Midterm 2 Practice

Chapters 6-9

Funding Characteristics

• Debt: A loan/obligation between company and lender with a promise to repay loan with interest

• Equity: Investment in company without a repayment but promise of ownership (preferred, common stock)

Short-Term Debt

Trade Credit, Accruals, Bank Loans, and Capital Market alternatives to bank loans

Trade Credit

Legal Arrangement, Terms of Sale, Net Credit

Legal Arrangement

• A/P, N/P and (bankers) acceptance

Terms of Sale

Consignments, seasonal dating, monthly billing, discount, net, cash on delivery (COD), Cash before delivery

Net Credit

• A/R - A/P

• Net supplier of trade credit (NC > 0)

• Net supplier user of trade credit (NC < 0)

Accruals

• Wages payables, taxes payable, interest payable, etc.

• Arises randomly through normal business practices

• Often free sources of financing

• Sometimes hidden costs

Bank Loans

• Arranging: pre negotiated, line of credit (no funds guaranteed), revolving credit line (guarantee of funds but commitment fee)

• Offering basis: no prior negotiation

• Pricing: base rate of interest (prime rate, london inter-banking offering rate)

• Asset-based: backed with a pledge of assets

  • collateral: property pledged in support (receivables, inventory)

• Factoring: Selling receivables

Capital Market Alternatives to BL

Commercial Paper and Euronotes

Commercial Paper

• Short-term, unsecured, backup revolving credit line

  • five reasons for popularity: lost cost, no fees, no institutional size restrictions, investment bank as resource, prestige

Euronotes

• Short-term, unsecured, standardized in Eurodollar market

  • Euronote facility: a contract for the issuance of euronotes

  • sub for revolving line of credit, price similar to LIBOR, cheaper than domestic borrowing, broad market for the debt

Intermediate & Long-Term Debt

Term Loans, Leases, Bonds, Floating-rate notes

Term Loans

• A loan with a maturity of more than one year

• Used to purchase an asset with intermediate-term life, a sub for line of credit with oper. cycle longer than a year, a “bridge loan” when market conditions are unfavorable/uncertain

Leases

• Five classifications: number of lessors, previous ownership of asset, services provided by the lessor, nature of the lease terms, financial accounting rules

Benefits of Lessee vs. Lessor

• Lessee: Tax savings, cost savings, risk avoidance, financing felxibility

• Lessor: A profitable loan

Bonds

• Described by 3: maturity, coupon, maturity (face, par) value

• Bond indenture is a formal loan agreement

• Trustee: Third party representing bondholders

• Mortgage bond - Collateral, Debenture - no collateral

Collateral

Something pledged as security for repayment of a loan, to be forfeited in the event of a default.

Bond Ratings

• measure risk of default

• investment grade bonds: rated in highest four categories

• speculative (junk) bonds: bonds rated below highest four

International Bonds

Issued outside of borrower’s home country

• foreign bond, eurobond, multi-currency bond

Retiring Bonds

• Full payment at maturity, periodic repayment, options permitting issuer to retire some/all of the issue before maturity (call privilege),

• sinking fund - account accumulates money to retire debt

• Serial bond issue (issues with maturity)

Floating-Rate Notes

• Bonds issued for intermediate and LT maturities with a variable rate of interest

• Sub for a term loan

• Many forms and features

Preferred Stock

• Stock-bond hybrid

• Similar to bond

• has face/maturity value, pays a fixed amount annually, no voting rights, priority above CS in liquidation, pays a dividend

• Cumulative feature: prohibits payment of common div. if preferred div. are in arrears (payments overdue)

Preferred Stock Advantages vs. Limitations

• A: preserves company’s debt capacity while raising funds, accepted as equity, lower capital cost than CS, tax benefits for some owners

• L: Preferred Div. are not tax-deductible, investors often see PS as risky, missed divideds leads to strong negative reaction from Creditors and SHr’s

Common Stock

• Share concepts: authorized shares, issued shares, outstanding shares (calculate earnings per share EPS), treasury shares

• Value measures: par, book, market, and liquidation values

Sustainability-Related Financing

Green Bonds: energy efficiency, waster reduction, water management, etc.

Social Impact Bonds: Between lenders and government, use proceeds to address a social problem

Moving Funds from Surplus Units to Deficit Units

• Direct transfer, semi-direct transfer (broker), Indirect transfer (financial intermediary)

Money Markets

Markets for debt securities of one-year maturity or less that are used for liquidity management

Capital Markets

Markets for debt and equity securities with maturity greater than one year that are used for intermediate and long-term financing

Investment Banker

• provides analysis.advice when issuing new securities, offers “underwriting” (guarantees proceeds of sale), puts together selling group of securities dealers, creates market stabilization by making a new issued securities to insure sec. can be resold.

Flotation Cost

• Cost of issuing new securities that consists:

  • underwriting spread (managing underwriter’s, underwriting risk, and concession selling fees).

  • Administrative costs (SEC registration, legal, printing, trustee’s and auditors’ fees, taxes)

• Varies with the difficulty of placing the issue.

Private Placement

• Sale of security issue directly to investors without going through the public markets for (speed, privacy, terms, and size)

Financial Market and Institutions Functions

• Payments mechanism, savings vehicle, credit supplier, wealth storehouse, liquidity source, risk reducer, policy vehicle

Secondary Market Functions

• permit trading, provide information, create continuity, protect participants, improve capital distribution

The Security Exchange

• Physical Exc.: Domestic (NYSE, Regional Ex., Local Ex.), International (In most countries for securities of company’s headquartered in that country)

• NASDAQ - network of security dealers that offer to buy and sell securities

Other Trading Mechanisms

• Institutional Block Trading - Large Blocks of securities handled like primary market issues

• Electronic communications networks (ECNs) - private companies that offer trading through their own computer systems.

Measuring the Markets

• Market indexes: Dow Jones, Standard & Poors (S&P), Composite, Multi-market, Foreign indexes

Investment Philosophies

Active Investors, Passive Investors, Algorithmic Traders, Activist Investors

Active Investors

• Fundamental investors who focus on value.

• Rational component of demand dominant in the long-run.

• Every financial asset has an intrinsic value that can be determined by skilled economic/financial analysis

• Purchase a security when its value exceeds its price by a “margin of safety”

Passive Investors

• Focus on avoiding ban investment decisions since it is difficult to consistently identify good investments

• Avoid spending on useless research

• Invest in broad market often ETFs

• Believe in capital market efficiency and the “random walk”

Algorithmic Traders

• Focus on next price change

• trades done automatically by computer programs and multiple transactions made every minute

• Arguments

  • in favor: increased market liquidity, more consistent inv. decisions

  • against: unfair advantage if computers located closer to exchange than competitors

Activist Investors

• Want to influence company management by holding large number of shares, can be short-term focused (corporate raiders, LBO firms) or long-term focused (impact investors, many large pension funds)

Classes of Intermediaries

Deposit, Contractual, Investment

Deposit Intermediaries

Commercial banks, savings and loan associations, mutual savings banks, credit unions

Contractual Intermediaries

Insurance companies, pension funds (provide retirement income), endowment funds (invested pool of assets held by a nonprofit or institution generating income for long-term support)

Investment intermediaries

Mutual funds (pool money from multiple investors)

Types of Intermediation

Amount, Risk, Maturity, Portfolio mix, Information

Risk

• The chance that something will come out worse than planned, more generally, the variation in possible outcomes

Three Attitudes Toward Risk

Seeker, Neutral, Averter (Most often in financial markets)

Risk And Financial Value

For risk averters, risk reduces value by increasing required rates of return (Fischer model)

Sources of Risk

Business Risk (environmental, process), Financial (financing mix) risk

Total Risk Model

• Outcomes are summarized by a probability distribution

• Return - measured by the expected value of distribution

• Risk - measured by the standard deviation of the distribution

Concept of Portfolio

• Group of investments held together that diversifies the investment and is characterized by the investments included in it and the amount % of the total money invested in each security

Portfolio Returns

The weighted average of the returns of the securities in the portfolio, weighted by the amount of money invested in each security

Portfolio Risk

• Depends on correlation among components of portfolio

  • High correlation (little risk reduction), Lower correlation (more risk red.), Negative correlation (significant risk red.)

• Can be lower than the risk of each component

Decomposing Risk

Systematic and Unsystematic Risk

Systematic (systemic) Risk

the risk caused by factors that impact all investments which causes investments to be correlated

Unsystematic (idiosyncratic) risk

the risk caused by factors that only impact a single investment that are uncorrelated across investments and tends to cancel out as more investments are added to a portfolio

Beta

• Characteristic line - the relationship of an investment’s rate of return to the overall rate of return available in the market.

• The slope of an investment’s characteristic line is Beta

Alpha

• The intercept of an investment’s characteristic line

• Investors are “seeking alpha”

Smart Beta

An attempt to combine the best aspects of active and passive investing

• active: focuses on constructing indexes that will perform better than the usual market indexes like the S&P 500

• passive: construct portfolios to match market indexes

Capital Market Line

• Return as a function of total risk

• Appropriate when evaluating assets not held in portfolio e.g. small business

Security Market Line

• Return as a function of systematic risk

• Appropriate when evaluating assets held in a portfolio, assumes unsystematic risk is (naively) diversified away.

Capital Asset Pricing Model

Popular name for the portfolio risk model where the required rates of return are important inputs to setting the market prices of financial (capital) assets

Improving on Traditional Financial Risk Models

• Finding relationships between intangible assets and financial risk.

• Assets and liabilities ignored by financial accounting

• other forms of capital (human, social, experiential, reputational)

• Organizational skills

• ESG performance

Financial Value

• the worth of a stream of cash flows modeled as a present value

• Required rate of return: investors minimum acceptable rate of return on any investment. The discount rate used to calculate value

Value of a security

Independent of any investor’s holding period. When an investor sells a security, the price received is the present value of future benefits, this is the same value the investor would receive by not selling the security.

Value

What something is worth

Price

What something sells for

Two groups of investment analysts

Technical and Fundamental

Technical

Prices depend on psychology, are often very different from value

Fundamental

Prices depend of economics and oscillate (swing back and forth) around their values

Traditional Bond

• Has both an interest coupon (an annuity) and a face value (a future value)

• Same calculation for both individual investors and market as a whole

Relationship of Price to Face Value

• Depends on the relationship of investors’ required rate of return to the bond’s coupon rate

• Par, Discount, or Premium Bond

Zero Coupon Bond

• A bond with no cash interest payments that typically sells at a “deep discount” to its face value

Bond Yields

• Yield-to-maturity (YTM) and Holding- Period Yield

Yield-to-maturity

The rate of return from holding a bond to maturity receiving all its promised cash flows

Holding-period yield

The rate of return an investor actually earns from an investment

Preferred Stock Valuation

• Fixed-rate preferred stock valued using the perpetuity PV model

• Variable-rate preferred stock (yield adjusts to market interest rates and price remains consistent)

Common Stock Valuation

Valued using the growing cash stream PV model, here renamed the “dividend growth model”

Free Cash Flow

• The cash flow distributed by a firm to its investors

• Similar (in cash flow terms) to the accrual accounting relationship

Multipliers

• A number used to estimate the value of common stock by multiplying an accounting performance figure

• Earnings, cash flow from operations, EBIT, EBITDA multipliers