Reading...
Play button
Play button
Use LEFT and RIGHT arrow keys to navigate between flashcards;
Use UP and DOWN arrow keys to flip the card;
H to show hint;
A reads text to speech;
87 Cards in this Set
- Front
- Back
|
Investment return in terms of dollars
|
amount recieved minus dollars invested
|
|
|
rate of return
|
[amount received
|
|
|
major areas of finance
|
1. money and capital markets
2. investments 3. financial management |
|
|
Forms of Business organization
|
1. sole proprietorship
2. partnership 3. coporation 4. Hybrid forms |
|
|
Advantages of sole proprietorship
|
1. ease of formation
2. subject to few regulations 3. no corporate income tax |
|
|
disadvantages to sole proprietorship
|
1. limited life
2. unlimited liability 3. difficult to raise capital |
|
|
partnership
|
has same advantages and disadvantages as a proprietorship
|
|
|
advantages of a corporation
|
1. unlimited life (as long as economically viable)
2. easy transfer and ownership 3. limited liability (limited to asset values, shareholders separate legally) 4. ease of raising capital |
|
|
disadvantages to a corporation
|
1. double taxation (corporate/personal)
2. cost of set up and report filings (legal restrictions) |
|
|
Corporate forms filled out at ______ level
|
state
|
|
|
If files for a corporation are not paid it's considered _____
|
inactive
|
|
|
Who owns a corporation?
|
Stockholders
|
|
|
registered agent
|
technical legal contract for documents (must be from a real person with a real address): usually the same as the secretary
|
|
|
goal of a corporation
|
shareholder wealth maximization (max. stock price)
|
|
|
biggest agency issue
|
shareholders vs. managers
|
|
|
Managers are naturally inclined to act in their own ____ ______
|
best interests
|
|
|
"stick" shareholder vs. agent factors
|
1. threat of firing
2. Threat of takeover |
|
|
"Carrot" shareholder vs. manager factors
|
1. managerial compensation plans
2. direct intervention by stockholders |
|
|
factors influence by managers that affect stock price
|
1. projected earnings per share
2. timings of the earning stream 3. riskiness of the earnings stream 4. use of debt (capital structure/amount of debt) 5. distribution or dividend policy |
|
|
Some debt is good, too much/little is ___ ____
|
not good
|
|
|
basic goal of a financial management
|
create value for customers through profit maximization
|
|
|
What do good managers focus on?
|
The long term, not short term, results and releasing accurate info so the market can accurately value shares
|
|
|
What is the economic logic behind profit maximization?
|
1. consumer benefits- better efficent products, better customer service
2. employee benefits- happier work environment, maximized job growth, special rewards 3. other benefits- earn extra $$ and stimulation of the economy. Economic benefits because individuals spend more ("wealth effect"), and corporate investment increases because it becomes easier to raise capital |
|
|
In basic terms, what determines a firm's value?
|
company's ability to generate cash flows now and in the future
|
|
|
What are some important effects of cash flows?
|
1. Any financial asset, inclueding a company's stock is valuable only to the extent that it generates cash flows.
2. the timing of the cash flows matters. The sooner cash is earned the better. |
|
|
free cash flows (FCF)
|
cash flows that matter because they are available to distribute to the company's investors (creditors and stockholders)
|
|
|
Three primary determinants of cash flows
|
1. sales revenues
2. operating costs and taxes 3. required new investments in operation |
|
|
What do sales revenues depend on?
|
the current level of unit sales, the price per unit, and the expected future growth
|
|
|
How is the after tax profit available to investor after a firm pays its employees and suppliers calculated?
|
sales - operating costs and taxes
|
|
|
Why is the amount of money a company invests into operations important?
|
Because it takes money to make money
|
|
|
intrinsic value
|
stock valuation based on expected free cash flows
|
|
|
market price
|
value quoted in the market based on the aggregate market's expectation of cash flows and is set by the marginal investor
|
|
|
fundamental value/price (true intrinsic value)
|
the intrinsic value an analyst would calculate given complete and accurate information about the company's future cash flows and risk.
|
|
|
equlibrium
|
when the market price of a stock is equal to the true intrinsic value
|
|
|
executive stock options
|
options that are worth more for managers when the stock price is high and so in theor makes the executives work harder to improve the stock price. This is hardly the case however.
|
|
|
agency problem
|
when managers own less the 100 percent of the firm's common stock and thus may not have the stockholders' needs at heart
|
|
|
agency relationship
|
whenever a principal hires someone else to perform some service
|
|
|
agency costs
|
costs that stockholders must incur, which include all costs borne by stockholders to encourage managers to maximize the firm's long term stock price rather than act in their own self interests
|
|
|
three major categories of agency costs
|
1. expenditures to monitor managerial action, such as auditing costs
2. expenditures to structure organizations in ways that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors 3. opportunity costs that are incurred when a shareholder imposes restrictions |
|
|
two extreme positions regarding how to deal with the shareholder-manager agency conflicts
|
1. Compensate the firm's manager solely on long term stock prices, making agency costs low. Makes it near impossible to hire a manager under these terms b/c takes to long to reflect in the price and would be affected by economic events.
2. Stockholders monitor every managerial action, but this would be costly and inefficient |
|
|
mechanisms used to motivate managers
|
1. managerial compensation plans that attracts and retains managers and aligns the managers' actions to that of the stockholders'
2. Direct Intervention by stockholders 3. Threat of firing 4. Threat of takeover |
|
|
structure of a senior executives' compensation
|
1. specified annual salary
2. cash or stock paid bonus paid at the end of the year, pending profitability 3. options to buy stock or actual shares of stock which reward the executive for long term performance |
|
|
executive stock options
|
allow managers to purchase stock at some future time at a predetermined price
|
|
|
economic value added
|
a new metric that measures managerial performance. Overcomes the flaw in conventional accounting to reflect the true economic value.
- Is a better measure than EPS and ROE - Found by subtracting from after-tax operating profit the annual cost of ALL the capital a firm uses - the higher the metric, the more the firm is creating wealth for its shareholders - There is a higher correlation between this metric and stock prices compared to other accounting measures |
|
|
steps in direct intervention by shareholders
|
1. Talk with management and make suggestions on how to run the business (like "lobbyists")
2. Anyone who has owned at least $1000 of a company's stock for one year can sponsor proposal that must be voted on at the annual stockholders' meeting, even if management opposes the proposal 3. Institutional money managers have to votes to replace a badly performing management team 4. Hedge funds have the ability to buy a controlling interest in any company they regard as being badly managed and thus undervalued and then change management |
|
|
Why are institutions taking such an interest in the management of companies they own these days?
|
1. no easy exit available
2. pressure on pension fund managers to work in best interest of the funds' beneficiaries 3. SEC expanding issues that shareholders can address in shareholder proposals, including executive compensation. and golden parachute packages |
|
|
hostile takeover
|
most likely to occur when a firm's stock is undervalued relative to its potential because of poor management. Management of the acquired firm are fired or lose status and authority.
|
|
|
other conflicts takeovers can also lead to
|
a) a target firm's manager tries to block a value enhancing merger that would threaten their jobs
b) where the target's managers do not strive to get the highest price because they would personally get a better deal from a bidder who would offer a lower price |
|
|
basis for creditors lending funds
|
1. riskiness of the firm's existing assets
2. expectations concerning the riskiness of the future asset additions 3. existing capital structure 4. expectations conerning the future capital structure changes |
|
|
Can and should stockholders, via their managers, try to attempt to invest in more risky than proposed projects, and in the process take advantage of creditors?
|
1. In general, no.
2. Creditors try to prevent themselves from such predicaments by including restrictive covenants 3. Unethical behavior has no place in business, and if the creditor finds out they can deny the firm more credit int eh future |
|
|
rules that help promote transparency in financial reporting
|
1. Publicly traded companies follow GAAP
2. publicly owned firms must have their reports examined by an independent auditor to verify accuracy 3. Auditors have been overseen by an accounting industry called the Public Oversight Board 4. Publicly traded firms must submit statements to SEC, which makes statements available to the public 5. Firms must release new info to all investors at the same time 6. Investment bandking and brokerage firms employ security analysts who make honest recommendations to the firms' clients 7. Any violators are to be prosecuted with speed and severity to deter others |
|
|
Sarbanes-Oxley Act of 2002
|
-has eleven chapters to establish wide ranging new regurlations for CEOs, CFOs, boards of directors, investment analysts, and investment banks.
- companies tha perform audits are sufficently independent of the companies they audit - board of directors' audit is relatively independent of the companies they analyze - a key executive in each company personally certivies that the financial statements are complete and accurate - financial analysts are relatively independent of management - companies publicly and promptly release important info about their finacial conditions |
|
|
quoted interest rate
|
= r = r* + IP+ LP + MRP + DRP
|
|
|
r*
|
real risk free rate of interest
|
|
|
IP
|
inflation premium, equal to the average expected inflation rate over the life of the security The expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not necessarily equal to current inflation
|
|
|
r(rf)
|
r*+ IP and it is the quoted risk free rate of interest on a securilty such as a US Treasury bill, which is very liquid and also free of most risks
|
|
|
DRP
|
default risk premium. The premium reflects the possibility an issuer will not pay interest or principal at the stated time and in the stated amount. DRP is zero for US treasury securities, but it rises as the riskiness of issuers increases.
|
|
|
LP
|
liquidity, or marketability premium. The preium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a reasonable price. LP is very low for treasury securities and securities issued by large strong firms, but is is relatively high on securities issued by very small firms
|
|
|
MRP
|
maturity risk premium. Longer term bonds, including Treasury bonds, are exposed to a significant risk of price declines and a maturity risk premium is charged by lenders to reflect this risk
|
|
|
the real risk free rate of interest changes over time depending on what conditions?
|
1. the rate of return corporations and other borrowers expect to earn on productive assets
2. the people's time preferences for current vs. future consumption |
|
|
indexed bonds
|
bonds issued by the US Treasury starting in 1997, with payments linked to inflation
|
|
|
Inflation has a major effect on the interest rates because it....
|
erodes the purchasing power of the dollar and lowers the real rate of return on investments
|
|
|
inflation premium is equal to
|
the average expected inflation rate over the life of the security.
|
|
|
Two important items to note about inflation premiums
|
1. The inflation rate built into interest rates is the inflation rate expected in the future, not the rate experienced in the past.
2. The inflation rate reflected in the quoted interest rate is the average rate of inflation expected over the security's life. Thus the inflation rate built into a 1 year security is the rate of inflation over the next year, while the rate built into a 30 year security is the average rate of inflation expected over the next 30 years. |
|
|
nominal/quoted risk free rate of interest
|
r(rf) is the real risk free rate plus the premium expected for inflation
|
|
|
what does it mean when we say "risk free rate"
|
the nominal risk free rate, which includes inflation premium equal to the average expected inflation rate over the life of the security
|
|
|
what is generally used to approximate short term risk free rate? long term risk-free rate?
|
T bills, T bonds
|
|
|
default risk premium is also known as
|
bond spread
|
|
|
default risk premium is
|
the difference between the quoted interest rate on a T bond and that on a corporate bond with similar maturity, liquidity and other features
|
|
|
The longer the maturity of a bond, the greater the
|
interest rate risk
|
|
|
what combats interest rate risk for long term securities?
|
maturity risk premium
|
|
|
reinvestment rate risk
|
risk that when a short term bill matures and is reinvested, the interest rates would necessitate a reinvestment at a lower rate and would result in a decline in interest income
|
|
|
Long term bonds are heavily exposed to __________________ while short term bonds are heavily exposed to _______________ .
|
interest rate risk; reinvestment rate risk
|
|
|
two ways riskiness of an asset can be considered
|
1. stand alone basis
2. in a portfolio context |
|
|
two components an asset's risk can be divided when in a portfolio context
|
1. diversification risk component, can be minimized through diversification of asset allocation
2. market risk component, which reflects the risk of the general stock market decline and is not diversable |
|
|
what risks are relevant?
|
only market risk
|
|
|
beta
|
a measure to quantify market risk. It measures how a particular firm's stock returns move more relative to the overall market's returns
|
|
|
dollar terms
|
one way of expressing an investment return
|
|
|
rate of return
|
(amount received - amount invested) / amount invested
|
|
|
The greater the chance of low or negative returns, the ______ the investment
|
riskier
|
|
|
No investment will be taken on unless ____________________ is high enough to compensate the investor for the perceived risk of the investment
|
expected rate of return
|
|
|
expected rate of return
|
the sum of the products of each possible outcome times its associated probability (it is the weighted average of the various possible outcomes, with the weights being the probability of occurrence)
|
|
|
what does a tighter probability distribution mean?
|
the more likely the actual outcome will be close to the expected value and consequently , the less likely it is that the actual return will end up far below the expected rate of return
|
|
|
The tighter the distribution, the _____ the risk assigned to a stock.
|
lower
|
|
|
coefficient of variation calculation
|
std. deviation/ expected return
|
|
|
what the coefficient of variation shows
|
the risk per unit of return and provides a more meaningful basis for comparison when expected returns on two alternatives are not the same
|
|
|
Most investors are ______ and will choose the stock with _____________
|
risk adverse; lower risk
|
