, you may be forced to pass up positive-NPV projects.

Payback period

Time until cash flows recover the initial investment in the project.

Equivalent annual annuity

The cash flow per period with the same present value as the cost of buying and operating a machine.

Mutually exclusive projects, mutually exclusive projects involving different outlays, lending or borrowing, and multiple rates of return.

Pitfalls of IRR

Soft or hard capital rationing. Favors small projects over larger projects.

Pitfalls of the Profitability Index

Ignores cash flows, ignores discounting, improperly rejects long-lived projects.

Pitfalls of the payback period