Principles of Finance Exam 1 Review Guide PDF

FINN 20403 Principles of Finance Review Guide for Term Exam 1 Instructor: Kefu Wu Q-1) What is the goal of the firm or financial managers? A: Maximize shareholders’ (owners) wealth, or equivalently, the stock price or market value of the firm. Q-2) Should the firm or financial managers set the goa...

FINN 20403 Principles of Finance Review Guide for Term Exam 1 Instructor: Kefu Wu Q-1) What is the goal of the firm or financial managers? A: Maximize shareholders’ (owners) wealth, or equivalently, the stock price or market value of the firm. Q-2) Should the firm or financial managers set the goal to maximize Profit? A: No. Maximization of Accounting Profit (earnings, or EPS) does not lead to highest possible share price. It ignores at least three important factors: (a) Timing (b) Cash flows (c) Risk Q-3) Should the firm or financial manager maximize Stakeholders’ (employees, customers, suppliers, creditors, and communities) Welfare? A: No. Stakeholders are difficult to be ranked, therefore their welfare cannot be maximized simultaneously. In a competitive market environment, if the firm maximizes shareholders’ wealth, it must take care stakeholders’ benefits. And provided a healthy legal system in the US, stakeholders’ interests are well protected. Q-4) What are financial managers’ key decisions? A: There are four types of decisions: (a) Financing decisions - how to raise funds, both short-term and long-term. (b) Investment decisions - how to allocate fund/capital in long-term projects. (c) Capital budgeting decisions - how to select the project(s) that create(s) most value for shareholders. (d) Working capital decisions - how to manager short-term resources to run a daily business. Q-5) What are Principles of managerial decisions? (a) The Time value of Money - timing matters (b) Risk-return tradeoff - high risk with high return and low risk with low return (c) “Cash is King” - focus on cash flows (d) Competitive financial market - follow the market demand/supply, respond to market signal (e) Incentive - to both employees and managers Q-6) What is the primary principle that Finance adopted from Economics, and how to apply it to financial decisions? A: It is Marginal cost-Marginal benefit analysis. All wise financial decisions must achieve the result of MB > MC. Q-7) What is the difference between Finance and Accounting in terms of business transactions? A: Financial managers emphasis on actual cash flows (inflows, outflows, and net flows); while Accountants prepare financial statements that recognize revenue at the time of sale (whether payment has been received or not) and recognize expenses when incurred; that is the accrual basis. For example: At the end of the calendar year, Firm A had a sale of goods in the amount of $10,000 during the year at a total cost of $8,000. Although the firm paid in full for the goods during the year, it is yet to collect at year end from the customer. Then, what is firm’s net profit, (accrual basis of accounting), and what is its cash flow (financial managers’ focus)? A: The net profit is $2,000, and cash flow is -$8,000. 1 Q-8) What is Principal-Agent problem and associated agent costs? How to solve the problem? (a) Owners (principal) of a firm and its managers (agent) are not the same people and the agent does Not act in the interests of the owners (principal) of the firm; therefore may increase the firm’s managerial costs so-called agent costs. (b) The firm’s owners (stockholders) bear agent costs. (c) Corporate governance being used to correct or solve principal-agent problem, such as rules, processes, laws. Internally, some firms may offer stock options and/or restricted stocks as a sort of compensation to managers which link managers’ performance/benefits directly to the firm’s stock prices, therefore align managers’ interests with the interests of owners. Q-9) What are job duties/business functions of top positions of a corporate? (a) Board of directors - make strategic decisions; (b) President/CEO - fully in charge of overall business operations; (c) CFO - under CEO, in charge of overall financial management; (d) Treasurer - under CFO, manages cash, pension plans, as well as key risks; (e) Controller - under CFO, chief accountant, responsible for accounting activities, tax management, and cost control. Q-10) What are three organizational forms? And what are major differences in their features? (a) Sole proprietorship - unlimited liability, taxed on proprietor’s personal tax return; (b) Partnership - unlimited liability for owners and may have to cover debts of other partners, taxed on partners’ personal tax return; (b) Corporation - limited liability, double taxation on firm and on individual. Q-11) How to calculate marginal tax and total tax payment due with a progressive taxation framework? A: According to firm’s taxable income and given Tax Codes, calculate tax payments for each applicable taxable income bracket with marginal tax rate of that bracket, then add them up together. Q-12) Does ethical behavior of the firm affect its share prices? A: Yes, definitely. Sarbanes-Oxley Act of 2002 set up several ethical guidelines to firms. Q-13) What are financial institutions, and what are they? A: There are fund demanders and fund suppliers in the economy. In general, individuals are net fund suppliers, and firms are net fund demanders. Financial institutions are intermediary that channels the savings of individuals, businesses, and governments into loans or investments to fund demanders. There are three types of financial institutions: (a) Commercial banks - receive deposits and make commercial loans; (b) Investment banks - assist companies in raising capital, advise firms on major transactions and business issues, and engage in security trading and market-making activities; (c) Shadow banking system (non-bank financial institutions) - such as insurance companies, mutual funds, pension funds, etc.; they engage in lending activities but do not accept deposits, and therefore not subject to the same regulations with which traditional depository institutions (i.e., commercial banks) must comply. Q-14) What are the differences between Money Market and Capital Market? What securities are traded in each market? 2 A: Money Market is a short-term financial market, in which only high liquid, marketable securities with one year or less than one year maturities being traded. Those typical financial securities (instruments) are: (a) Treasury bills (T-bills) (b) Commercial paper (c) Negotiable certificates of deposit (CD) While Capital Market is a long-term financial market, in which traded securities have maturities of more than one year, or without maturity. Those typical securities (instruments) are: (a) Long-term government securities, i.e., treasury notes (T-notes) and treasury bonds (T-bonds) (b) Corporate bonds (c) Corporate preferred stocks and common stocks (d) Financial derivatives Q-15) What is the difference between Primary Market and Secondary Market? A: Primary market is for a firm to issue or sell its new financial securities, most cases are common stocks, in order to raise long-term funds. The stocks are purchased by investors at the first time in the market. The process is so-called Initial Public Offering (IPO). While Secondary Market is a financial market where investors trade for pre-owned securities. NYSE and Nasdaq are typical secondary security markets. Q-16) What are major forms of firm owners’ income? (a) Ordinary income, the income coming from business operations, such as wages, salaries, and dividends distributions. (b) Capital gain, the income coming from proceeds of selling the firm’s assets, including physical assets and financial securities. Q-17) What are the differences between Broker Market and Dealer Market? A: Both broker and dealer markets are secondary markets because they trade for pre-owned securities. The differences are: (a) Broker market has a trading floor (such as NYSE). Brokers bring sellers and buyers together to make a transaction, but brokers do not buy or sell securities themselves. Brokers charge transaction fees (commission) for each completed transaction. (b) Dealer market (such as Nasdaq) usually does not have a physical market place or trading floor. Dealers provide liquidity for security buyers and sellers by either buying securities from investors or selling securities to investors; therefore they play a role as “market makers”. Dealers charge ½ of the bid/ask spread + transaction fees (commission) for each completed transaction. So, transaction costs in dealer market are higher than that of broker market. Q-18) What is the Over-the-Counter (OTC) market? A: A financial market where smaller, unlisted securities are traded. The total trading volumes in this market are small. Q-19) What does the theory of Efficient Market Hypothesis claim? And what implication does it suggest? A: The EMH claims: 3  (a) At any point in time security prices fully reflect all information (including historical, public available, and inside information) available about the firms and its securities. (b) Securities are typically in equilibrium; they are fairly priced. (c) Because market quickly reach equilibrium and securities are fairly priced, investors cannot easily find mispriced (undervalued or overvalued) securities; therefore, investors cannot make systematic gains in such a market environment. Q-20) What is a different view of the school of Behavioral Finance opposing the Efficient Market Hypothesis? A: Behavioral Finance claims that, stock prices can deviate from their true values for extended periods; these deviations may lead to predictable patterns in stock prices. In particular, some evidences indicate that, stocks performed poorly in the past displayed a predictable tendency to rebound, giving investors aware of that pattern a profit opportunity. Q-21) What were major measures of Glass-Steagall Act of 1933? (a) Prohibited institutions that took deposits from engaging in activities of high risk business such as securities underwriting and trading, thereby effectively separating commercial banks from investment banks. (b) Established Federal Deposit Insurance Corporation (FDIC). The major functions of FDIC are: Provides deposit insurance to individual who held it in a bank that failed. Examines hanks on a regular basis to ensure that their operations are “safe and sound.” Q-22) What was the purpose of Gramm-Leach-Bliley Act of 1999, and what did it do? A: In order to promote competitions in US banking industry, this Act allows business combinations between commercial banks, investment banks, and insurance companies and thus permits these institutions to compete in markets in a wider range of activities. Q-23) What are two major ways for a firm to raise capital? (a) Private placement - raise fund by selling the firm’s new securities directly to an investor or a group of investors through its own business network. (b) Public offering - sale of either bonds or stocks to the general public conducted by financial institutions (investment banks) through capital market, typically a primary market. Q-24) What are venture capital and venture capitalists (VCs)? And what are deal structure and pricing with VCs? A: Venture capital is an equity financing provided by a firm that specialized in financing young, rapidly growing firms. Venture capitalists are formal business entities that take in private equity capital from many individual and institutional investors, and make private equity investment decisions on their behalf. Usually, these kinds of investments are usually very risky. When VCs invest in a target company, a legal agreement clearly defines the deal structure and pricing. (a) The agreement will specify a guidance of the target company’s operation strategy, and a timeline to go IPO. (b) The agreement will specify an explicit exit strategy for the VC that defines when and how the VC must be repaid, in what prices. (c) VCs will require More equity ownership and pay Less for the riskier and less developed firms. 4 Q-25) What is so-call IPO? And what major procedures, institutions, concepts, results are involved with IPO? A: IPO stands for Initial Public Offering, a private firm goes public by issuing its new common stocks to public investors in a primary capital market. After the IPO, the firm’s stocks become outstanding, listed in stock exchange(s), and will be traded in secondary market(s). (a) Prospectus - a security registration statement submitted to SEC and to potential investors, which describes the key aspects of the issue, the issuers, its management and financial position. (b) Underwriting - the securities purchased by investment bank(s) from an issuing corporation at an agreed-on (discount) price. (c) IPO offer price - the price at which the issuing firm sells its securities to public investors. (d) Underwriting syndicate - a group of investment banks formed by the originating investment bank to share the investment opportunities as well as financial risk associated with underwriting new securities. (e) Selling group - a large number of brokerage firms that join the originating investment bank for selling a certain portion of a new security issue on a commission basis. (f) Total proceeds = IPO offer price x # of IPO shares issued (g) Net proceeds = Total proceeds – issuing costs paid to investment banks (h) Market price - the price of the firm’s shares as determined in the secondary market. (i) Market capitalization = market price of stock x # of shares of stock outstanding (j) IPO market price - the final trading price of the first day in the secondary market. (k) IPO underpricing = (market price – offer price) / offer price Q-26) What are so-called securitization of mortgage loans and mortgage-backed securities? A: It is a process of pooling mortgages of other types of loans to be a financial package or product and then selling claims or securities against that pool in the secondary market. This kind of securities are mortgage-backed securities that represent claims on the cash flows generated by the pool of mortgages. Q-27) What are subprime mortgages? A: Mortgage loans made to borrowers with lower incomes and poorer credit histories as compared to decent income and good credit history “prime” borrowers, therefore subprime mortgages borrowers have much higher delinquency or default risks. Q-28) What is an equilibrium rate of interest? And how the equilibrium rate is determined? A: Equilibrium rate of interest (or equilibrium interest rate) is a general market interest rate. It is determined by the interaction of total supply and total demand of funds in financial markets. Q-29) What is the relationship among nominal interest rates, real interest rates and expected inflation rates (premiums)? (a) Nominal rate of interest (r) - the actual rate of interest charged by the supplier of funds and paid by the demander of funds. (c) Real rate of interest (r*) - the rate of return on an investment measured not in dollars but in the purchasing power that the investment provides. (d) Expected inflation rate (i) - an expectation rate in prices rising of most goods and services in a specified period of time, usually a year. (e) Thus: r* = r – i; equivalently, a nominal interest rate can be described as a real interest rate added up with an expected inflation rate (premium), r = r* + i. 5 Q-30) What are risk-free securities? And what are risk-free rates? A: Risk-free securities refer to those securities with No default risk. The interest rates offered by those securities is a benchmark of rate return in the absence of risk. In US, federal government securities are regard as risk-free; therefore, the nominal interest rate offered by T-bills, T-notes, or T-bonds becomes a common proxy of risk-free rate (R_f), thus: R_f = r* + i. Q-31) What is risk premium for an underline non-government security? A: Corporate issued securities (bonds and stocks) are Not risk-free; they all have certain degree of delinquency or default risk. For investors, in order to compensate the risk for an underline security j, a risk premium (RP_j) should be added to a benchmark risk-free rate (Rf), and form a rate of required return for that security j: r_j = R_f + RP_j. Q-32) What kinds of the firm’s risks should be examined? And how to measure risk premium of a security issued by a specific firm? (a) All kinds of risks with a firm should be examined, including business risk, financial risk, interest rate risk, liquidity risk, and tax risk, as well as the purely debt-specific risks - default risk and contractual provision risk. (b) There are three main ratings agencies that evaluate the creditworthiness of bonds: Moody's, Standard & Poor's, and Fitch. (c) Based on risk-return tradeoff, if a company is rated high (risk is low), its risk premium should be low. If a company is rated low (risk is high), its risk premium should be high. Credit ratings are risk measurements which determine the costs for corporate securities, typically debt financing instruments. Q-33) What are yield to maturity (YTM), term structure of interest rates, and yield curve? (a) YTM is compound annual rate of return earned on a debt security purchased on a given day and held to maturity, and it is an estimate of the market’s required return on a particular bond. (b) Term structure of interest rates is the relationship between the maturity and rate of return for bonds with similar levels of risk. (c) Yield curve is a graphic depiction of the term structure of interest rates of, specifically, T-bills, T- notes, and T-bonds. Q-34) What are typical shapes of yield curves? And what theories explain the term structure of interest rates (YTM)? (a) There are three types of yield curves: normal (upward sloping), flat, and inverted (downward sloping). (b) There are three theories to explain the shapes of yield curves. Expectations theory, expectation could cause any shape of a yield curve; Liquidity preference theory, it claims that long-term yield is higher than short-term yield, so causing an upward sloping yield curve; Market segmentation theory, market for loans is segmented on the basis of maturity, and the supply of and demand for loans within each segment determine its prevailing interest rate, thus determine the shape of the yield curve; So, the shape or slope of a yield curve is resulted from the combination of these three factors; the strong one will dominate the shape. Q-35) Why do financial professions and economists want to study yield curve? 6  (a) For financial managers, in comparison of costs for long-term funds or short-term funds, yield curve may affect the firm’s financing decisions. (b) Yield curve is a good predictor or indicator for future economy. A positive slope predicts an economic growth or boom; whereas a negative slope foreshadows a recession. Q-36) What economic activities require foreign currencies and foreign exchanges? And how many forms of foreign exchange rates? A: International trade and international investment are major driving forces for demand and supply of foreign currencies, then the markets and activities of foreign exchanges. (a) Direct rate: USD/JPY, the domestic currency (USD) is in the numerator; (b) Indirect rate: JPY/USD, the domestic currency is in the denominator; (c) GBP/CAD - a direct or an indirect rate? Since I am an American, this exchange rate is neither a direct nor an indirect rate to me; (d) No matter direct or indirect rate, if an FX rate rises in its figure, the value of the currency in the numerator falls relative to the currency in the denominator, and vice-versa; (e) The value of a currency falls vs another currency, is called depreciation, or to be depreciated. The value of a currency rises vs another currency, is called appreciation, or to be appreciated. Q-37) What is the Bretton-Woods International Monetary System? A: In 1944, top leaders of several major allied countries held a conference and then signed an agreement in Bretton-Woods, NH, which established a Pegged Exchange Rate system for all member countries. Under the Bretton-Woods International Monetary System, initially, one Oz of gold = US$35, and US dollar had fixed exchange rate with each currency of member countries. US government guaranteed that people could use dollar to redeem gold from Federal Reserve Banks. However, USSR, China, and other communist countries were not in this system. The Bretton-Woods monetary (foreign exchange) system eliminated risks of foreign exchange rate in international trade markets; therefore it dramatically promoted world trade as well as world economy in the post WWII era. In 1970, US government declared that, US Federal Reserve Banks will no longer be obligated to redeem gold for US dollars; then the Bretton-Woods International Monetary System collapsed. Since then, foreign exchange rates are mostly determined by market forces in foreign exchange markets. Nowadays, some countries’ governments intervene foreign exchange markets in certain degrees to maintain the foreign exchange rates of their currency in a fixed rate with another currency, or manage the floating of foreign exchange rates within a narrow range. Q-38) What is Purchasing Power Parity (PPP)? A: PPP is an economic theory explaining the fundamental determination of foreign exchange rates. It states that exchange rates will make the prices of goods and services the same in all countries according to currencies’ real purchasing power to goods and services. Q-39) Who are winners, and who are losers due to changes on exchange rates? (a) Buyer or seller of a currency? If you want to buy a currency, you want a “cheap” (or weak) currency If you want to sell a currency, you want an “expensive” (or strong currency) (b) Strong USD or weak USD? A Japanese airline ordering new aircraft from Boeing - Japanese want weak USD Disney which received yen denominated receipts from Tokyo Disneyland - TD wants weak USD Arkansas farmers who export rice to Japan - exporters want weak USD 7  A Japanese company with an outstanding dollar denominated loan - the Japanese borrower wants weak USD Q-40) What are major factors that influence foreign exchange rates and how? (a) Trade flows If Country A has trade deficit with Country B, i.e., imports exceed exports; then the Country A’s currency should be depreciated relative to Country B’s currency, the Country B’s currency should be appreciated, and vice-versa. (b) Inflation rates If Country A has higher inflation rates than Country B, the Country A’s currency should be depreciated relative to Country B’s currency, the Country B’s currency should be appreciated, and vice-versa. (c) Interest rates If Country A has lower interest rates than Country B, the Country A’s currency should be depreciated relative to Country B’s currency, the Country B’s currency should be appreciated, and vice-versa. 8