BA 318 Midterm Study Guide
BA 318 Midterm Study Guide BA 318
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This 10 page Study Guide was uploaded by Samantha Neal on Tuesday February 10, 2015. The Study Guide belongs to BA 318 at University of Oregon taught by Deborah Bauer in Fall. Since its upload, it has received 624 views. For similar materials see Finance in Finance at University of Oregon.
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Date Created: 02/10/15
BA 318 Midterm Study Guide 11042014 Covers Chapters 1 4 5 6 7 1 Agency problems why they arise ways to reduce them board of directors for ex The relationship between stockholders and management is called an agency relationship because a corporation is owned by multiple stockholders management is predominantly in control of the rm Managers run the corporation as caretakers for the Shareholders People buy stock for investment purposes While they become owners in the corporation when they buy stock they are not running the corporation on a day to day basis This results in an agency relationship where managers act as agents for shareholders the possibility of con ict of interest between the owners and management of a rm Agency problems arise due to the separation of ownership and management Ways to reduce them 0 Compensation plans tied to the performance of the rm Ex Make managers owners in the rm by compensating them with shares of stock or stock options Then maximizing shareholder wealth becomes the same as maximizing managers wealth o The Board of Directors oversees management and can re them 0 Threat of takeover exists if they act inef ciently 2 Goal of nancial manager and problems w alternative goals such as pro t maximization The nancial management function is usually associated with a top of cer of the rm often called a CFO They are the caretakers of the shareholders money they act as agents for the shareholders Three concerns are capital budgeting capital structure and working capital management would be the most commonly cited business goal but this is not a very precise objective this goal doesn t tell us the appropriate tradeoff between current and future pro ts The goal of nancial management is to maximize shareholder wealth also called stockholder wealth 0 With this goal there is no ambiguity and there is no shortrun vs longrun It explicitly says that the goal is to maximize the current stock value 0 For rms that have no traded stock a more general goal is to maximize the market value of the existing owner s equity O Realize that maximizing shareholder wealth is NOT the same as maximizing accounting pro ts Accounting pro ts have a short term focus and if they are the focus it can lead to poor decision making by management Consider what you might do if told to maximize accounting pro ts revenues minus expenses You may for instance lay people off stop doing research and development stop advertising etc These may not be wise long term decisions 3 Forms of business organization and their characteristics sole proprietorship partnership corporation 0 O O O O a business owned by a single individual Easiest to start and is the least regulated form of organization Owner keeps all the pro ts Owner has unlimited liability for business debts creditors could take personal assets for payment There is no distinction between personal and business income so all business income is taxed as personal income Life of rm is limited to owner s life span The amount of equity that can be raised is limited to one person Ownership is dif cult to transfer because it requires the sale of the entire business to a new owner 0 a business formed by two or more individualsentities O O In a general partnership all the partners share winslosses and all have unlimited liability for all partnership debts The way the pro ts are divided is speci ed in the partnership agreement In a limited partnership one or more general partners will run the business and have unlimited liability but there will be one or more limited partners who do not actively participate in the business This limited partner is only liable for the amount that they contribute to the partnership The proscons are the same as a single owner Disadvantages are unlimited liability limited life of the rm hard to transfer ownership 0 a business created as a distinct legal entity owned by or more individuals or entities A corporation is a legal person that has similar rights Shareholders own the corporation and more speci cally the common stockholders 0 They can borrow money and own property can sue and be 0 sued can enter into contracts can be a general or limited partner in a partnership and can own stock in another corporation Its hard to form have to prepare a charter and set of bylaws o In large corporation stockholders and managers are separate stockholders elect board of directorswho select managerswho run the corporation s affairs in the stockholder s interests 0 Advantages ownership can be transferred easily life of rm is not limited stockholders have limited liability o Disadvantages double taxation bc a corporation is a legal person it is taxed and then when dividends are paid to stockholders they are taxed again 4 Investing capital budgeting vs Financing capital structure Decisions vs Working Capital Management The financial manager CFO must be concerned with three things 0 the process of planning and managing a rm s long term investments 0 ln capital budgeting the nancial manager tries to identify investment opportunities that are worth more to the rm that they cost 0 The managers must evaluate the size time and risk of future cash ows most important things to consider 0 the mixture of debt and equity maintained by a rm 0 This is the second question for the CFO that concerns how the rm obtains the nancing it needs to support its long term investments 0 Asks how much should the rm borrow and what are the cheapest sources of funds for the rm 0 a rm s short term assets and liabilities 0 Working capital refers to short term assets like inventory and short term liabilities like money owed to suppliers 0 Managing the rm s day to day activity to make sure that the rm has suf cient resources to continue its operations 5 Real vs nancial assets de nitions and which deal with investing vs nancing decisions 0 assets that are used to produce goods and services 0 Investment or capital budgeting decisions are decisions that deal with real assets In what should we invest Should we expand shrink or diversify assets that have a claim on the income generated by the real assets 0 Financing or capital structure decisions are decisions that deal with nancial assets O How much cash should we raise How should we raise cash How much cash should we return to investors Investment decisions create value as they determine where future cash ows will come from in the long term Future cash ows are what create value for a company Concept behind the time value of money a dollar today is worth more than a dollar tomorrow why Also present and future value relationships 0 The basic concept behind the time value of money is that a dollar today is worth more than a dollar tomorrow in real terms This is because in ation is happening the general rise in the prices of goods and services Also you d rather have your money sooner as you could then invest it earn interest on it and turn it into more money in the future 0 Amount to which an investment will grow after earning interest 0 For example if you invested 100 today and earned 10 over one year what would the future value be FV100110 FV110 Value today of a future cash ow how much money today will make me just as happy as a cash ow in the future 7 Annuity and perpetuity de nitions a special case of multiple cash ows where there is a level cash payment C that ends at some point 0 With an ordinary annuity the cash ows occur at the end of each period 0 Annuity due an annuity for which the cash ows occur at the beginning of the period 0 The present value of an annuity tells me how much money today will make me just as happy as a nite stream of future cash ows 0 an annuity in which the cash ows continue forever 0 PV for a perpetuity Cr 8 Determinants of required rate of return real rate expected in ation risk Real rate interest rates or rates of return that have been adjusted for in ation o Investors want to nd a rate of return that compensates them for the time value of money during the period of investment the expected rate of in ation during the period and the risk involved The summation of these three components is called the required rate of return This is the minimum rate of return that you should accept from an investment to compensate you All else equal the higher the interest rate the lower the present value of an amount to be received at some point in the future 9 Stock exchanges Physical exchanges NYSE OTC exchanges NASDAQ what determines stock prices 0 The equity shares of most large rms in the USA trade in organized auction markets The largest such market is the New York Stock Exchange NYSE which accounts for more than 85 of all shares traded in auction markets 0 In addition to stock exchanges there is a large OTC market for stocks 0 In 1971 the NASD made available to dealers and brokers an electronic quotation system called NASDAQ There are roughly three time as many companies on NASDAQ as there are NYSE but they tend to be much smaller and trade less actively However the total stock value of NASDAQ is much less than that of the NYSE Stocks that trade on an organized market are said to be listed on the exchange 0 In order to be listed rms must meet certain minimum criteria concering for example asset size and number of shareholders The criteria differs for different exchanges 10 Yield to maturity de nition estimate use as discount rate 0 the interest rate required in the market on a bond Used to determine the value of a bond at a point in time o It is the single interest rate that implies a present value of cash ows of a bond that equals its current price 0 In general the yield to maturity is a complicated average of interest rates in the term structure The yield to maturity is not a market rate of interest but it can be used as our discount rate to nd price 0 It is important to remember that yield to maturity does not determine prices rather yield to maturity is implied by a bond39s price and its pattern of future cash ows 0 Prices are determined by market rates of interest or spot rates that make up the term structure 0 Yield to maturity is just an easy way to summarize the quotaveragequot rate of discount for a bond with multiple cash ows 0 We often use the yield to maturity of a bond with a quoted market price to value a bond that does not have an easily observed market price 11 Primary vs secondary stock markets what happenswho gets money on each The stock market consists of a primary market and a secondary market 0 when stocks are sold from the company to investors for the rst time 0 Initial public offerings lPOs 0 New issues from existing companies SEOs or Seasoned Equity Offerings the market in which previously issued securities are traded among investors o What we know as quotthe stock marketquot 0 Provides liquidity by allowing investors to easily sell their shares to other investors o NYSE and NASDAQ are examples 12 Risks you face when you own bonds interest rate risk credit default risk how do these differ for government versus corporate default premium and short versus long term bonds 0 There are two main risks of bonds 0 We know that as interest rates change bond prices change as well o If interest rates rise and you are locked into a longterm bond you are missing out on higher returns that could be earned in the market 0 A rise in interest rates will also cause the value of your investment in the longterm bond to fall Consider the fact that you have lent your money for 30 years at a low rate 0 Shortterm bonds are less volatile to changes in interest rates You are locked in for only a short period of time even if interest rates do rise Therefore long term bonds are more risky than short term bonds 0 Credit risk is the risk that the issuer of the bond ie the borrower will default Default is de ned as not making interest payments 0 US Treasuries are said to be quotriskfree as our national government will not go bankrupt o The difference between the yield on a corporate bond which is risky and a Treasury bond is the default premium The default premium is the additional compensation required for taking on the risk of default All else equal the longer time to maturity the greater the interest rate risk All else equal the lower the coupon rate the greater the interest rate risk 13 Ei Rating Bond ratings general ideas from the table showing SampP and Moody39s ratings highlow risk highlow returns expensivecheap money Firms frequently pay to have their debt rated The two leading bond rating rms are Moody s and Standards amp Poor s The bond rating system helps investors determine a company s credit risk The debt ratings are as assessment of the credit worthiness of the corporate issuer The de nitions of creditworthiness used by Moody s and SampP are based on how likely the rm is to default and the protection creditors have in the event of a default The highest rating a rm s debt can have is AAA or Aaa this debt is judged to be the best quality and to have the lowest degree of default risk is not very common AA represents very good quality debt and are more common The lowest rating is D I V E A Gree ek Medy lfe SampP Fiteli ee I i lt i Highest Quality he A I 39ii EEilEI E l High Quality h I ii ltm l Etrng Bee BET hireetrheht Medium Grade He E HE E Thhh SPEE MIETWE Heart at EEEEEKE Iiihle Highlyr E E l 39 E El 111th In Defehlt bonds with high quality ratings have low required returns because they are low risk For the rms issuing these bonds this translates to be able to borrow money cheaper than for a high risk rm 14 Characteristics of bonds preferred stock common stock voting rights cash ows received debt or equity rights in bankruptcy etc o A bond is a longterm loan to a company or government that is made by investors o The borrower company receives funds today and in exchange agrees or enters into a contractual promise to make a series of coupon payments until the maturity date of the bonds Par Value is the principal amount to be paid at maturity usually 1000 per bond Also known as face value Coupon rate is the percentage of par value that is paid every year 10 in our example Coupon payment is the interest payment it is determined by the coupon rate and is xed throughout the life of a bond Coupon rate par coupon payment 10x1000100 A security that represents ownership in corporation Common stockholders are on the bottom of the priority ladder for ownership structure In the event of liquidation common shareholders have rights to a company39s assets only after bondholders preferred shareholders and other debt holders have been paid in full 0 O O O O No promised payments of dividends Payments come in the form of dividends that are declared at the discretion of the Board of directors Lower priority than bonds often called residual claims Paid last in bankruptcy Typically have voting rights Represents an ownership claim that has no maturity o A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock 0 O O O O 15 Shares some features of common stock and some features of bonds receives a prespecified regular dividend like a bond s coupon Typically does not have voting rights similar to a bond It has no maturity similar to common stock Preferred stockholders have priority over common stock holders are paid their dividends before any payments are made to common stockholders Fisher Effect what this is describing the relation between o is the relationship between nominal returns real returns and in ation Because investors are ultimately concerned with what they can buy with their money they require compensation for in ation o actual interest rates This is how bonds loans etc are quoted o Nominal rates adjusted for in ation also known as purchasing power 16 When a bond sells at par premium or discount 0 is the principal amount to be paid at maturity usually 1000 per bond Also known as face value 0 When a bond sells for above par This means that present value of the future cash ows is greater than 1000 assuming which we always will that par is 1000 A bond will sell at a premium anytime the coupon rate is greater than the required rate of return The bond is offering to pay you more than you require and therefore you will pay more than face value remember face value is the same as par value for the bond 0 When a bond sells for below par This means that present value of the future cash ows is less than 1000 assuming which we always will that par is 1000 A bond will sell at a discount anytime the coupon rate is less than the required rate of return 0 the par value is not the price of the bond A bond39s price uctuates throughout its life in response to a number of variables When a bond trades at a price above the face value it is said to be selling at a premium When a bond sells below face value it is said to be selling at a discount 0 interest earned only on the original principal amount invested o interest earned on both the initial principal and the interest reinvested from prior periods 0 interest rate that is annualized using simple interest It is the interest rate charged per period times the number of periods in a year It is typically the stated rate on a loan 0 interest rate that is annualized using compound interest It is the rate at which funds will grow over the course of a year o If you are comparing two accounts the account with the higher EAR will produce more money because the interest accumulates its compounded 0 When comparing two loans with the same time period and amount you should choose the loan that has the lowest EAR Discount rate the interest rate used to calculate the present value of future cash ows
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