Corporate Finance Exam 1

Front 1

Investment return in terms of dollars

Back 1

amount recieved minus dollars invested

Front 2

rate of return

Back 2

[amount received

Front 3

major areas of finance

Back 3

1. money and capital markets
2. investments
3. financial management

Front 4

Forms of Business organization

Back 4

1. sole proprietorship
2. partnership
3. coporation
4. Hybrid forms

Front 5

Advantages of sole proprietorship

Back 5

1. ease of formation
2. subject to few regulations
3. no corporate income tax

Front 6

disadvantages to sole proprietorship

Back 6

1. limited life
2. unlimited liability
3. difficult to raise capital

Front 7

partnership

Back 7

has same advantages and disadvantages as a proprietorship

Front 8

advantages of a corporation

Back 8

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

Front 9

disadvantages to a corporation

Back 9

1. double taxation (corporate/personal)
2. cost of set up and report filings (legal restrictions)

Front 10

Corporate forms filled out at ______ level

Back 10

state

Front 11

If files for a corporation are not paid it's considered _____

Back 11

inactive

Front 12

Who owns a corporation?

Back 12

Stockholders

Front 13

registered agent

Back 13

technical legal contract for documents (must be from a real person with a real address): usually the same as the secretary

Front 14

goal of a corporation

Back 14

shareholder wealth maximization (max. stock price)

Front 15

biggest agency issue

Back 15

shareholders vs. managers

Front 16

Managers are naturally inclined to act in their own ____ ______

Back 16

best interests

Front 17

"stick" shareholder vs. agent factors

Back 17

1. threat of firing
2. Threat of takeover

Front 18

"Carrot" shareholder vs. manager factors

Back 18

1. managerial compensation plans
2. direct intervention by stockholders

Front 19

factors influence by managers that affect stock price

Back 19

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

Front 20

Some debt is good, too much/little is ___ ____

Back 20

not good

Front 21

basic goal of a financial management

Back 21

create value for customers through profit maximization

Front 22

What do good managers focus on?

Back 22

The long term, not short term, results and releasing accurate info so the market can accurately value shares

Front 23

What is the economic logic behind profit maximization?

Back 23

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

Front 24

In basic terms, what determines a firm's value?

Back 24

company's ability to generate cash flows now and in the future

Front 25

What are some important effects of cash flows?

Back 25

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.

Front 26

free cash flows (FCF)

Back 26

cash flows that matter because they are available to distribute to the company's investors (creditors and stockholders)

Front 27

Three primary determinants of cash flows

Back 27

1. sales revenues
2. operating costs and taxes
3. required new investments in operation

Front 28

What do sales revenues depend on?

Back 28

the current level of unit sales, the price per unit, and the expected future growth

Front 29

How is the after tax profit available to investor after a firm pays its employees and suppliers calculated?

Back 29

sales - operating costs and taxes

Front 30

Why is the amount of money a company invests into operations important?

Back 30

Because it takes money to make money

Front 31

intrinsic value

Back 31

stock valuation based on expected free cash flows

Front 32

market price

Back 32

value quoted in the market based on the aggregate market's expectation of cash flows and is set by the marginal investor

Front 33

fundamental value/price (true intrinsic value)

Back 33

the intrinsic value an analyst would calculate given complete and accurate information about the company's future cash flows and risk.

Front 34

equlibrium

Back 34

when the market price of a stock is equal to the true intrinsic value

Front 35

executive stock options

Back 35

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.

Front 36

agency problem

Back 36

when managers own less the 100 percent of the firm's common stock and thus may not have the stockholders' needs at heart

Front 37

agency relationship

Back 37

whenever a principal hires someone else to perform some service

Front 38

agency costs

Back 38

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

Front 39

three major categories of agency costs

Back 39

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

Front 40

two extreme positions regarding how to deal with the shareholder-manager agency conflicts

Back 40

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

Front 41

mechanisms used to motivate managers

Back 41

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

Front 42

structure of a senior executives' compensation

Back 42

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

Front 43

executive stock options

Back 43

allow managers to purchase stock at some future time at a predetermined price

Front 44

economic value added

Back 44

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

Front 45

steps in direct intervention by shareholders

Back 45

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

Front 46

Why are institutions taking such an interest in the management of companies they own these days?

Back 46

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

Front 47

hostile takeover

Back 47

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.

Front 48

other conflicts takeovers can also lead to

Back 48

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

Front 49

basis for creditors lending funds

Back 49

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

Front 50

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?

Back 50

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

Front 51

rules that help promote transparency in financial reporting

Back 51

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

Front 52

Sarbanes-Oxley Act of 2002

Back 52

-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

Front 53

quoted interest rate

Back 53

= r = r* + IP+ LP + MRP + DRP

Front 54

r*

Back 54

real risk free rate of interest

Front 55

IP

Back 55

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

Front 56

r(rf)

Back 56

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

Front 57

DRP

Back 57

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.

Front 58

LP

Back 58

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

Front 59

MRP

Back 59

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

Front 60

the real risk free rate of interest changes over time depending on what conditions?

Back 60

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

Front 61

indexed bonds

Back 61

bonds issued by the US Treasury starting in 1997, with payments linked to inflation

Front 62

Inflation has a major effect on the interest rates because it....

Back 62

erodes the purchasing power of the dollar and lowers the real rate of return on investments

Front 63

inflation premium is equal to

Back 63

the average expected inflation rate over the life of the security.

Front 64

Two important items to note about inflation premiums

Back 64

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.

Front 65

nominal/quoted risk free rate of interest

Back 65

r(rf) is the real risk free rate plus the premium expected for inflation

Front 66

what does it mean when we say "risk free rate"

Back 66

the nominal risk free rate, which includes inflation premium equal to the average expected inflation rate over the life of the security

Front 67

what is generally used to approximate short term risk free rate? long term risk-free rate?

Back 67

T bills, T bonds

Front 68

default risk premium is also known as

Back 68

bond spread

Front 69

default risk premium is

Back 69

the difference between the quoted interest rate on a T bond and that on a corporate bond with similar maturity, liquidity and other features

Front 70

The longer the maturity of a bond, the greater the

Back 70

interest rate risk

Front 71

what combats interest rate risk for long term securities?

Back 71

maturity risk premium

Front 72

reinvestment rate risk

Back 72

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

Front 73

Long term bonds are heavily exposed to __________________ while short term bonds are heavily exposed to _______________ .

Back 73

interest rate risk; reinvestment rate risk

Front 74

two ways riskiness of an asset can be considered

Back 74

1. stand alone basis
2. in a portfolio context

Front 75

two components an asset's risk can be divided when in a portfolio context

Back 75

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

Front 76

what risks are relevant?

Back 76

only market risk

Front 77

beta

Back 77

a measure to quantify market risk. It measures how a particular firm's stock returns move more relative to the overall market's returns

Front 78

dollar terms

Back 78

one way of expressing an investment return

Front 79

rate of return

Back 79

(amount received - amount invested) / amount invested

Front 80

The greater the chance of low or negative returns, the ______ the investment

Back 80

riskier

Front 81

No investment will be taken on unless ____________________ is high enough to compensate the investor for the perceived risk of the investment

Back 81

expected rate of return

Front 82

expected rate of return

Back 82

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)

Front 83

what does a tighter probability distribution mean?

Back 83

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

Front 84

The tighter the distribution, the _____ the risk assigned to a stock.

Back 84

lower

Front 85

coefficient of variation calculation

Back 85

std. deviation/ expected return

Front 86

what the coefficient of variation shows

Back 86

the risk per unit of return and provides a more meaningful basis for comparison when expected returns on two alternatives are not the same

Front 87

Most investors are ______ and will choose the stock with _____________

Back 87

risk adverse; lower risk