Midterm_Exam_Review

Lecture 1: Corporation and Financial Markets

• Major Decisions by Financial Managers

  • Two major decisions:

    1. Investment (capital budgeting decision)

    2. Financing decision

  • Need to decide which real assets to invest in and how to fund those investments.

• Real Assets

  • Assets used in the production or sale of products/services, either tangible or intangible

• Financial assets

  • claims on the income from real assets, stocks, and bonds.

• Advantages and Disadvantages of Corporations

  • Advantages:

    • Distinct, permanent legal entities

    • Separation of ownership and control

    • Limited liability for owners

  • Disadvantages:

    • High management costs

    • Double taxation (corporate profits and shareholder dividends)

• Principal Financial Managers

  • Treasurer: Responsible for raising capital (getting money from outside sources) and maintaining financial relationships.

  • Controller: Prepares financial statements, and manages budgets.

  • CFO: Oversees both treasurer and controller, involved in policy and planning.

• Maximizing Shareholder Wealth

  • Value maximization: natural financial goal to avoid displacement by more efficient firms.

  • Value-added decisions: enable shareholders to invest or consume wealth in their best interests when decisions are made.

• Investment Decision Trade-offs

  • Opportunity Cost of capital: return that shareholders can earn for themselves.

• Manager-Shareholder Conflicts

  • Agency problems: arise from conflicts of interest between managers and shareholders. Kept in check by financial controls, compensation packages, and corporate governance.

• Where does the financing for corporations come from?

  • individuals’ savings flowing into firm

• What are the functions of financial markets?

  • Financial markets: channel savings into corporate investment and provide liquidity and diversification opportunities for investors

Lecture 2: The Time Value of Money

• Future Value of Investments

  • Future Value (FV): PV(1+r)^t

• Present Value of Future Cash Flows

  • PV = FV / (1 + r)^t

• Cash Flow Streams

  • Perpetuity: cash payments indefinitely.

    • PV = C/r

  • Annuity: cash payments for a limited duration.

    • PV = C(1/r - 1/(r(1+r)^t))

  • The total PV of cash flows is the sum of individual PVs.

• Interest Rate Comparisons

  • APR does not consider compounding; effective annual rate accounts for compound interest.

  • Equations:

• Real vs Nominal Values

  • Real value accounts for inflation; nominal does not.

  • Nominal cash flows discounted at nominal rates; real cash flows at real rates.

Lecture 3: Valuing Bonds

• Difference between bond coupon rate and yield to maturity

  • Bonds: Long-term debt of government or corporation; you receive fixed annual coupon payment based on face value.

  • Bond Coupon Rate: annual coupon payment expressed as a fraction of face value

  • Yield to maturity (YTM): Rate of return held until maturity.

• Find market price of bond given YTM

  • Discount coupon payments at YTM to find bond price.

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

• Find Bond Yield given price

  • rate of return = (cpn income+price change)/investment

• Interest Rate Risk

  • Bond prices rise when market rates fall; long-term bonds = higher risk.

• Why do investors pay attention to bond ratings and demand a higher
  interest rate for bonds with low ratings?

  • Higher yields required for low-rated bonds due to default risk.

  • Credit risk: the possibility that a bond issuer may fail to make the required payments on their debt, leading to potential losses for investors.

  • Default Premium: additional yield investors require for bearing there credit risk

Lecture 4: Accounting and Finance

• Key Financial Statements

  • Balance Sheet: Snapshot of assets and liabilities; difference = shareholders’ equity.

  • Income Statement: Measures profitability during the year (revenues - expenses).

  • Cash Flow Statement: Tracks sources and uses of cash.

• Market vs Book Values

  • Book values: Historical costs minus depreciation.

  • Market values: Current prices; firms strive for higher market than book values.

  • shareholders equity: measures the cash shareholders have previously contributed to a company

• Accounting Income vs Cash Flow

  • Accounting income: Investment in fixed assets spreads across years (spread as depreciation)

  • Cash Flow: Revenues are recognized when sold but not paid.

• Corporate Income Taxation

  • Corporate taxable income: Marginal tax rate of 21%; deductions for depreciation and interest, not dividends.

Lecture 5: Valuing Stocks

• Stock Trading Reports

  • Include price, price change, trading volume, dividend yield, and P/E ratio.

• Valuation Methods

  • Valuation by comparables emphasizes assessing similar firms for price estimates.

• Growth and Stock Valuation

  • P/E ratio reflects firm’s growth opportunities

Lecture 6: Net Present Value and Other Investment Criteria

• Calculating Net Present Value

  • NPV measures difference between value and cost of a project; accept projects with positive NPV to maximize shareholder wealth.

• Internal Rate of Return

  • IRR: Discount rate where NPV = 0; attractive if exceeds opportunity cost of capital.

• Profitability Index

  • In capital shortages, select projects with highest NPV/$ to maximize resource use.

• Limitations of Payback Rule

  • Payback rule ignores cash flows beyond recovery period and fails to discount within the payback period.

Lecture 7: Cash Flow Calculation for New Projects

• Checklist for Cash Flow Forecasting

  • discount cash flows, not profits.

  • Include incremental cash flows and indirect effects, but exclude sunk costs.

  • Treat inflation consistently; do not include financing costs in NPV calculations.

• Depreciation and Tax Implications

  • Depreciation reduces taxable income, offering a depreciation tax shield benefit.

• Working Capital Effects

  • Changes in working capital impact cash flows significantly; investments reduce cash flow, while reductions increase it.