Study Guide for Finance

Chapter 1 1.1 There are three basic questions that are addressed by the study of finance. They are How can the firm best manage its cash flows as they arise in its day-to-day operations (working capital management decisions)? How should the firm raise money to fund new investments (capital structure decisions)? What long-term investments should the firm undertake (capital budgeting decisions)? Even if you are not planning a career in finance, a working knowledge of finance can be useful in both your personal and professional life for the following reasons: For those who plan to be entrepreneurs, managing company finances is crucial to the survival of the firm. Even if you do not pursue a career in finance, you may find yourself working closely with finance managers. As an individual you will be faced with numerous financial decisions throughout your life. Knowledge of financial principles will help you make the right decisions. Financial management is a key component of other academic disciplines such as management, marketing, production and operations management, and accounting. 1.2 Which of the following are legal forms of business organization? Sole proprietorship, corporation, partnership Which of the following statements regarding a sole proprietorship are correct? Sole proprietorships are easy to set up with no paperwork required before the business can be opened. The sole proprietor is personally responsible for all debt of the sole proprietorship. Sources of funds for a sole proprietorship typically include personal savings, as well as raising funds from a bank or personal loans from friends and family. Limited partnerships have two classes of partners. The general partner actually runs the business and face unlimited liability for the firm’s debt, while the limited partner is only liable up to the amount the limited partner invested. The typical business organization for large companies is the corporation. Advantages of the corporate form of business organization include: The owners' liability is limited to the amount of their investment in the company. The life of the business is not tied to the status of the corporate owners. Corporations have a greater ease in raising large sums of money than other forms of business organization. One attractive alternative to the corporation for a small business is the limited liability company because it combines the tax benefits of a partnership with the limited liability of a corporation. In a large corporation, the primary responsibility for overseeing the firm's finance-related activities falls to the Chief Financial Officer (CFO) 1.3 When managers have little or no ownership in the firm, they are less likely to work energetically for the company's shareholders. We call this type of conflict a(n) agency problem There are several measures that can be taken to help limit the agency problem. The board of directors can actively monitor the actions of managers to keep pressure on them to act in the best interest of shareholders. Financial markets play a key role in monitoring management. Firms that fail to maximize shareholder wealth may be taken over and their management team replaced. Compensation plans can be put in place to reward managers when they maximize shareholder wealth. The Sarbanes-Oxley Act of 2002 (SOX) was passed to directly confront concerns about both agency and ethical issues. Select all the following statements that correctly describe this act. The purpose of SOX is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the security laws. While the goal of SOX is to provide greater protection against accounting fraud and financial misconduct, the demanding reporting requirements of SOX are quite costly and may inhibit firms from listing on U.S. stock markets. SOX holds corporate advisors who have access to or influence on company decisions, legally accountable for any instances of misconduct. 1.4 There are four basic principles of finance. Which principle correctly describes the following statement: "A dollar today is worth more than a dollar received in the future. Conversely, a dollar received in the future is worth less than a dollar received today"? Principle 1: Money has a time value. Which basic principle of finance correctly describes the following statement: "Profit is an accounting concept designed to measure a business's performance over an interval of time. Cash flow is the amount of cash that can actually be taken out of the business over this same interval"? Principle 3: Cash flows are the source of value. Which basic principle of finance correctly describes the following statement: "Investors respond to new information by buying and selling their investments. The speed with which investors act and the way that prices respond to the information determine the efficiency of the market"? Principle 4: Market prices reflect information. Which basic principle of finance correctly describes the following statement: "We won't take on additional risk unless we expect to be compensated with additional return"? Principle 2: There is a risk-return tradeoff. 1.N Agency Theory: The study of the relationship between managers and stockholders Stock Options: mechanism often used to align the goals of managers and stockholders If a company grants stock options to upper level management to encourage performance the exercise price needs to be Above the current market price.; When markets react instantaneously to the release of new information it is a sign of market efficiency. Stock prices tend to already reflect expected EPS when markets are efficient. If earnings are released that are 20 cents below expectations the price of a stock will very likely _decrease___. A company's CEO is appointed by the board of directors. The board of directors is elected by shareholders. The people in charge of managing a corporation at the highest level are known as the board of directors The top corporate officer in charge of the financial component of a firm is known as the CFO Forecasting cash flows would be easiest for a firm in manufacturing Valuation is easier when cash flows are stable and consistent The principle that maintains companies have a responsibility to increase society's overall welfare is known as social responsibility Corporate ethics deals with questions of company decisions being either good or bad Shareholder wealth maximization and social responsibility are not inconsistent goals The primary goal of the financial manager is shareholder wealth maximization When a financial manager makes good or bad financial decisions the impact of these decisions will be reflected in the company's stock price Financial decisions that are deemed to be consistent with firm strategy and considered? good? decisions should increase stock price. Chapter 1 Quiz The typical business organization for large companies is the corporation. Advantages of the corporate form of business organization include The owners' liability is limited to the amount of their investment in the company. The life of the business is not tied to the status of the corporate owners. Corporations have a greater ease in raising large sums of money than other forms of business organization. In a large corporation, the primary responsibility for overseeing the firm's finance-related activities falls to the: Chief Financial Officer (CFO). Which basic principle of finance correctly describes the following statement: "Investors respond to new information by buying and selling their investments. The speed with which investors act and the way that prices respond to the information determine the efficiency of the market"? Principle 4: Market prices reflect information. There are four basic principles of finance. Which principle correctly describes the following statement: "A dollar today is worth more than a dollar received in the future. Conversely, a dollar received in the future is worth less than a dollar received today”? Principle 1: Money has a time value. There are several measures that can be taken to help limit the agency problem. The board of directors can actively monitor the actions of managers to keep pressure on them to act in the best interest of shareholders. Financial markets play a key role in monitoring management. Firms that fail to maximize shareholder wealth may be taken over and their management team replaced. Compensation plans can be put in place to reward managers when they maximize shareholder Wealth Chapter 2 2.1 Within the financial markets there are three principal sets of players that interact. Savers are those who have money to invest, including individuals accumulating money for a down payment and businesses that have excess cash. Borrowers are those who need money to finance their purchases such as a business expanding its inventory. Financial intermediaries bring savers and borrowers together. Which of the following would be classified as savers? A business that has excess cash for the year. An individual who is putting money aside each month for retirement. An individual who is accumulating a down payment for a home. 2.2 Financial intermediaries include: Commercial banks, investment banks, finance companies, investment companies, and insurance companies Financial markets are often described by the maturities of the securities traded in them. Money markets are markets for short-term debt instruments with maturities of 1 year or less, while capital markets are markets for long-term financial instruments with maturities that extend beyond 1 year. Banks collect the savings of individuals and businesses and then lend these pooled savings to other individuals and businesses. In this role, banks are: making money by charging a rate of interest to borrowers that exceeds the rate they pay to savers acting as a financial intermediary. Investment companies are specialized financial intermediaries that provide financial services to businesses. These investment companies include: hedge funds. mutual funds. private equity firms. Insurance companies play several roles in the financial markets. Insurance companies can provide other financial services, including equipment leasing, consumer finance, and debt and loan insurance. Insurance company reserves can be used for investment purposes, including loans to individuals and businesses. Insurance companies pay out claims to insured individuals and businesses to cover insured losses. Insurance companies collect premiums from selling insurance to individuals and businesses. The type of investment company that allows beginning investors as well as experienced investors to invest in virtually all of the securities offered in the financial markets is called a mutual fund. Both venture capital (VC) firms and leveraged buyout (LBO) firms are types of private equity firms. The primary difference between venture capital firms and leveraged buyout funds is that venture capital firms provide financing for start-up companies when they are first founded while leveraged buyout firms acquire established firms 2.3 A security is a negotiable instrument that represents a financial claim. Securities markets are of two forms. A primary market is a market in which new securities are bought and sold for the first time. The secondary market is where all subsequent trading of previously issued securities takes place. All the following correctly describe common stock and common stock ownership, EXCEPT: Holders of common stock are guaranteed a share of the company's success in the form of dividends. The par value of a bond is the face value of the bond, which is received by the bondholder when the bond matures at its normal maturity date Preferred stock is an equity security that has seniority rights Preferred stock is sometimes referred to as a hybrid security. Owners of preferred stock receive their dividends before dividends are distributed to common stock shareholders Preferred stock dividends, which are unpaid due to a lack of profits may accrue to be paid later when the corporation returns to profitability. During the liquidation of a company, holders of preferred stock would have a claim on assets before any claims by common stock shareholders. Characteristics of money market debt include which of the following? Borrowers use money market debt to borrow money to match short-term needs. For the investor, money market debt is a very liquid investment and relatively safe. For the borrower, money market debt is a good way to raise money for short periods of time 2.N The process of putting an initial public offering (IPO) together to provide a firm with capital is known as underwriting A group of investment bankers that join forces to buy new equity issues and resell them to their clients is known as an underwriting syndicate The investment banker that is the primary contact for the firm raising capital and the one in charge of the new issues is called the lead underwriter A new issue of stock on the primary market is called a(n) initial public offering When a stock trades between investors this trade occurs on the secondary market When the underwriting syndicate makes an outright purchase of a company's IPO it is known as a firm commitment QUIZ CH 7 Homework 1. Which of the following best measures an asset’s risk? A: The standard deviation 2. Even though an investor expects a positive rate of return it is possible that the actual return will be negative. A: True 3. Which of the following sequences is arranged in the correct order, from highest long-term returns to lowest? A: Small stocks, large stocks, treasury bills 4. Investments that have earned the highest rates of return over time also have A: the highest standard deviation of returns. 5. The difference between returns on stocks and government bonds is known as A: the equity risk premium 6. An emerging market is: A: a market located in an economy with low to middle per capita income 7. The risk-return tradeoff tells us that expected returns should be higher on investments that have a higher risk. A: True 8. Investments in emerging markets have higher volatility than do U.S. Stocks. A: True 9. Investors are always rewarded for taking a higher risk with higher realized returns. A: False 10. Marcus Berger invested $9842.33 in Hawkeyehats, Inc. four years ago. He sold the stock today for $11,396.22. What is his geometric average return? A: N=4 PV=9842.33 FV=11396.22 PMT=0 I/Y= 3.73271 A: 3.73% 11. Michael Lynch invested $10,000 in the Rearguard Fund four years ago. All earnings were reinvested in the fund. If his compound annual rate of return was 7%, what is his investment worth today? A: $1,310.8 NEED TO FIND OUT HOW THIS IS COMPUTED Roddy Richards invested $12014.88 in Wolverine Meat Distributors (W.M.D.) five years ago. The investment had yearly arithmetic returns of minus−9.7%, minus−8.1%, 15%, 7.2%, and 15.4%. 12. What is the arithmetic average return of Roddy Richard's investment? A: 3.96% Add up returns and divide by number of returns 13. What is the geometric average return of Roddy's Richard's investment? A: (1+-9.7%)x (1+-8.1%)x(1+15%)x(1+7.2%)x(1+15.4%) ={.903(.919)(1.15)(1.072)(1.154)]^1/5 -1 = 0.0337614… =3.38% 14. How much money did Roddy Richards receive when he sold his shares of W.M.D.? A: 14,184.73 Take starting amount 12014.88 + rate + N=1, move FV to PV. 15. An investor who wishes to hold a stock for five years will be most interested in geometric average rather than in the arithmetic average return. A: True Pg. 207 16. Each of the following would tend to weaken the Efficient Market Hypothesis EXCEPT a. Muguet Company consistently underperforms the market in October but outperforms the market in May. b. ACG, Inc. performed well for the past six months, but they just lost a major distribution contract, but the price of ACG stock continues to go up. c. Louisville Slugger, Inc., gets a contract to supply bats for Little League play, a contract it never had before, and stock price remains stable. d. There is publicly available information that Boeing Aircraft has procured a contract to build 25 planes for the U.S. Government and the price of Boeing quickly goes up. 17. Jayden spends a lot of time studying charts of stocks past performance, but his investment return is only average. This outcome supports weak-form, semi-strong, and strong form efficient market hypotheses. 18. Madison was hired to design and decorate the offices of a large pharmaceutical company. She accidentally read a report indicating that a new drug had just been approved by the Food and Drug Administration. She immediately bought the company's stock which doubled in price over the following week. This outcome is inconsistent with A: the strong form efficient market hypothesis. Her action was probably illegal. HOW IS THIS ILLEGAL, DID SHE READ AN INSIDER REPORT?? 19. Strategies that exploit market inefficiencies tend to lose their effectiveness when they become widely known. A: True 20. The S&P stock index represents a portfolio comprised of 500 large publicly traded companies. On December 24, 2007, the index had a value of 1,410, and on December 24, 2008, the index was approximately 888. If the average dividend paid on the stocks in the index is approximately 5.0 percent of the value of the index at the beginning of the year, what is the rate of return earned on the S&P index? What is your assessment of the relative riskiness of investing in a single stock such as Google compared to investing in the S&P index (recall from Chapter 2 that you can purchase mutual funds that mimic the returns of the index)? A: P end + Dⅈv −Pbeg P beg [ 888+ 1410(.05) – 1410 ] / 1410 = -32.02%; In general, investing in a single stock is riskier than investing in the S& P index 21. Related to Checkpoint 7.1) (Expected rate of return and risk) B. J. Gautney Enterprises is evaluating a security. One-year Treasury bills are currently paying 4.3 percent. Calculate the investment's expected return and its standard deviation. Should Gautney invest in this security? Probability Return 0.10 x -5% = -.005 0.40 x 1% = .004 0.40 x 7% = .028 0.10 x 8% = .008 a) The investment's expected return is = .035 = 3.5% b) The investment's standard deviation is [(-0.05 - 0.035)^2 x 0.10]+[(.01- 0.035)^2 x.4]+[(.07-0.035)^2 x .4] + [(.08-.035)^2 x .10] = variance in rates of return (then take sq root of that for std dev.) = .001665 square root of which is .040804 Probabilit y 0.1 0.4 0.4 0.1 Return -5% 1% 7% 8% -0.005 0.004 0.028 0.008 Expecte d Rate of Return 0.035 VARIANCE IN RATE OF RETURN 0.000723 0.00025 0.00049 0.000203 0.001665 0.040804 c) Should Gautney invest in this security? No. B. J. Gautney Enterprises should not invest in this investment because the return is lower than the Treasury bill and the level of risk higher than the Treasury bill. 22. Caswell Enterprises had the following end-of-year stock prices over the last five years and paid no cash dividends: a) Calculate the annual rate of return for each year from the above information. b) What is the arithmetic average rate of return earned by investing in Caswell's stock over this period? c) What is the geometric average rate of return earned by investing in Caswell's stock over this period? d) Considering the beginning and ending stock prices for the five-year period are the same, which type of average rate of return best describes the average annual rate of return earned over the period (the arithmetic or geometric)? a. The annual rate of return at the end of year 2 is 33.33% The annual rate of return at the end of year 3 is -31.25% The annual rate of return at the end of year 4 is -18.18% The annual rate of return at the end of year 5 is 33.3% b. The arithmetic average rate of return earned by investing in Caswell's stock over this period is 4.31% c. The geometric average rate of return earned by investing in Caswell's stock over this period is 0% d. Considering the beginning and ending stock prices for the five-year period are the same, the geometric average rate of return best describes the average annual rate of return earned over the period. Tim e 1 2 3 4 5 Caswel l $12 $16 $11 $9 $12 RoR 0.33 -0.31 -0.18 0.33 AA-RoR 1.33 0.69 0.82 1.33 AA-RoR GAR 0.04 1.00 0.00% Homework 6 Chapter 9 1. The interest on corporate bonds is typically paid semiannually. 2. The detailed legal agreement between a bond's issuer and its trustees is known as the indenture. 3. The issuance of bonds to raise capital for a corporation is a cheaper form of capital than the issuance of common stock. increases risk to the stockholders. magnifies the returns to the stockholders 4. The Bensington Glass Company entered into a loan agreement with the firm's bank to finance the firm's working capital. The loan called for a floating rate that was 30 basis points (0.30percent) over an index based on LIBOR. In addition, the loan adjusted weekly based on the closing value of the index for the previous week and had a maximum annual rate of 2.20 percent and a minimum of 1.75 percent. Calculate the rate of interest for weeks 2 through 10. Date LIBOR Week 1 1.98% Week 2 1.66% Week 3 1.52% Week 4 1.35% Week 5 1.60% Week 6 1.63% Week 7 1.67% Week 8 1.88% Week 9 1.93% 2.2800 % Use week prior 1.9600 Add 0.3% to each libor for the basis % points 1.8200 % 1.6500 % 1.9000 % 1.9300 % 1.9700 % 2.1800 % 2.2300 % 5. The yield to maturity on a bond is the required return on the bond. 6. A $1,000 par value 10−year bond with a 10% coupon rate recently sold for $900. The yield to maturity is greater than 10%. 7. The Blackburn Group has recently issued 20−year, unsecured bonds rated BB by Moody's. These bonds yield 443 basis points above the U.S. Treasury yield of 2.76%. The yield to maturity on these bonds is 7.19% (2.76 + 4.43) 8. Colby & Company bonds pay semiannual interest of $50. They mature in 15 years and have a par value of $1,000. The market rate of interest is 8%. The market value of Colby bonds is (round to the nearest dollar) N=30 I/Y= 8/2=4 PMT=50 FV=1000 PV=1172.92 9. Davis & Davis issued $1,000 par value bonds at 102. The bonds pay 12% interest annually and mature in 30 years. The market rate of interest is (round to the nearest hundredth of a percent) 11.71% HOW??? Market interest rate A bond with a face amou nt of $1,000 may have a bond price of 100, or 100 percent of par value ($1,000). Bonds issued at a premium have a bond price of more than 100. For example, a price of 102 means 102 percent of par value. In this case, a$1,000 bond's price would be $1,020. 10. What is the expected rate of return on a bond that matures in seven years, has a par value of $1,000, a coupon rate of 14%, and is currently selling for $911? Assume annual coupon payments. 16.22% HOW?? Yield to maturity 11. What is the value of a bond that has a par value of $1,000, a coupon rate of $80 (annually), and matures in 11 years? Assume a required rate of return of 11%, and round your answer to the nearest $10. $813.80 how?? Bond valuation