Finance Midterm - chapters 7 8 9

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Finance Midterm - chapters 7 8 9
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Finance Midterm - chapters 7,8,9
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  1. Companies need to raise money to
    finance business activities
  2. Savers/Inestors need a place to
    deposit their savings and to earn a return
  3. Financial Markets
    connect producers' need for money with investors' available savings.
  4. Businesses spend money on:
    • - Day to day operations (inventory, wages, etc)
    • - Capital investments (i.e. new production lines, expansion overseas, etc)
  5. Term
    the length of time between now and end (or term-ination) of something
  6. Maturity matching
    Long term projects (usually lasting 5-10 years) usually financed with long term funds

    Short term projects (lasting less than 1  year) usually financed through short term funds
  7. Financial markets may be classified as
    • Capital or money markets
    • - Capital markets are the Market for shares and long-term debt
    • - Money markets are markets for short-term, high quality debt securities with maturities of 1 year or less, and are marketable securities such as commercial paper, notes, bills, federal government issues treasury bills


    • Primary or secondary markets
    • -Primary market transactions can occur directly (issuing firm sells securities to investors through investment dealer) and indirectly (issuing firm sells securities to institutional investor such as a mutual fund)
  8. Money markets are...
    Money markets are markets for short-term, high quality debt securities with maturities of 1 year or less, and are marketable securities such as commercial paper, notes, bills, federal government issues treasury bills
  9. Capital markets are
    Capital markets are the Market for shares and long-term debt
  10. Primary market transactions can occur
    directly (issuing firm sells securities to investors through investment dealer) and indirectly (issuing firm sells securities to institutional investor such as a mutual fund)
  11. Institutional investors
    -Pay a major role in financial market... they own 1/4 of all stocks but make 3/4 of all trades.

    For example...

    •Mutual funds

    •Pension funds

    •Insurance companies

    •Banks and trust companies
  12. Stock market
    Is a network of exchanges and brokers.

    The market in which shares of publicly held companies are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership in the company. The stock market makes it possible to grow small initial sums of money into large ones, and to become wealthy without taking the risk of starting a business or making the sacrifices that often accompany a high-paying career
  13. Exchanges can be ___ or ____.
    Physical or electric (TSX, OTC, NYSE)
  14. Brokers are
    individuals who assist people in buying and selling securities
  15. Security Exchanges (Example: TSX)
    Financial marketplace with specific requirements for listing and trading securities
  16. Over-the-counter (OTC) Market
    • Public stock issues not traded on stock exchange.
    • Dealers act as market makers.


    A decentralized market, without a central physical location, where market participants trade with one another through various communication modes such as the telephone, email and proprietary electronic trading systems. An over-the-counter (OTC) market and an exchange market are the two basic ways of organizing financial markets. In an OTC market, dealers act as market makers by quoting prices at which they will buy and sell a security or currency. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected. In general, OTC markets are therefore less transparent than exchanges and are also subject to fewer regulations.
  17. What do brokers do?
    • -Investors open an account with a broker and place trades via telephone or online.
    • - On the TSX, they buy and sell orders matched electronically.
    • - Specialists make markets in designated securities
    • - Confirmation of trade is forwarded to broker and investor
  18. Are markets regulated?
    Yes. 

    • •10 provinces and three territories
    • regulate own securities markets

    • –Ontario
    • Securities Commission —the
    • most influential because it has the most investors and companies within its
    • jurisdiction

    • •Securities law primarily aimed at unfair
    • trading practices

    –For example, unfair use of insider information
  19. What does going public mean?
    Received approval of the Securities Commission officer to sell securities to general public.

    Privately (closed) held companies have strong regulations and restrictions on the sale of securities.
  20. What is a security?
    A financial instrument that represents: an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer.
  21. How does a company go public?
    • 1. The process of obtaining approval and registration is known as going public.
    • 2.  The prospectus - using an investment dealer to determine if the market exists for shares of a company, and the likely issue price for shares.  The prospectus is a printed document that advertises or describes a school, commercial enterprise, forthcoming book, etc., in order to attract or inform clients, members, buyers, or investors.

    3. The provincial securities commission reviews the prospectus.  A prospectus that is not yet approved is called a preliminary or a red herring.

    4. Once the prospectus is approved by SC, securities can be sold to the public.

    5. After the company goes public, its shares are usually traded in over-the-counter (OTC) market
  22. Initial sale of securities once prospectus is approved is known as
    IPOs.

    Initial Public offerings.  

    Market IPOs can be very volatile and risky.  Prices can rise or fall very dramatically

    •Buyers are usually institutional investors (bought deal)
  23. True or False. IPOs are volatile and risky
    True.  Prices can rise or fall very dramatically
  24. OTC trades are _______ transactions
    secondary market
  25. _____ and ______ compete for investors dollars.
    Shares (equity) 

    AND

    Bonds (debt)
  26. K =
    Interest rate.

    K = base rate + risk premium.
  27. Base rate
    –Base rate is pure interest plus expected inflation

    •Rate at which people lend money at no risk



    The lowest rate at which a bank will charge interest, also known as the repo rate The rate is set in the UK by the monetary policy committee of the Bank of England, with a view to controlling inflation over the medium-term. Banks usually charge interest at a stipulated figure 'above base rate', with the figure depending on all sorts of circumstances to do with the loan and the borrower. If the base rate rises, then usually the rate of interest charged on the loan will rise to preserve the differential. If it falls, so will the rate on the loan. Thus, a loan at '4% above base rate' will be 10% if the base rate is 6%, and will rise to 11% if the base rate rises to 7%.
  28. What is the premium for lender's risk?
    Added to the base rate to calculate the interest rate (k).

    K = base rate + risk premium.

    There are default risks, liquidity risk, maturity risks
  29. The base rate is _____ plus _____.  It is the rate at which people lend money at _____ risk.
    The base rate is pure interest plus expected inflation.  It is the rate at which people lend money at no risk.
  30. Pure interest rate is
    rent paid to lenders for use of their money.
  31. Inflation
    general increase in prices.

    The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.
  32. Lenders must charge an interest rate ____ than the ____ rate.
    Lenders must charge an interest rate higher than the Inflation rate.
  33. What are risk premiums?
    Some loans are more risky than others.  Lenders demand risk premium of extra interest for risky loans. 

    The return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.
  34. What is default risk?
    The chance the borrower won't pay principal or interest, or will repay late.  Losses can be portion of or the entire amount.
  35. Lenders demand _____ premium.
    Lenders demand  default risk premium. It depends on the lenders perception of creditworthiness of the borrower.  The perception is based on the borrower's financial condition and credit record
  36. What is liquidity risk?
    • The difficultly in selling bond of little known issuer.  
    • Sellers may have to reduce their prices

    A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.
  37. What is maturity risk?
    • -–Long-term bond prices change more with
    • interest rate swings than short-term bond prices

    –Give rise to maturity risk

    • –Investors demand maturity risk premium
    • •Ranges from 0% for short-term securities
    • to 2% or more for long-term issues
  38. What are federal government securities?
    –Federal government issues many short-term securities

    • •Treasury
    • bills and short-term bonds

    –Treasury bills have terms from 90 days to a year

    • –ST
    • bonds have terms from 1 to 10 years

    • –No default risk, liquidity risk associated
    • with federal government debt

    •Can print money to pay off its debt
  39. What is the risk free rate?
    The risk-free rate is approximately the yield on short-term treasury bills.  It includes pure rate and allowance for inflation.  It is viewed as current minimum interest rate. 

    DEFINITION of 'Risk-Free Rate Of Return'The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
  40. What is the real rate of interest?
    The current interest rate less inflation adjustment. It tells investors whether or not they are getting ahead. 

    The real interest rate is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
  41. Effective annual rate is
    An investment's annual rate of interest when compounding occurs more often than once a year.
  42. What is continuous compounding?
    As compounding periods become infinitesimally short, interest is said to be compounded continuously
  43. Future Value
    • –Amount present sum will grow into at  certain
    • interest rate over specified period
  44. What are two different types of time/value problems?
    1. Amount - the single amount that grows at interest over time (FV and PV)

    2. Annuity - a stream of equal payments that grow at interst over time (FV and PV).  A Finite series of equal payments separated by equal time intervals
  45. What are the two types of annuity problems?
    • Ordinary annuity
    • - payments occur at the end of the time periods
    • -Monthly lease, pension, and care payments are annuities

    • Annuity due
    • -payments occur at the beginning of time periods.
  46. What is an annuity?
    An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase.
  47. what is a sinking fund?
    Provides cash to pay off bond's principal at maturity.  It's what a periodic deposit must be invested to have the needed amount at the end of the bond's maturity - a future value of an annuity problem.

    A means of repaying funds that were borrowed through a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market.r
  48. What is an amortized loan?
    An amortized loan's principal is paid off regularly over its life. It is generally structured so that a constant payment is made periodically.  It represents the present value of an annuity.

    A loan with scheduled periodic payments of both principal and interest. This is opposed to loans with interest-only payment features, balloon payment features and even negatively amortizing payment features.
  49. What are mortgage loans (aka "mortgages")?
    –Loans used to buy real estate

    –Typically an amortized loan over 30 years

    • –Large total interest amounts over life of
    • loan

    –Most of early payments is interest
  50. What is a perpetuity?
    A stream of regular payments that go on forever... it's an infinite annuity. 

    A constant stream of identical cash flows with no end.
  51. Rate of return is ___.  Rate of return is also known as ____ or ____.
    • the interest rate that equates the present value of expected future cash flows with current
    • price.

    Rate of return is also known as Yield or Interest.
  52. Most bonds purchased by
    institutional investors: banks, mutual funds, insurance companies, pension funds
  53. A bond’s term (or maturity) is ____.  When do bonds mature?
    A bond's term (or maturity) is the time from the present until principal is to be returned.  Bonds mature on the last day of their term.
  54. A bond's face value (or par) is the
    amount the firm intends to borrow (the principal) at the coupon rate of interest.
  55. What are primary markets?
    The primary markets are where investors can get first crack at a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. Exchanges have varying levels of requirements which must be met before a security can be sold.
  56. What are secondary markets?
    A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The national exchanges - such as the New York Stock Exchange and the NASDAQ are secondary markets.
  57. Bond prices respond to
    changes in market interest rates
  58. Bond prices and interest rates move  in ____ directions
    opposite.

    When interest rates fall, prices of bonds go up.  When rates increase, prices go down.
  59. When interest rates fall, prices of bonds go ____.  When rates increase, prices go ____.
    When interest rates fall, prices of bonds go up.  When rates increase, prices go down.
  60. Bonds don’t generally sell for face values until
    close to maturity
  61. What are bonds called when they sell above face value?
    trading at a premium
  62. What are bonds called when they sell belowface value?
    Bonds are selling at a discount
  63. Bearer bonds
    –interest payment to bearer of bond
  64. Registered bonds
    Interest payment to holder of record.  Record of registered securities kept by transfer agent (trust company)
  65. Secured bonds and mortgage bonds
    backed by collateral


    DEFINITION of 'Mortgage Bond' A bond secured by a mortgage on one or more assets. These bonds are typically backed by real estate holdings and/or real property such as equipment. In a default situation,mortgage bondholders have a claim to the underlying property and could sell it off to compensate for the default.
  66. Debenture
    –Unsecured bonds

    –Pay higher interest

    DEFINITION of 'Debenture'A type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture.Read more: http://www.investopedia.com/terms/d/debenture.asp#ixzz3ecIdcPAu Follow us: @Investopedia on Twitter
  67. Subordinated debentures
    –Lower in priority than senior debt

    DEFINITION of 'Subordinated Debt'A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings.
  68. Junk bonds
    -issued by risky companies and pay high interst

    INVESTOPEDIA EXPLAINS 'Junk Bond'Junk bonds are risky investments, but have speculative appeal because they offer much higher yields than safer bonds. Companies that issue junk bonds typically have less-than-stellar credit ratings, and investors demand these higher yields as compensation for the risk of investing in them. A junk bond issued from a company that manages to turn its performance around for the better and has its credit rating upgraded will generally have a substantial price appreciation.Read more: http://www.investopedia.com/terms/j/junkbond.asp#ixzz3ecJ2D0R6 Follow us: @Investopedia on Twitter
  69. Convertible Bonds
    Bonds exchangeable for a specified number of shares at option of bondholder.  Bondholders convert if price of shares rises enough. 

    INVESTOPEDIA EXPLAINS 'Convertible Bond'Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.Read more: http://www.investopedia.com/terms/c/convertiblebond.asp#ixzz3ecJF1DMU Follow us: @Investopedia on Twitter
  70. Corporations are owned by
    common shareholders
  71. A capital gain aka _____, occurs if you _____
    A capital gain, aka a loss, occurs if you sell the shares for a price greater (lower) than you paid for it
  72. Bonds VS shares - which one is guaranteed?
    • Bonds - interest payments are guaranteed.
    • Shares - dividends on common shares are not guaranteed.
  73. Bonds VS shares - interest/dividends
    • Bonds - interest payments are fixed
    • Shares  - dividends on common shares may increase, decrease, or stop at discretion of management
  74. Bonds VS shares  - when  can you sell?
    • Bonds  - maturity value is fixed.  Also, on maturity, the investor receives par or face value from issuing company.
    • Shares - shareholder sells shares at prevailing market price.  Shares are sold to another investor.
  75. Common shareholders have a ______ on both
    income and assets of the firm.
    residual claim
  76. The larger the variance of the probability distribution of returns, the more actual returns will cluster around the mean or expected value
    True
  77. The longer the time to maturity, the smaller the maturity risk associated with a bond
    False
  78. Shareholder's value is based on
    assumptions made by potential investor.  They must estimate the future expected cash flows.  They need to perform fundamental analysis of firm and industry.

    Different investors with different cash flow estimates will develop different intrinsic values.  For example... 

    Fundamental analysis: developing intrinsic values and comparing them to market prices
  79. What are dividend valuation models? What are a three types?
    • -Constant growth model
    • - Zero growth model
    • -Two-stage growth model


    DEFINITION of 'Dividend Discount Model - DDM'A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
  80. Gordon model forecasts
    price of a share expected to grow at constant, normal rate
  81. If a share is expected to pay constant, non-growing dividend... each
    dollar is the same.

    The gordon model simplifies to Dividend/Required rate of return
  82. Zero growth share is a  ..... to the investor
    perpetuity
  83. What are preferred shares?
    • They are a form of equity financing.
    • intermediate position between common shares and long-term debt.  There is no maturity date (like common shares) and there is a fixed dividend payment. 

    DEFINITION OF 'PREFERENCE SHARES'Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a company bankruptcy, preferred stock shareholders have a right to be paid company assets first. Preference shares typically pay a fixed dividend, whereas common stocks do not. And unlike common shareholders, preference share shareholders usually do not have voting rights.
  84. What is the value of a preferred share?
    the present value of all its future expected dividends.
  85. For preferred shares, the growth rate is
    Zero.

    No growth rate in preferred share dividends, so growth rate equals zero.  Preferred shares are valued as a perpetuity
  86. Preferred shares vs common vs bonds
    How are payments to invsestors?
    • Preferred shares -  dividends are constant
    • Common shares  - dividends are discretionary

    Bonds - interest is constant
  87. Preferred shares vs common vs bonds
    How is the maturity and return on principal?
    • Preferred shares - Dividends can be passed but are cumulative
    • Common shares - issuing firm does not return principal.  Holder must sell on market.
    • Bonds - Issuing firm returns principal on maturity date
  88. Preferred shares vs common vs bonds
    How is assurance of payment created?
    • Preferred shares - Dividends can be passed but are cumulative
    • common shares -  dividends can be passed indefinitely

    Bonds - interest must be paid or bondholders can put into bankruptcy
  89. Preferred shares vs common vs bonds
    Who has priority in bankruptcy?
    1. Bonds - Bondholders have first claim on company assets

    2.Preferred Shares - Shareholdes have claim on company assets after bondholders 

    3. Common Shares
      - have last claim on company assets
  90. Preferred shares vs common vs bonds
    Who has voting rights?
    Just common share holders.
  91. Preferred shares vs common vs bonds
    Which are subject to tax deductions?
    • Preferred & common shares are not tax deductible.
    • Bonds - interest payments are deductible.
  92. Preferred shares vs common vs bonds
    Rank in terms of risk to the investor
    • Common shares - HIGHEST
    • Preferred shares - Middle
    • Bonds - lowest
  93. What is the two stage growth model?
    to value  share that is expected to grow at unusual rate for limited time.

    Helpful hints:

    1.Draw a timeline

    2.Calculate each dividend on the timeline

    • 3.During period of non-constant growth,
    • present value dividends back to time zero

    –Oncegrowth has stabilized:

    • 4.Calculate present value of all dividends from that point forward out to
    • infinity.

    5.Bring calculated value back to time zero.
  94. Shares That Don’t Pay Dividends
    Can still have a substantial share price.  Most likely they are using profits to finance growth.  Future/distant dividends impart value.

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