Business Finance - exam 1

chapters 1, 4, 5, 6

What is Finance?

1. Looking forward

2. Where can we expect to be, momentarily, at some point in the future (future value)

3. Where we want to be, momentarily, at some point in the future (present value)

What 3 things do we need to know in business finance?

1. How do we get the money we need/what long-term investments : investors

2. Where will the long-term financing come from/How do investors of the business get money from the business?

3. What should the business spend money on/invest in (manage everyday financial activities)?

What term describes where the business will get the money?

Capital Structure

• focuses on financial decisions

• focuses on fundings like debts, equity

• Q: how much should the firm borrow? What’s the least expensive source

• ex: whether or not to finance a factory with a bank loan or issue more shares

What term describes what long term investments are to be made?

Capital Budgeting

• focuses on investment decisions/opportunities

• looks at purchasing new machinery, factories or expanding facilities

• ex: whether to build a new factory

What term describes how the money/assets & obligations of the firm will be handled?

Managing working capital : short term

• day to day activity

• How will money/asset and obligations of the firm be handled . Make today about the future, best guess

What is a Sole Proprietorship?

single owner; owner and business are one

• Advantages: all profits to owner, undivided allegiance (I am the business), one tax payment

• Disadvantage: Unlimited personal liability, All personal tax, Life of business = Life of proprietor, Equity limited to personal wealth of proprietor, Non-divisible ownership (difficult to obtain financing)

• The debt of the business is the debt of the individual

What is a Partnership?

More than one owner with a contract between those owners

• Advantage: share in all profits, easy formation, easier to get loans

• Disadvantage: Unlimited liability for all debts of partnership, Life limited to life of any one partner(if one leaves you have to redo the plan. Time & money= not efficient), Non-divisible ownership (if partner damages a house it affects all).

  • what you share in profits might not be equality split in paying off debt. Depends on personal wealth

• The debt of the business is the debt of the individual

What is the difference between limited partnership and general partnerships?

In a limited partnership (LP), liability for business debts and obligations is divided between general partners and limited partners, while in a general partnership (GP), all partners share equal liability.

What is a Corporation?

A business, chartered by the State, which is its own distinct entity
(identity not tied to “owners”)

• Advantages: Indefinite life, Divisibility of ownership, Ease of transfer, Limited liability, Ability to raise capital/money (easier to take chances)

• Disadvantages: Double taxation, Complex formation

What is the bus problem?

If you get hit by a bus and die your business is over, gone

What is the goal of a financial manager?

Maximization of shareholder wealth (Profit Maximization!!)

• A.K.A.: Maximize market value of existing owners’ equity

• A.K.A.: Maximize current value of stock

What is the Agency Problem?

Corporations typically have many “owners”. Shareholders often do not know how, nor do they want to, run the business. Managers” (agents) are hired to run the business. Managers’ interests (securing personal income and perquisites) conflict with shareholders’ interests (securing the firm’s profits & growth of stock value)

• conflict of interest between shareholder (principal’s) and manager (agent). Agents might prioritize their own goals over the principals, leading to decisions that aren’t in the best interest of the principal

What are ways of managing the Agency Problem?

• Stock Options (gives holder rights to buy or sell a stock)

• Performance based compensation: Align managers’ interest with shareholders

• Independent oversight: “Independent” board members, Auditing

• “Cost of Agency” : Dollars paid, Performance lost

What is a financial market?

It’s the place where corporations get money
• Equity market v. Debt market
• Primary market v. Secondary market
• Dealer market (price and buy) v. Auction market (bid//ex: NY Stock Exchange)
• Auction market ≈ Stock exchange (aka “over-the-counter”)

What is the difference between primary and secondary markets?

• The primary market refers to original sale of securities by government and corporations (2 types : public offerings and private placement)

• Secondary markets are when the securities are bought and sold after the original sale (where we come in)

What is Equity?

It’s the money we put into our business (our money!)

What is debt?

It’s the money we borrow from others to invest in a business.

• the more debt you have the harder it is to get more debt (harder it is to borrow)

What are the five basic areas of finance?

1. Corporate Finance

2. Investment

3. Financial institutions

4. International finance

5. Fintech

What is Investments?

Deals with financial assets and stocks and bonds.

Questions can include

1. what determines the price of financial assets like share of stocks

2. What are the potential risks and rewards associated with investing in financial assets

3. What is the best mixture of assets to hold?

What do the portfolio manager do?

They manage money for investors (ex: buy mutual funds)

What is a stockbroker?

They advise customers on what types of investments to consider and helping them make buy and sell decisions

What is a security analysis?

They research individual investments, such as stock in particular companies and makes a determination as to whether the price is right.

What is a financial institution?

They are business that deal with financial matters (ex: banks and insurance companies)

What is International Finance?

Deals with international aspects of corporate finance, investments, and financial institutions

What is Fintech?

It’s the combination of technology and finance. (ex: internet, phones, software).

What is blockchain?

A list of records, called blocks, used to record transactions.

What is the controller’s office handle?

They handle the cost and financial accounting, tax payments, and management information systems

What is the treasurer’s office responsibilities?

They are in charge of managing the firm’s cash and credit, financial planning, and capital expenditures

What is the Sarbanes-Oxley Act?

AKA “SOX” is to strengthen protection against corporate accounting fraud and financial malpractice.

What are some unintended results of the Sarbanes-Oxley Act?

1. Public firms have chosen to “go dark”, meaning shares are no longer traded in major stock markets

2. Many companies are choosing to go public outside of the U.S

What is a stakeholder?

It’s someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm

What is a proxy?

It’s the authority to vote someone else’s stock; gives someone permission to vote or make decisions at corporate meetings

What is time value to money?

Money today is worth more than the same amount of money in they future do to earning capacity, inflation, and risk.

“Money makes money. And the money that money makes makes more money” - B. Franklin

*MOST important concept in Finance!

Why is it better to have more money now then to get it later in the future?

1. Inflation : purchasing power diminishes over time

2. Alternate uses of money : giving up the opportunity to consume

What is a principle?

It’s the base amount used to calculate

What is interest earned?

It’s the amount or rate given on principle amount

What is basis point?

Using the one hundredth of one percent (0.abcd // 1%=100 // ab.cd%)

What is simple interest?

It’s interest earned only on initial principal

What is compound interest?

It’s interest earned on initial principal and interest each period “Interest on Interest”

Example of Simple Interest

• Year 1: 10,000 x 0.05 = 500 interest

• Year 2: 10,000 x 0.05 = 500 interest

• Year 3: 10,000 x 0.05 = 500 interest

• Year 4: 10,000 x 0.05 = 500 interest

• Year 5: 10,000 x 0.05 = 500 interest

  Total interest earned = 2,500
  Asset total after 5 years 12,500 = [10,000+2500]

Example of Compound Interest

• Year 1: 10,000 x 0.05 = 500 interest

• Year 2: 10,500 x 0.05 = 525 interest

• Year 3: 11,025 x 0.05 = 551.25 interest

• Year 4: 11,576.25 x 0.05 = 578.8125 interest

• Year 5: 12,155.0625 x 0.05 = 607.7531 interest
  Total interest earned = 2,762.8156
  Asset total after 5 years 12,762.8156

What is the equation for future value factor?

Present Value x (1+r)^t = Future Value

ex: $10,000 x (1.05)^5 is the same as $10,000 × 1.05 × 1.05 × 1.05 × 1.05 × 1.05

What are the 2 ways to calculate present value factor (aka. discounting)?

1. FV / (1 + r) ^t = PV

2. FV x 1/ (1 + r) ^ t = PV

What is discount rate?

It’s the interest rate used to calculate PV from FV : “r”

What is Discount Cash Flow valuation?

It’s calculating present value from future value (PV from FV *only this way)

What number do you start at present value?

Present value is always today (start at 0 and go from there)

What are the effects of change in Rate and Term?

Change	Future Value	Present Value
Rate Increase	Increases	Decreases
Rate Decreases	Decrease	Increases
Term Increases	Increase	Decreases
Term Decreases	Decreases	Increases

What is the Rule of 72?

Any amount of money will double when the rate times the term equals 72
When (r x t) = 72, FV = 2PV (approximately)

An investment of $1,000 grows to $1,100 in one year. What is the rate of return?

10% // (100 / 1,100 = .10)

When dealing with compound interest, it is more financially advantageous to have a ______ time horizon for investment.

Longer

Given an investment and a set of interest, the _____ the time horizon the ______ the future value.

longer; greater

What is the basic present value equation?

PV = Fvt/(1+r)^t

What does N I/Y PMT PV and FV stand for?

N = number of periods (t)

I/Y = Interest Rate

PMT = payment

PV = Present value

FV = Future Value

What 3 things are involved in Valuing Level Cash Flows

1. Annuities (legal structures)

2. Annuities Due

3. Perpetuities

what does multiple mean?

It’s payments made at a number of times over the life of the re-payment agreement

What is an annuity?

It’s the level stream of cash flows for a fixed period

• same $ amount paid each period

• The time period and intervals of time are defined

• payments is made at end of period

What is the equation for annuity?

PV= C x [(1-present value factor)/r] PV= C x {1-[1/(1+r)^t]}/r

FV= C x [(1+r)^t -1 ] /r

What is annuity due?

It’s an ordinary annuity where the payment is due at the beginning of the period

Example: car loans, mortgages, apartment rent

Equation for Annuity Due vale?

=Ordinary Annuity Value x (1+r)

What is Perpetuity?

It’s an annuity where the cash flows continue forever (never ending payment)

PV=C/r

What are the three ways of comparing interest rates?

1. Quoted (or stated) rate

2. Annual Percentage Rate (APR)

3. Effective Annual Rate (EAR)

What is a quoted rate?

It’s the rate per compounding period

ex: 0.99% “compounded [timer period]”

What is the equation for APR?

=Rate per period x period per year

ex: 4%/ month x 12 moths/year= 48% per year

What is the equation for EAR?

=(1+ Quoted Rate/m)^m -1

m=number of periods per year

allows for comparison of loans with different compounding periods

• (1+APR/12)^12-1

Example EAR:

• Honda Car loan: 36 months, 1.9% APR

• Monthly rate = APR/12 = 0.0016

EAR = (1 + 0.019/12)12 – 1 = 0.0192 or 1.92%

What are three types of loans?

1. Pure discount loans

2. Amortized loan

3. Interest only loans

What is pure discount loans

One single payment of principle and interest
• Interest calculated and payment made on specified future date
Example: US Treasury Bills ( T-Bills)
• Simple calculation
• FV = PV ( 1 + r ) ^t
• PV = FV / ( 1 + r ) ^t

What are amortized loans?

Payment of interest and part of principle at specific intervals
• Amortizing or Amortization : paying of the principle over the course of the loan term
• Amount of interest paid per period decreases over course of loan term because of decreasing principle, but amount of payment (typically) remains constant

Example: Home mortgages, car loans, student loans
• Calculated using amortization schedules
o Available on-line or as spread sheet add-on (Often a direct calculation or in terms of $1000)

What is Interest Only loans?

Interest paid at specific intervals; principle repaid at end of loan or
• No repayment of principle, i.e. a perpetuity
• Calculated using regular payments (Using “PMT” button on TVM register)
• Example: Corporate Bonds

What is nominal rate?

It’s the change in amount of dollars (not adjusted for inflation)

What is real rate?

It’s changed in purchasing power (adjusted for inflation - reflects true buying power)

• the return for the use of money

What is the fisher effect?

Nominal = real + Inflation
r=i- 𝜋 (r=real intrest rate) = (I = Nominal Intrest rate - (𝜋 =inflation rate)

1+ Nominal rate = (1+real rate) x (1+ inflation rate)

What is a bond

Source of “Capital” = method of raising money

A certificate of indebtedness (IOU) : literally just borrowing!

Detailed legal agreement between the bond issuer (debtor) and bond holder (creditor) Names: Bill, Note, Debenture

• specifies: date of maturity, interest rate

• issued by: federal/state/local governments, and firms

  Bonds are sold at discounted value (paid today)

  At the date of maturity, bond holders are paid the face value

• Bond holders are paid the fixed interest and face value

Characteristics of a bond

Value = Face value = Par value (usually $1000)
• Repayment terms
1. Interest rate = “Coupon”
2. Term = Maturity
3. Registered or Bearer payment
• Call provisions (early repayment)
• Other features (Security, Seniority, Protective Covenants)

What does bond ratings look like?

• Investment Grade”
  - AAA, AA, A, BBB (S&P) // Aaa, Aa, A, Baa (Moody’s)

• “High yield” a.k.a.“Junk” bonds
  - BB, B, CCC, CC, C, D (S&P)

What is default risk?

Risk that a borrower will fail to make required payments on a loan or debt, essentially not paying back what they owe (borrower not paying you back)

What is taxability premium?

It’s federal tax credit that lowers the cost of monthly health insurance premiums for eligible individuals and families. 

What is liquidity premium?

It’s the additional return an investor expects to receive for holding an illiquid asset—an asset that cannot be easily or quickly sold at a fair price.

What cash flows will continue forever?

Perpetuity

How far is the United States in Debt?

In the Debt market it’s $40 trillion USD. (Stock marketing $30 trillion USD)