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FINA3004 Survey of Financial Management: Midterm Study Guide

by: Karlie

FINA3004 Survey of Financial Management: Midterm Study Guide FINA 3004

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Study guide to Midterm covering Chapters 1-6 referencing: Corporate Finance Online by Stanley Eakins and William McNally.
Survey of Financial Management
Dr. Eric Dicken
Study Guide
bonds, finance, Interest, Risk, premium, annuity
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This 13 page Study Guide was uploaded by Karlie on Tuesday October 11, 2016. The Study Guide belongs to FINA 3004 at East Carolina University taught by Dr. Eric Dicken in Spring 2016. Since its upload, it has received 9 views. For similar materials see Survey of Financial Management in Finance at East Carolina University.


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Date Created: 10/11/16
FINA3004: Survey of Financial Management  Midterm Study Guide Chapter 1 What is finance?  Finance is the art and science of managing money. Three main areas of Finance: 1. Financial Markets and Institutions/Corporate 2. Investments  3. Financial System Finance Money Markets=Maturity < 1  Portfolio­ group of  Moves money from NET SAVERS to NET  year investments BORROWERS Capital Markets=Maturity > 1  year Diversification – how  this reduces risk Financial Institutions – Banks, Thrifts (ex. Credit union), ThTime Value of Money – “Fed” how money grows over  time Corporate Finance­ evaluation methods of long term projects,  study of how to acquire funds­ isk Return Tradeoff – borrow, issue stock or sell out?t a greater return you  must incur greater risk Asset Valuation –  Stocks and Bonds Role of a Financial Manager:  Goal: to MAXIMIZE SHAREHOLDER WEALTH by: o Increase the firms CASH FLOW o Get those cash flows to the firm ASAP o Do both while minimizing RISK What are the responsibilities of shareholders vs. bondholders?  Shareholders own part of the company  Bondholders loan the company money Five Key Concepts of Finance: 1. Greater Returns Require Taking   How does this work? Greater Risk  People want things now.   To forego getting something now you have  to pay them extra.  This “extra” has to give them greater  consumption in the future.   The additional amount of consumption  demanded is called…  The Real Rate of Interest   What you pay me to put off buying X 2. Good Deals Disappear Fast  As new information becomes available to  investors, security prices adjust so that  the return for investors is fair.  Efficient Markets quickly and accurately  price securities  If markets are highly efficient, there are no  deals.  3. The Value of Money Depends on   People want things now rather then later. When it is received   People are willing to pay more for what  they want.  Cash flow is just another thing.   The longer people are made to wait for a  cash flow the less valuable it becomes  to them.   In a world without interest, the value of  any cash flow to a person would decline steadily the longer you made a person  wait to receive it.  What is more is that few people would be willing to wait at all.   Imagine an economy that didn’t have the  ability to borrow or invest. 4. Cash is King  Taxable earnings does not pay bills  Accounting earnings does not pay bills  Profits do not pay the bills.  Cash pays the bills.  5. Not Everyone Knows the Same Things  Asymmetric Information o Not everyone knows everything Types of Interest:   Real Rate of Interest – What you pay me for foregoing consumption of an item  now for some future date.  Risk Free Rate – The rate I can earn without incurring any risk.  Required Return – the minimum return I will accept for X amount of risk. This  changes as the risk changes.  Expected Return – The criteria for choosing the investment. What I expect earn. If an investor expects more then they require, they buy.  Actual Return – What I actually earned (remember risk?) This is unknown at the  time I pick the investment.  Opportunity Cost – The interest rate I could have earned if I didn’t invest. We  compare this to the investment expected return.  Chapter 2 Financial market objectives:  Establish Prices for Securities Large volume – a lot bought and sold Standardization – Similar X for comparison Regular Transactions – X are sold  everyday  Provide Liquidity Liquidity is the ease with which assets can  be converted into cash…i.e. “Liquid  Assets.”  The willingness of people to purchase X is  its liquidity.  Willingness can change as markets expand  or contract. A  “Dealer” buys a security to resell later. A “Broker” sells other people’s securities. The lower the cost of doing a transaction   Reduce Transaction Costs  the more accurately priced an item will be High transaction costs not only drive up the price of an item they can drive away  consumers Transaction costs are minimized by:  High volume  Rules  Standardization  Search costs  Structure of Financial Markets: Primary Secondary Organized Organized Over­the­ Auction Counter (OTC) where  where  fixed trading  are usually  no centralized  securities are  securities are  rules and a  called  location or  offered for sale  offered for  physical  “exchanges.”  method for the first  resale location,  Examples are  time trading is  the New York  usually  Stock  conducted at  Exchange  auction (NYSE) and  American  Stock  Exchange Features of a Money Market:  Securities that are highly liquid are traded here  Used for short­term investing/financing needs  Maturity of less then one year (Definition)  Traded via phone and electronic markets (OTC)  Active Secondary Market  Trade in large amounts ($1 million plus dollars)  Low risk = low interest paid/earned  Many participants – US Treasury, Fed, Banks, Investment Firms, Finance  Companies, Insurance Companies, Pension Funds Features of a Capital Market:  Securities with an original maturity of greater than one year  Stocks and Bonds  Entities issue them for many reasons  Households buy them to significantly increase their wealth Bonds:  Discount – priced below par  Premium – priced above par  Face value– priced at par  Bonds are quoted at a % of face value Types of Bonds: Treasury Notes Agency Municipal Corporate Low interest rate  Agencies authorized Issued by local,  Many different  due to low risk by the US Congress  county, and state  types with different  to issue bonds.  governments  features Examples include  normally used for  mortgage lenders  public interest  like the VA, FHA,  projects (schools). Ginnie Mae, Sallie  Mae, etc. Vocabulary: Common Stock: Stocks represent ownership in the corporation.  Preferred Stock: Combines features of both bonds and stock. Pays a fixed return but no  maturity date. Receives dividends before common shareholders. Indexes: A group of stocks tracked based on their average performance. Meant to give  investors an indication of the stock market trends. Chapter 3 What determines an interest rate?  Supply and demand  Risk What is interest?  The price you pay for renting money  Includes factors such as rental rate, defined period of time, contract that specifies  conditions and limitations  What is money?  Money is a medium of exchange, store of wealth, unit of account. It is generally  more efficient then bartering.  Money is a commodity o The price of a commodity is influenced by supply and demand How does supply and demand operate?  Financial markets establish interest rates so that the demand for money equals the  supply.   As business opportunities rise, interest rates rise.  This increases supply, and reduces demand, until supply equals demand. What is a business cycle?  The changes in the levels of business activity. o Recession ­ $ Supply > Business Demand (Low Int. Rates) o Inflation ­ $ Supply < Business Demand (High Int. Rates) Determining the level of interest rate: N = r + INF + LP + DRP + MRP      N = Nominal Rate      r = Real Rate (91 day US T­bill rate)      INF = expected inflation      LP = liquidity premium      DRP = default risk premium      MRP = maturity risk premium INF (inflation compensation):  Inflation averages between 2% and 4% annually.   Inflation is the largest risk premium in the change of the nominal rate over time.  What is a liquidity risk premium? Your compensation for the time it may take you to convert your investment to  cash without substantially effecting value. What is a default risk premium? This is used in the chance that you could lose some or all of your money. The  terms of the loan are spelled out in a document called an indenture.  What two factors determine the probability of default?  Business Risk   Financial Risk Chapter 4 What is Time Value of Money? Money has different values at different times. People value money differently based on  the time in which they expect to be received. Simple vs. Compound Interest: Simple Interest Compound Interest  Interest earning interest only on the princ Interest earning interest on interest. It is  paid at the end of the time period. paid whenever the interest is paid.  The time period does not matter since interest is  paid once at the end of the period. Compounding Frequencies:  Annual = 1  Semi – annual = 2  Quarterly = 4  Monthly = 12   Weekly = 52  Daily = 365 Types of TVM problems:  Future Value of a lump sum  Present value of a lump sum o The present value calculation lets us determine how much a sum received in the future is worth today.  Future value of an annuity  Present Value of an annuity Non­Annual Compounding  I/Y=N=PMT Ordinary Annuity vs. Annuity Due: Ordinary Annuity Annuity Due  The payment occurs at the end of the   The payment occurs at the beginning  time interval of the time interval  How are loan payments computed?  Using the present value of annuity method  Let the loan amount represent the present value of the annuity Perpetuity  A cash flow that continues forever Formula: PV   = Pmt / % perp Effective Interest Rate  The interest rate shown based on interest compounding on interest Formula: Effective Rate= (1+i/m)^m ­1 Chapter 5 What is risk? the probability or likelihood of an event occurring & defined in finance as the volatility  of expected returns What is the coefficient of variation? It scales the standard deviation to make assets with different returns comparable: CV= ok / k CV= St. Dev. /Ex. Return    Define portfolio.  The total holdings of the securities, commercial paper, etc., of a financial institution or private investor.  It is a grouping of Investments Expected return for a portfolio is… Computed as the weighted average (based upon dollars invested) of the expected return  from each asset in the portfolio Types of risk: Firm Specific risk Market risk Can be eliminated by diversification  Is not reduced by diversification 1.Business cycle If eliminated by diversification… 2.Changes in interest rates  This risk is not important to an  3.downturn in the Asian economy  investor  And should not affect the security’s  required return Therefore…the relevant risk to consider when buying an asset is MARKET RISK. Correlation­ a predictable relationship between two series of numbers Diversification­ Reduces the risk specific to holding any particular stock (systematic),  but it does not reduce the risk of the market Beta­ Found by finding the relationship between the return on the market  and the return on the asset  B = 1  as risky as the market  B = 2 twice as risky as the market  B = 0.5 only half as risky as the market The Risk Premium for the average security is: Market risk premium = (R  m R )f Rm = market return Rf  = risk­free rate of return What should be done is the security is more or less risky than average? Multiply the risk premium by the firm’s beta Chapter 6 What is a bond?  A bond is a long term debt instrument that consists of periodic interest payments  and pays a lump sum upon maturity  Bond prices are quoted as a percentage of par value   Even though bonds are called “fixed income securities” they… o are subject to significant price changes when interest rates are volatile o are fixed income, not fixed price Premium Par Discount Current price is > par Current price = par Current price is < par Coupon Rate Coupon Payment  The stated annual rate the bond pays.   The periodic interest payment made  It is fixed for the life of the bond. to the owner of the bond  Coupon rate is used to calculate the   Coupon pmt = coupon rate * face  coupon payment value Vocabulary: Face amount­ the maturity value of the bond (Face amount = per value = maturity value) Maturity­ The number of years or periods until the bond matures and the holder is paid  the face value Current yield­ Is the percentage return earned in a year from interest payments, an  approximation of the return the investor is going to earn (current yield= coupon  pmt/current market $) Yield to maturity­ The return the investor will earn if the bond is purchased at current  market price and held to maturity Call provision­ The ability of the issuer to make the bond due and payable prior to the  stated maturity date Market rate­ The rate currently in effect in the market for bonds of like risk and like  maturity IT IS THE MARKET RATE THAT WE USE TO VALUE OUR BONDS! Indenture­ The contract that accompanies the bond Cash flows from a bond­ The equal annual interest payments (an annuity) What occurs when market interest rates rise and fall?  The value of the bond changes  There is an inverse relationship between market rates and Bond prices   If interest rates increase, the value of the bond falls What to do when… Interest is paid semi­annually­ Double the number of periods Divide the required return (market or interest rate) and coupon payment (interest pmt) by  2 Finding interest or coupon payment­ Multiply the coupon interest rate by the bond’s  face value  Citation Corporate Finance Online by Stanley Eakins and William McNally


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