Exam 1 Review
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Principles of Finance Exam 1 Review Chapter 1 The Role and Objective of Financial Management Chapter Introduction Key Chapter Concepts Shareholder wealth is defined as the present value of the expected future returns to the owners of the firm It is measured by the market value of the shareholders common stock holdings The primary normative goal of the firm is to make the most efficient use of the firm s resources and thereby to maximize shareholder wealth Achievement of the shareholder wealth maximization goal is constrained by social responsibility concerns and problems arising out of agency relationships The market value of a firm s stock is determined by the magnitude timing and risk of the cash ows the firm is expected to generate Managers can take a variety of actions to in uence the magnitude timing and risk of the firm s cash flows These actions are often classified as investment financing and dividend decisions Ethical standards of performance are an increasingly important dimension of the decision making process of managers The most important forms of business organization are the 0 Sole proprietorship 0 Partnership both limited and general 0 Corporation Corporations have the advantages of limited liability for owners potentially perpetual life and the ability to raise large amounts of capital Even though they account for only 20 percent of US firms corporations account for 84 percent of US business revenues The finance function is usually headed by a chief financial officer 0 Financial management responsibilities are often divided between the controller and treasurer 0 The controller normally has responsibility for all activities related to accounting 0 The treasurer is normally concerned with the acquisition custody and expenditure of funds 11 Introduction 12 The Goal of Shareholder Wealth Maximization The most widely accepted objective of the firm is to make the most efficient use of the firm s resources and thereby maximize the value of the firm for its owners that is to maximize shareholder wealth Shareholder wealth Present value of the expected future returns to the owners that is shareholders of the firm It is measured by the market value of the shareholders common stock holdings that is the price per share times the number of shares outstanding Management should seek to maximize the present value of the expected future re turns to the owners of the firm Present value The value today of a future payment or a series of future payments evaluated at the appropriate discount rate Discount rate The rate of interest used in the process of finding present values also called the required rate of return Intrinsic value arises from the magnitude size timing the longer it takes to receive a benefit the lower the value and risk higher risk results in less value Risk The possibility that actual future returns will deviate from eXpected returns the variability of returns Shareholder wealth number of Shares outstanding market price per Share 121 Stakeholder Concerns A manager who takes an appropriate long term perspective in decision making rather than focusing only on short term accounting profits will recognize responsibility to all of a firm s constituencies and will help lead the company to the maximization of value for shareholders while balancing concerns of other stakeholders Stakeholders the constituent groups in a firm including stockholders bondholders suppliers customers employees community neighbors and creditors 122 Divergent Objectives Separation of ownership shareholders and control managers has permitted managers to pursue goals more consistent with their own self interests as long as they satisfy shareholders sufficiently to maintain control of the corporation 123 Agency Problems Stockholders and Creditors Stockholders and Managers Agency costs costs incurred by owners of a firm when the firm is managed by others includes monitoring costs bonding costs and any losses that cannot be eliminated economically by monitoring and bonding Mechanisms available to reduce agency con icts between shareholders include Corporate Governance Managerial Compensation Threat of Takeovers 13 Maximization of Shareholder Wealth Managerial Strategies 131 Determinants of Value Cash Flow Magnitude More money gt Less money Timing of Cash Flows Timing Money now gt Money later Risk In general the greater the perceived risk associated with an expected cash ow the greater is the rate of return required by investors and managers Less risk gt More risk 132 Managerial Actions to In uence Value Factors Aitecting Stock Prices Economic Environment Factors i Level of economic activity 1T3 rates and regulations 3 Competition including tiniest of new competitors and substitute products 4 Laws and government regulations 5 Ulmoniiation of employees 6 International businesa conditions and currency exchange rates it Earpining of buyers l Major Policy Decisions Under Management Control ll Ptoducts and sewita oi 39ered for sale 2 Production technology 3 Marketing and distribution network 4 investment strategies 5 Employment policies and compensation packages for managers and other employees 6 lDwnership fowl proprietors hipi partnershipor cooperation 339 Capital structure use of debt and equity to nance the firm 8 Working capital management polities 9 Dividend policies l Amount Timing and Ridk of Expected Cash Flows Conditions llr39ll k Financial Markets w m I u I Shareholder Weal n 2 were me a 39 Mice Price of Static nl VESMi39 optimum 3 Anticipated in ation Ev Loan 1 Five competitive forces affecting market prices of stock according to Porter and Rappaport Threat of new entrants Threat of substitute products The bargaining power of buyers The bargaining power of suppliers The rivalry among current competitors 14 Forms of Business Organization 141 Sole Proprietorship Sole proprietorship A business owned by one person The owner of a sole proprietorship has unlimited liability for debts incurred by the business Advantage Easy and inexpensive to establish Disadvantage Unlimited personal liability for all debts and other obligations incurred by the firm Difficulty raising funds to finance growth Common in retail trade service construction and agriculture industries 142 Partnership Partnership A business organization in which two or more persons form a business with the intention of making a profit In a general partnership each partner has unlimited liability for the debts of the firm Limited partnerships allow one or more partners to have limited liability General Partnership General partnership a business organization where each partner has unlimited liability for all obligations of the business Disadvantage Unlimited personal liability for all debts and other obligations incurred by the firm Limited Partnership Limited partnership A business organization in which the liability of the partners is generally limited to their investment Advantage Relatively easy to form Greater capacity to raise capital than sole proprietorship Disadvantage Must be reformed if a change in general partners occurs Lack tremendous capital attraction ability of corporations Common in real estate ventures important to agriculture mining oil and gas finance insurance real estate and service industries 143 Corporation Corporation a business organization that is created as a legal person separate and distinct from the individual or individuals who own the firm s stock The primary characteristics and advantages of incorporating include limited liability for the firm s owners permanency and flexibility with respect to making changes in ownership Advantage Limited liability Permanency Flexibility Ability to raise capital Corporate Organization and Governance Corporate Securities Corporations issue certificates or securities to investors in exchange for use of their funds Securities represent claims against the assets and future earnings of the firm Types of corporate securities Debt securities Investor lends money to the corporation Equity securities Investor takes ownership of the corporation through stock purchase Equity security types Common stock Preferred stock 144 Other Types of Business Organizations S corporation Criteria lt100 domestic stockholders Advantage Avoids double taxation of earnings pass through taxation Limited liability LLC Limited Liability Company Hybrid organization similar to a S corporation Comprised of members Earnings ow through to members owners and taxed at an individual level LLP Limited Liability Partnership Limited liability among partners Taxes are passed through to partners PLLP professional limited liability partnership specific type of LLP Partnership formed to render specific professional services such as legal accounting or medical services 15 Organization of the Financial Management Function Sample Organization Chart Board of Finance Dinetters Committee Chief Executive Of cer WLPermnnel WMarlceting VlLEngineering VPMamlacturing Controller Treasurer Financial Coat T Data Cash 81 W5 Financial Credit Investor Pension Fmd keem ng Accenth u Prueusing Management I I Planning Analysis Relations Management 3 E3 0 Cengage Learning 151 Financial Management and Other Disciplines Accounting Economics 152 Marketing Production Quantitative Methods and Human Resource Management 16 Career Opportunities in Finance 17 Professional Finance Affiliations and Certifications Affiliations Financial Executives Institute Institute of Chartered Financial Analysts Financial Management Association FMA Certifications Certified Financial Manager CFM Certified Financial Planner CFP Chartered Financial Analyst CFA Certified Treasury Professional CTP 18 Summary 1 2 10 The primary normative goal of financial management decision making is the maximization of shareholder wealth as measured by the price of the firm s stock Agency relationships such as the relationship between stockholders and managers and the relationship between owners and lenders give rise to certain agency problems and costs that can have an important impact on firm performance The amount timing and risk of the cash flows generated by a firm are in large part determined by key financial management decisions including investment decisions dividend decisions financing decisions and ownership structure decisions These decisions must be made in the context of factors in the broader economic environment The three primary forms of business organization are the sole proprietorship the partnership and the corporation Corporations have certain advantages over the other two forms of business organization especially for large businesses A corporation is defined as a legal person composed of one or more actual individuals or legal entities The owners of a corporation are called stockholders or shareholders The stockholders elect a board of directors that usually deals with broad policy matters whereas the day to day operations are supervised by the corporate officers Corporations issue debt securities to investors who lend money to the corporation and equity securities to investors who become owners The optimal form of organization for a business enterprise is influenced by such factors as cost complexity owner liability business continuity need for raising capital the owners desire to maintain decision making authority and tax considerations The finance function is usually headed by a vice president or chief financial officer The financial management responsibilities are often divided between the controller and the treasurer The controller normally has responsibility for all accounting related activities The treasurer is normally concerned with the acquisition custody and expenditure of funds Financial management is closely related to other areas of business decision making particularly accounting and economics The finance profession offers a number of exciting career opportunities both within the corporate finance function and in the financial services sector Chapter 2 The Domestic and International Financial Marketplace Chapter Introduction Key Chapter Concepts 1 21 Introduction In the US financial system funds ow from net savers such as households to net investors such as businesses through financial middlemen and financial intermediaries 0 Financial middlemen include securities brokers and investment bankers 0 Financial intermediaries include commercial banks thrift institutions investment companies and finance companies Financial markets are classified as money or capital markets and primary or secondary markets a Short term securities with maturities of one year or less are traded in money markets Long term securities have maturities of more than one year and are traded in capital markets b New securities are traded in the primary markets Existing securities are traded in the secondary markets such as the New York Stock Exchange the American Stock Exchange and NASDAQ Companies engaged in international financial transactions face such problems as political and exchange rate risk in addition to those risks encountered in domestic transactions The exchange rate is the rate at which a currency can be converted into another currency a The spot rate is the present exchange rate for immediate delivery b The forward rate is the present exchange rate for deliveries of currencies in the future The Eurocurrency market is an important alternative to domestic sources of financing for multinational firms LIB OR the London InterB ank Offer Rate is the basic interest rate against which Eurocurrency loans are priced In efficient capital markets security prices represent an unbiased estimate of the true economic value of the cash flows expected to be generated for the benefit of that security holder Holding period returns measure the actual or expected return from holding a security including price changes and distributions such as dividends or interest 22 An Overview of the US Financial System Savings Investment Cycle Net savers surplus spending units transfer funds indirectly to net investors deficit spending units US financial system facilitates flow of funds through financial markets and institutions FlowofFunds Diagram Funds Financial Middleman lFunds Priman Pi il iii i Claims mesment Bankers Claims l Financial Intermediaries li Surplus Commercial Banks De cit P Spending iFunds irhnilt lnm grmm lFunds Spending Units Pme mgm Pam Units 393 r enSIon Funds I 31 THE Ultimate aim Insurance Companies ML The Ultimate 3 Lenders Claims Finance Campylie Clam Borrowers 221 Financial Assets 222 Financial Markets Financial markets are the vehicles which financial assets are bought sold and traded Money and Capital Markets Money markets financial market in which short term lt1 year are bought and sold Capital markets financial market in which long term gt1 year are bought and sold Primary and Secondary Markets Primary financial market financial market in which new securities from an issuing firm are bought and sold for the first time investment banker are active in the primary markets Example IPOs Secondary financial market financial market in which eXisting securities are offered for resale NYSE is a secondary market 223 Financial Intermediaries Commercial Banks Commercial banks accept demand deposits checking accounts and time deposits savings accounts and certificates of deposit Important source of short term loans Major source of term loans Term loan debt obligation having an initial maturity between 1 and 10 years generally repaid in installments over the life of the loan Thrift Institutions Include savings and loan associations mutual savings banks and credit unions Accept both demand and time deposits Investment Companies Include mutual funds and real estate investment trusts REITs Pool funds of many savers and invest in various assets Pension Funds Pool funds of the contributions from employees andor employers and invest funds in various types of assets Insurance Companies Receive periodic or lump sum premium payments from individuals or organizations in exchange for agreeing to make certain future contractual payments Finance Companies Obtain funds by issuing their own debt securities and through loans from commercial banks 23 The Structure and Operation of US Security Markets 231 Security Exchanges and Stock Market Indexes Secondary markets can be classified as Listed security exchanges market that operates at designated places of business NYSE is an example of a listed security exchange OTC security market network of security dealers connected by a communications system of telephones and computer terminals that provides price quotations on individual securities Listed Security Exchanges NYSE AMEX Chicago Stock Exchange regional National Stock Exchange regional OTC Over the counter Markets NASDAQ Stock Market Indexes Indexes give a broad indication of how the stock market or a segment of it performed during a particular period DJ IA Dow Jones Industrial Average Comprised of 30 large well established corporations SampP 500 Standard amp Poor s 500 More broad than DJ IA Market value weighted index 232 Regulation of the Security Markets 24 The Global Economy and Multinational Enterprises 25 Foreign Currency Markets and Exchange Rates Exchange rate rate at which a currency can be converted into another currency 251 The Eurocurrency Market Eurocurrency currency that is deposited in a bank outside of the country of origin Eurodollar US dollars deposited in banks outside the US LIB OR London InterB ank Offered Rate interest rate at which banks in the Eurocurrency market lend to each other 252 The Euro A Common European Currency 253 Direct and Indirect Quotes Direct quote home currency price of one unit of a foreign currency Indirect quote foreign currency price of one unit of the home currency 254 Spot Rates Spot rate rate of exchange between two currencies being bought and sold for immediate delivery 255 Forward Rates Forward rate rate of exchange between two currencies being bought and sold for delivery at a future date Annualized forward premium V discount where S0 spot rate F forward rate n number of months in the forward contract 256 Foreign Currency Futures Forward contract contract calling for the delivery of a specified amount of some item at a future point in time at a price set at the present time compared to futures contracts forward contracts are not liquid can be customized with regard to the date or amount and carry performance risk Futures contract contract calling for the delivery of a standardized quantity of some item at a future point in time at a price set at the present time 257 Foreign Currency Options Options contract that gives its holder the right to buy or sell an asset at a set price during a specified time period Call option option to buy an asset at a set price call Put option option to sell an asset at a set price put American option give the holder the right to buy call options or sell put options the underlying currency at any time prior to expiration including at expiration European option gives the holder the right to buy or sell the underlying currency only at expiration 26 Market Efficiency In an efficient capital market stock prices provide an unbiased estimate of the true or intrinsic value of an enterprise Efficient capital market financial market in which new information is quickly re ected in security prices in an unbiased manner 261 Information and Capital Market Efficiency Capital markets are efficient if security prices instantaneously re ect in an unbiased manner all economically relevant information about a security s prospective returns and the risk of those returns 262 Degrees of Market Efficiency Weak Form Efficiency No investor can expect to earn excess returns based on an investment strategy using historical information US capital markets are efficient in a weak form context Semistrong Form Efficieny No investor can expect to earn excess returns based on an investment strategy using any publicly available information Strong Form Efficiency 263 Implications of Market Efficiency for Financial Managers Timing or Gambling An Expected NPV of Zero Expensive and Unnecessary Corporate Diversification Security Price Adjustments 264 Behavioral Finance Perspectives on the Financial Marketplace 27 Holding Period Returns Ending price Beginning price Distributions received HOZding PeriOd mum gt 2 Beginning Price Ex post after the fact Ex ante before the fact 28 Overview of the Financial Crisis Beginning in 2007 281 Causes of the Financial Crisis 281 How Firms Were Affected by the Financial Crisis 29 Income Taxes and Financial Management 291 Implications of Income Taxes for Financial Managers Capital Structure Policy Interest payments associated with debt financing are deductible from earnings when computing a company s income tax liability whereas common stock dividends and preferred stock dividends are not deductible Dividend Policy Capital Budgeting Leasing 291 Tax Rate Used in the Text 210 Summary 1 The main purpose of an economy s financial system is to facilitate the transfer of funds from surplus spending units to deficit spending units Financial middlemen such as investment bankers bring together the surplus and deficit spending units in the capital markets so that funds can be transferred Financial intermediaries such as commercial banks receive primary claims from their borrowers and issue secondary claims to their lenders Secondary claims have different risk and liquidity characteristics than primary claims 2 Financial assets consist of money debt securities and equity securities 3 Financial markets are the vehicles through which financial assets are bought and sold They include money or capital markets and primary or secondary markets Money markets deal in securities with maturities of approximately one year or less while capital markets deal in securities with maturities greater than one year Primary markets are those in which new securities are issued secondary markets are those in which existing securities are traded 4 Capital markets are considered to be efficient if security prices instantaneously and fully re ect in an unbiased way all economically relevant information about a security s prospective returns and the risk of those returns 5 A Eurocurrency is a currency deposited in a bank located outside the country of origin The Eurocurrency market is an important alternative to domestic sources of financing for multinational firms The interest rate charged for Eurocurrency loans is tied to LIBOR the London InterB ank Offered Rate 6 The exchange rate is the rate at which one currency can be converted into another The spot rate is the rate of exchange for currencies being bought and sold for immediate delivery today The forward rate is the rate of exchange between currencies to be delivered at a future point in time usually 30 90 and 180 days from today The futures rate is also a rate of exchange between currencies to be delivered at a future point in time In contrast to forward contracts futures contracts are standardized with respect to size and delivery date and are traded on organized exchanges such as the International Monetary Market Foreign currency options give the option holder the right to buy or sell a foreign currency at a fixed price over some time horizon 7 Investment returns are normally measured using the holding period return concept Chapter 5 The Time Value of Money Chapter Introduction Key Chapter Concepts 1 5 1 Introduction The concept of interest 0 Simple interest is paid on the principal sum only 0 Compound interest is paid both on the initial principal amount and on any interest earned but not withdrawn during earlier periods Future compound value calculations determine the value at some point in time in the future of a given amount invested today earning some compound rate of interest i per period Present value calculations determine the value today present value of some amount to be received in the future An annuity is a series of equal periodic payments a Ordinary annuity payments are made at the end of each period b Annuity due payments are made at the beginning of each period Future value of an annuity calculations determine the future value of an annuity stream of payments Present value of an annuity calculations determine the present value of an annuity stream of payments The net present value rule is the primary decision making rule used throughout the practice of financial management a The net present value of an investment is equal to the present value of the future cash ows minus the initial outlay b The net present value of an investment made by a firm represents the contribution of that investment to the value of the firm and accordingly to the wealth of shareholders Other important topics include a Compounding frequency b Determining the present value of perpetuities c Determining the present value of uneven cash flow streams d Determining the present value of deferred annuities 52 The Use of Financial Calculators and Spreadsheets 53 Interest Interest return earned by or the amount paid to an individual who forgoes current consumption or alternative investments and rents money to a business bank the government some other form of institution or another individual Principal amount borrowed or invested Rate of interest percentage on the principal that the borrower pays per time period as compensation for forgoing other investment or consumption opportunities 54 Simple Interest Simple interest interest paid or earned on the principal only 55 Compound Interest and Future Value Compound interest interest that is paid not only on the principal but also on any interest earned but not withdrawn during earlier periods FVnzPV01i 01 FVIF 221 n FVnzPVOZ 551 Solving for the Interest Rate 552 Solving for the Number of Compounding Period 56 Present Value Discounting is the process of finding present values PV W 0 1i 01 PVIF tam onsznz 561 Solving for Interest and Growth Rates A higher discount rate results in a lower present value 57 Annuities Annuity payment or receipt of a series of equal cash ows per period for a specified time Types of annuity Ordinary annuity series of equal periodic payments or receipts that occur at the end of each period Annuity due series of equal periodic payments or receipts that occur at the beginning of each period 571 Future Value of an Ordinary Annuity FVIFA 22 i n FVAanPMTZ 572 Future Value of an Annuity Due F VIFA tn1i FVANDnzPMTZ 573 Present Value of an Ordinary Annuity PVIFA 22 i n PVAN0 2 PM T 2 Capital recovery problem annuity amount necessary to recover a capital investment 574 Present Value of an Annuity Due PVANDOPMTPVIFAM 1i 58 Present Value Some Additional Cash Flow Patterns 581 Perpetuities Perpetuity financial instrument that pays an equal cash ow per period into the indefinite future Some bonds and preferred stock take the form of a perpetuity PM T l PVPER0 582 Present Value of an Uneven Payment Stream quot PMTt PV0Z tl 01 PVIF PMTtZZit onzz z tl 583 Present Value of Deferred Annuities 512 Summary 1 An understanding of interest is crucial to sound financial management Simple interest is interest earned or paid on the principal only Compound interest is interest paid not only on the principal but also on any interest earned but not Withdrawn during earlier periods 2 An annuity is the payment or receipt of a series of equal cash flows per period for a specified number of periods In an ordinary annuity the cash flows occur at the end of each period In an annuity due the cash flows occur at the beginning of each period 3 Sinking fund problems determine the annuity amount that must be invested each year to produce a future value 3 Capital recovery problems determine the annuity amount necessary to recover some initial investment
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