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F370 Midterm notes, Study notes of Business Finance

Indiana University Bloomington (IU)Business Finance

Indiana University Bloomington I-Core Finance - Midterm Review

Typology: Study notes

2012/2013

Uploaded on 01/15/2013

ashleyfu2010
ashleyfu2010 🇺🇸

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F370 Mid-term Notes
Study Packs: A1, A2, A3, B1
Financial Contract: involves the exchange of money or cash flow over time; exchange of risk over time
Money Market Securities: Short term (less than a year); also called debt securities (future flow is legally
binding)
•T-Bill: lump sum from the Gov’t
• Trading at historic low returns right now
•Commercial Paper: lump sum from a business corporation
•Certificate of Deposits or CDs: lump sum (at the time of contracts maturity) from a
commercial bank
Long-term Debt Contracts:
•Corporate Bonds: lump sum + coupon payments
• Coupon payments = coupon rate * face value
• Sold in markets to a number of investors, the borrowing firm is borrowing from a
number of different investors are the same time
• Risk: the higher the risk, the more returns an investor will ask for
■Default risk: the issuing company runs into trouble and cannot make its
payments thus the investor sees a horrible return
■Price risk: if the investor sells the bond before it reaches maturity, the selling
price (and their earned rate) will be uncertain
•Treasury and Gov’t Bonds: lump sum + coupon payments, issued by gov’t institutions
• If the bond has an initial maturity between 1-5 years, it is usually called a Note
•Loans: a way for a person or company to borrow money; typically issued by commercial
banks
• No lump sum/ face or par value
• Has a set of even regular flows that happen frequently (often monthly) and are due at
the end of each month (ordinary annuity)
• Private transactions between one firm borrowing from one bank
• Lender: looking for a low-risk loan to grow their current cash
•Leases: borrower gains the use of some physical asset over some period
• Has a steady stream of payments due at the beginning of each month (annuity due)
Ownerships or Equity Contracts
•Common Stock: grants a person a share in a business activity / part ownership
• Have the right to vote on certain corporate matters however most investors don’t
• The important part is the future cash flows
• Not Debt / no promised or legally binding cash flows
• Dividend payments (not usually a steady stream)/ uneven stream problem
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F370 Mid-term Notes Study Packs: A1, A2, A3, B

Financial Contract : involves the exchange of money or cash flow over time; exchange of risk over time Money Market Securities : Short term (less than a year); also called debt securities (future flow is legally binding)

  • T-Bill : lump sum from the Gov’t
    • Trading at historic low returns right now
  • Commercial Paper : lump sum from a business corporation
  • Certificate of Deposits or CDs: lump sum (at the time of contracts maturity) from a commercial bank

Long-term Debt Contracts:

  • Corporate Bonds : lump sum + coupon payments
    • Coupon payments = coupon rate * face value
    • Sold in markets to a number of investors, the borrowing firm is borrowing from a number of different investors are the same time
    • Risk: the higher the risk, the more returns an investor will ask for ■ Default risk: the issuing company runs into trouble and cannot make its payments thus the investor sees a horrible return ■ Price risk: if the investor sells the bond before it reaches maturity, the selling price (and their earned rate) will be uncertain
  • Treasury and Gov’t Bonds : lump sum + coupon payments, issued by gov’t institutions
    • If the bond has an initial maturity between 1-5 years, it is usually called a Note
  • Loans : a way for a person or company to borrow money; typically issued by commercial banks - No lump sum/ face or par value - Has a set of even regular flows that happen frequently (often monthly) and are due at the end of each month (ordinary annuity) - Private transactions between one firm borrowing from one bank - Lender: looking for a low-risk loan to grow their current cash
  • Leases : borrower gains the use of some physical asset over some period
  • Has a steady stream of payments due at the beginning of each month (annuity due)

Ownerships or Equity Contracts

  • Common Stock : grants a person a share in a business activity / part ownership
    • Have the right to vote on certain corporate matters however most investors don’t
    • The important part is the future cash flows
    • Not Debt / no promised or legally binding cash flows
    • Dividend payments (not usually a steady stream)/ uneven stream problem

■ Use the CF, IRR, and NPV buttons for a finite holding period ■ For a growing perpetuity…

  • D2 = D1 * (1+g) where g is the “dividend growth rate”
  • Assume dividends grow in a smooth way
  • I button: enter r-g
  • PMT button: enter first dividend payment
  • N: 1000
  • Firms face a trade-off in raising cash between stocks and loans ■ Issue shares of stock to avoid somewhat dangerous legally-binding payments ■ Or incur debt (loan) to avoid giving away too much of future flows

A confusing Contract

  • Preferred Stock : Like common stock it is issued in stocks and pays dividends, but like debt, it grants no ownership or voting rights - Dividends are a specified amount and are legally binding (finance theory considers preferred stock a form of debt) - A constant dividend payment is paid forever ([N] 1000) / no face or par payment - The investor can be subject to default or price risk here - R = D/P

Contract Length/Term Orig. Flow @ Time Zero Lump Sum Flow Periodic Flow

Bill, Paper, CD <1 year P0: Market Price Face or Par None

Bond 1-30 years P0: Market Price Face or Par Coupon PMT C

Loan 1-30 years LA: Loan Amount None Regular PMT (Ord. Ann.) Lease Months to yrs None, Fixed asset transferred None Regular PMT (Ann. Due) Pref Stock Perpetual P0: Market Price None Dividend PMT D

Stock Perpetual P0: Market Price None Growing Dividend Pmts

Valuation : the process of finding a price or value in today’s (time-zero) dollars

Comparables Approach : to find value of a non-traded asset, you observe the market price for a similar traded asset and then tweak the price to account for any small differences

Traded company stock price (per share) / traded company NI per share = PE ratio PE ratio x non-traded company NI per share = non traded stock price (per share)

  • Many predictable and large changes in security prices in order to make large profits as quickly as possible
  • High Quality Market for Passive Investors need to balance all the following factors and not be perfect in any of them
  • Lots of different types of contracts to choose from ■ Having a lot of different contracts available allows firms and investors to fine-tune strategies that will work best for them individually
  • Almost-Accurate prices with no “excess volatility” ■ They need to be able to trust that prices are accurate ■ However, these prices cannot be entirely accurate gauges of economic value ■ If prices were perfectly accurate, speculators would make any money and would thus leave the market ■ If no one is processing information and speculating, then prices wouldn’t even be nearly accurate ■ Therefore policy makers need to make some pricing errors as an incentive to keep speculators interested in trading and collecting new information, but the errors cannot be too big or the market would be come to risky for passive investors
  • A level Playing field ■ Policy makers want speculators to make profits from their hard work ■ Regulation and enforcement are critical to stop insider trading and the fraudulent advising practices ■ Passive investors needs to be able to trust that participation in the markets will not set them up for a risk of big losses from dubious practices
  • Low access Costs ■ If brokerage fees for investors or the consulting fees that investment banks charge firms are too high, then market participation will go down ■ If the access costs are too high, then the firm will not be able to profitabably adapt its strategies to a changing world and financial contracts will not have the full impact on business that they can have
  • Fast Transactions and Transfers of Ownership ■ A lot of passive investors and businesses find it optimal to be somewhat active in markets and to change their strageies on a daily or weekly basis ■ The accounting and legal recording of these transactions (trades) must keep up with the pace or the markets will not reach its potential
  • Lots of Trading Volume or Liquidity ■ Lots of trading and liquidity just in case you need to move a contract very quickly at some future date ■ Speculators provide a great deal of liquidity to passive investors ■ Prices should have some “volatility” (prices swing up and down as new info hits the financial community) ■ If speculators are undisciplined or too emotional they can create excess volatility

Mutual Funds : purchase stocks and bonds from markets and then sell shares of their portfolios to investors and pension funds Hedge Funds : Similar to mutual funds but they will purchase any contract that they believe will create a profit for them. They also take more risk than a mutual fund

Business Investment : when corporate finance raises their cash and manages their stock price then use this raised-capital to invest in products and ideas Capital Investment: are of corporate finance that focuses on how to apply the knowledge, discipline, and skills from the area of financial investments to the firms informal business opportunties

A Utility versus Value

  • Utility: the satisfaction that you derive from some transaction
  • Aim for a fair deal
    • When LA=CP and i=r
  • Value: is the PV of any cash flows gained above and beyond CP
  • When i>r, the lender is capturing some value from the borrower

Loan Amortization and Balances

  • Balx: the amount that the borrower must pay at time x to end the loan early
  • PMTx = INTx + BALREDx
  • Loans are amortized debt which means that the borrower pays periodic interest plus some extra cash that goes to reduce the loans outstanding balance
  • INTx (the interest portion) keeps going down over time
  • BALREDx (the balance-reduced portion) goes up over time

B The Pricing Equilibrium

  • Other names for this: competitive prices, fair prices, intrinsic values
  • Definition: a theoretical price or present value of a financial contract that results in the contract being consistent with all other contracts in the financial market
  • The terms pricing and capitalization both refer to the process of converting a stream of flows into a current price

Pricing Rules when Investors are Risk and Time Neutral

  • This means that waiting time (N) and risk level (+/-) surrounding the cash flow have no impact on how much a flow is worth today
  • P0 = E CFi : fair price is just the sum of all the expected values of the cash flows in the contract
  • A firm’s identity, reputation, popularity, etc. do not influence risk, they are already accounted for in the cash flow amounts
  • Capital investment
    • Investing 15M in a business project today gets you a return of CF1: 4.5M, CF2: 5 M, CF3: 5.5M, and CF4: 6M
    • In order to get this return from a financial contract, you would have to invest 21M