Financial Intermediaries and Markets

Financial Intermediaries and Banks

• A financial intermediary is a corporation that gathers funds from investors and provides capital to those in need
• A bank using demand deposits to issue long-term mortgage loans exemplifies a financial intermediary

Derivatives and Stock Options

• Common stock shares are not derivatives
• Options to buy stock are derivatives, as their value depends on the stock's value

Diversification of Financial Institutions

• Financial institutions are more diversified now than in the past
• Federal laws once kept investment banks, commercial banks, and insurance companies separate, but larger financial service corporations now offer varied services from checking accounts to stock brokerage

Money Markets

• Money markets are for short-term debt securities like Treasury bills and commercial paper

Primary vs Secondary Market Transactions

• Purchasing Disney stock from a brother-in-law is not a primary market transaction
• Disney issuing new shares through an investment banker would be classified as a secondary market transaction
• Money market transactions typically involve debt securities with maturities of less than one year

The Stock Market

• The New York Stock Exchange (NYSE) is an example of an over-the-counter market
• Only institutions, and not individuals, can engage in derivative market transactions

Stock Transactions

• Selling Disney stock through a broker is a secondary market transaction

Initial Public Offering (IPO)

• IPO is shorthand for Introductory Price Offered
• This refers to the price at which shares of a new company are offered to the public
• IPO prices are generally established by the market

Dutch Auction IPOs

• Investors submit bids indicating how many shares they want and what price they will pay in a "Dutch auction”.
• The company determines how many shares to sell
• The highest price enabling the company to sell the desired shares becomes the price for all buyers

IPO Oversubscription

• The price set in an IPO could be too high causing investors to refuse buying the number of shares the company wants to sell which is referred to as oversubscription
• It is possible that the set price is too low that investors will want to buy shares exceeding the company's selling amount

New York Stock Exchange

• The New York Stock Exchange is an auction market with a physical location

Interest Rates and Inflation

• Interest rates increase during periods of increasing inflation and decrease when inflation declines

Nominal vs Real Rate of Return

• In the absence of expected inflation, the nominal rate of return on a short-term U.S. Treasury bond should match the real risk-free rate (r*)

Interest Rate Risk/ Price Risk

• The risk that rising interest rates will decrease the prices of already existing bonds is interest rate risk, also known as price risk

Treasury Yield Curve

• With steady future decline anticipated for inflation, and a constant real risk-free rate (r*), the Treasury yield curve will be downward sloping

Factors Leading to Increased Nominal Interest Rates

• A new technologies increasing investment opportunities can lead to increase in interest rates

Treasury Securities Issuance

• If the U.S. Treasury issues $50 billion of short-term securities and sells them to the public, a likely effect is a decrease in short-term securities prices and an increase in interest rates

Maturity Risk Premium (MRP)

• If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping

Corporate Bond Yield Curve

• Maturity risk premiums can help explain the upward slope of the current corporate bond yield curve

Inverted Yield Curve

• The higher the maturity risk premium, the higher the probability that the yield curve will be inverted
• Investors expecting inflation to decrease is the most likely explanation for an inverted yield curve

Yield Curve Relationships

• If the yield curve is inverted, short-term bonds have lower yields than long-term bonds
• Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted

Retained Earnings

• Retained earnings reported on the balance sheet represents the amount of cash a company has available to pay out as dividends to shareholders

Corporate Tax

• 70% of the dividends received by corporations is excluded from taxable income

Delip Industries Cash Flow

• Delip Industries had negative cash flow from operations, a negative free cash flow, and an increase in cash as reported on its balance sheet due to the company sold a new issue of common stock.

Nantell Corporation Equipment Depreciation

• The Nantell Corporation purchased an expensive piece of equipment. The firm plans to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years
• The new requirements would reduce Nantell's reported net income for the year.

Besley Golf Equipment Depreciation Assumptions

• Besley Golf Equipment commenced operations on January 1, 2014, and it was granted permission to use the same depreciation calculations for shareholder reporting and income tax purposes
• The company planned to depreciate its fixed assets over 15 years, but in December 2014 management realized that the assets would last for only 10 years
• The firm's accountants plan to report the 2014 financial statements based on this new information and the provision will increase the company's tax payments

Start-up Firm Equipment Depreciation

• A start-up firm is making an initial investment in new plant and equipment with the equipment must be depreciated on a straight-line basis over 10 years
• If Congress is considering legislation that would require the firm to depreciate the equipment over 7 years and the legislation becomes law, the firm's cash flow would increase in the year following the change

Depreciation and Cash Flow

• A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments

Common Equity

• Common equity includes common stock and retained earnings, less accumulated depreciation

Retained Earnings Account

• If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative

New Common Stock Issuance

• Dave Industries plans to issue $300 million of new common stock, and use the proceeds to reduce some of its outstanding bonds that carry a 7% interest rate
• The company does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant
• The company's net income would increase

Bauer Software Equity

• Bauer Software's current balance sheet shows total common equity of $5,125,000, with 530,000 shares of stock outstanding
• Stocks are selling at a price of $27.50 per share and the firm's market and book values per share differ by $17.83

Brown Fashion Equity

• Brown Fashions Inc.'s December 31, 2014, balance sheet showed total common equity of $4,050,000 and 200,000 shares of stock outstanding
• During 2014, the firm had $450,000 of net income, and it paid out $100,000 as dividends and it had a book value per share at 12/31/14 of $22.00

Company's Current Ratio

• An increase in accounts receivable would increase a company's current ratio

Company's Financial Position

• An increased quick ratio increases and current ratio would generally indicate improvement in a company's financial position

Strengthening Financial Position

• Issuing new stock, then using some of the proceeds to purchase additional inventory and holding the remainder as cash will strengthen a firm's financial position

Inventory Turnover Ratio

• If a firm increases its sales while holding its inventories constant, then inventory turnover ratio will increase

Stock Earnings Per Share

• Companies E and P each reported the same earnings per share (EPS), but Company E's stock trades at a higher price, meaning Company E trades at a higher P/E ratio

New President Financial Management

• A firm's new president wants to strengthen the company's financial position and increase EBIT while holding sales, and assets constant

Loan Request Review

• Consider lowering the total debt to total capital ratio for favorable review of loan requests

Current Ratio

• Borrow using short-term notes payable and use the proceeds to reduce long-term debt decreases current ratio

Treasury and Corporate Bond Ratings

• Differences in rates among these issues were most probably caused primarily by default and liquidity risk differences

Coupon Rate Required

• Adding a call provision is most likely to increase the coupon rate required for a bond to be issued at par

Tucker Corporation Bond Issuance

• Tucker Corporation is planning to issue new 20-year bonds that are non-callable
• The bond is made callable after 5 years at a 5% call premium will increase the bond being risky to a bondholder

Corporate Bonds

• A 10-year corporate bond has an annual coupon of 9% and is currently selling at par ($1,000). The bond's expected capital gains yield is zero

Bond Value

• A 15-year bond with a face value of $1,000 currently sells for $850 and has a yield to maturity that is greater than its coupon rate.

Bond Value Percentage

• If the yield to maturity declined by 1%, a 10-year zero coupon bond would have the largest percentage increase in value

Stock Diversifiable Risk

• An individual stock's diversifiable risk, which is measured by its beta, cannot be lowered by adding more stocks to the portfolio in which the stock is held

Tangible and Intangible Assets

• The relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders

Market Risk Premium

• Since the market return represents the expected return on an average stock, which is the amount over and above the risk-free rate that is required to compensate stock investors for assuming an average amount of risk.

Portfolio Risk

• The beta of the portfolio is equal to the weighted average of the betas of the individual stocks

Investment Risk

• Adding more stocks will reduce the portfolio's unsystematic, or diversifiable, risk

Net Working Capital

• Net working capital is defined as current assets divided by current liabilities, resulting in Net working capital increase

Cash Conversion Cycle

• Take steps to reduce the DSO for Helena Furnishings to reduce its cash conversion cycle

Finance Wealth

• Creating and maintenance of economic wealth best represents what finance is about.

Public Corporation Growth

• Public corporations grow more quickly and faster than partnership or proprietorship due to having access to the capital markets

Firm Goal

• The goal of the firm should be the maximization of shareholder wealth

Corporation Business Forms

• Corporations have the ability to raise larger sums of capital than the other forms of business organization

Social Responsibility

• Difficulty in finding profitable projects is due to competitive markets

Profit Minimization

• Risk minimization is NOT a principle of basic financial management.

Capital Investment

• In terms of raising capital, the corporation is the most effective form of organization

Ethical Dilemmas

• Ethical dilemmas frequently exist in finance
• The limited Liability is NOT an advantage of the sole proprietorship

Legal Requirements

• No time limit imposed on its existence and no legal requirements starting the business are advantages of the sole proprietorship

Sole Proprietorship Liability

• Owners have unlimited liability that is the chief disadvantage of the sole proprietorship as a form of business organization when compared to the corporate form

Limited Partners

• Limited partners can only manage the business

Organizational Costs

• Sequences is generally correct, moving from lowest to highest cost in organizational costs

Start-Up Business Organizations

• Assume that you are starting a business that is expected to grow very quickly and a great deal of capital will be needed soon, then corporation what type of business organization

Owner Liability

• Shareholders (common stock) of a corporation enjoy limited liability

Limited Partnerships

• All of the above
• A limited partnership allows one or more partners to have limited liability
• It requires one or more of the partners to be a general partner to whom the privilege of limited liability does not apply
• It prohibits the limited partners from participating in the management of the partnership

Financial Investment

• The debt of the company carries with it an opportunity for significant upside if management is successful

Public Corporation

• A public corporation attracts new capital and shareholders of a corporation that have limited liability

Sole Proprietorships

• Sole proprietorships is a form of organizations that are free of initial legal requirements

Business and Personal Assets

• For sole proprietorships, no distinction is made between business and personal assets

New Issues

• For liability purposes ownerships of the sole proprietorship is the same as the individual

General Partnership

• In a general partnership, all partners have unlimited liability for the actions of any one partner when that partner is conducting business for the firm

Partnership Assets

• There is no legal distinction made between the assets of the business and the personal assets of the owners in the limited partnership

Corporate Investments

• The owners of a corporation are liable for the corporation's obligations up to the amount of their investment

Transferring Liability

• General partners have unrestricted transferability of ownership, while limited partners must have the consent of all partners to transfer their ownership

Organization of Power

• Ultimate control in a corporation is vested in the board of directors

Proprietorship

• Owners must register and pay yearly fees to their State of residence when establishing a sole proprietorship is false

Managing Businesses

• Limited partners may actively manage the business is false

Corporations

• Corporations receive money from investors with initial public offerings, seasoned new issues, and primary market transactions

Market Transactions

• IBM issuing new shares of common stock would be classified as a new seasoned issue

Shareholder Wealth

• Maximization of shareholder wealth as a goal is superior to profit maximization because it considers the time value of the money, and it considers uncertainty

Goal of a Firm

• The maximization of the total market value of the firm's common stock best describes the goal of the firm

Profit Maximization

• Profit maximization of dividend payout ratio is a better description of the goal of the firm

Working Capital

• Current assets and current liabilities, is the investment and financing decisions related to capital management

Managing Working Capital

• The goal of managing working capital, such as an inventory, should be to minimize the aggregate of carrying and shortage costs

Zap and Zing Companies

• Zap Company follows an aggressive financing policy in its working capital management while Zing Corporation follows a conservative financing policy. Zing has a high current ratio

Short-term Borrowing

• Shortening of time will increase the amount of short-term borrowing

Accounts Payable

• The longer the firm's accounts payable period and less the firm must invest in working capital.

Cash Assets

• The average length of time a peso is tied up in current asset is called the cash conversion period

Credit Policy Administration

• All these factors are used in credit policy administration except peso amount if receivables

Credit Policy

• Accounts payable deferral period, is not considered in determining credit policy

Inventory Stock

• Increase inventory costs, is the use of safety stock by a firm