1
Q
What is the classic simplified organizational chart from the point of a CFO?
A
- CFO
- Treasurer’s office
- cash management
- credit management
- capital expenditure
- financial planning
- Controller’s office
- tax manager
- cost accounting manager
- financial accounting manager
- data processing manager
- Treasurer’s office
2
Q
What are the CFOs main 3 areas of concern?
A
- Capital budgeting: managing long-term investments in assets
- Size, type of fixed assets, timing and riskiness of future cash flows
- Capital structure: obtaining long-term financing
- Financing cost (interest), the size, timing, source, optimal mix
- Working Capital Management: managing short-term assets and liabilities
- Size of inventory, credit policy and source
3
Q
What are the different forms of business organization? (large firms)
A
- Sole proprietorship
- owned by one person who gets all profits but who is also unlimited liable for debts
- Other disadvantages are business lifetime and issues of transferring ownership
- Partnerships
- 2 or more owners who divide profits according to the partnership agreement and who are liable for business debts.
- Other disadvantages are business lifetime and issues of transferring ownership
- Corporation
- Legal ‘person’ and distinct from its owners
- Difficult to form and requires a lot of administrative work
- Easier to raise capital
4
Q
What is (ACCORDING TO THE BOOK) the goal of financial management?
A
To maximize the current value per share of the existing stock
If no stocks ⇒ maximize the market value of existing owner’s equity.
5
Q
What is the Sarbanes-Oxley act?
A
A 2001 law passed by US Congress which has increased the supervision and requirements regarding accounting activities to protect investors from corporate abuses.
6
Q
What is an agency problem and why might it occur with corporations?
A
Agency problem: the possibility of conflict of interest between the stockholders and management of a firm
With corporations, there can be so many owners that the management effectively controls the firm and thus might pursue their own goals at the stockholder’s expense.
7
Q
How can you help solve the classic agency problem?
A
- Through the managerial compensation structure
- Having a “proxy fight” such that stockholders can easily fire unwanted management (proxy fight = opportunity for voting with other’s stock shares).
8
Q
What is the difference between primary and secondary markets?
A
- Primary market: the corporation is the seller of corporate securities (public offerings and private placements)
- Secondary markets: one owner or creditor selling to another
- Stock exchanges /NYSE, HKex) and OTC markets (NASDAQ)
9
Q
What is the difference between dealer and auction markets?
A
- Dealers: buy and sell for themselves at their own risk
- Dealer-markets in stock and long-term debt = over the counter (OTC) markets
- Auction markets:
- Physical location like Wall Street (NYSE)
10
Q
What does OTC refer to?
A
Over the counter markets/transactions which is transactions in stock and long-term debt with dealers.
Largest OTC market is NASDAQ
11
Q
What are the two types of agency costs?
A
- Direct: corporate expenditure that benefits management + costs to monitor management
- Indirect: lost opportunity due to management forgoing profitable but risky projects for fear of losing job if project fails
12
Q
Why is cash flow at Time 0 denoted -CF0?
A
Because it is a negative cash flow. An outflow of cash occurs.
13
Q
What is present value?
A
The value of a cash flow at an earlier period on a time line. The value at Time 0 unless anything else is stated.
14
Q
What is future value?
A
The value of a cash flow at some time in the future.
15
Q
What is the difference between annuity and perpetuity?
A
Annuity = a finite series of equal payments
Perpetuity = an infinite series of equal payments
16
Q
What is the principal?
A
The original amount borrowed or invested
17
Q
What is the difference between simple and compounded interest?
A
With compounded interest, you also earn interest on your interest whereas with simple interest you only earn interest on your principal amount.
18
Q
What is the formula for calculating future value?
A
FV = PV * (1+ r)^t
19
Q
What is the formula for calculating present value?
A
PV = FV / (1+ r)^t
20
Q
What is the formula for calculating r?
A
r = SQRT(FV/PV) - 1
21
Q
What is the formula for calculating t?
A
t = Log(FV/PV) / Log*(1+r)
22
Q
What is the rule of 72 and what is it used for?
A
Used to calculate the number of periods it takes to double an investment.
It is an approximation.
If you take 72 and divide by the interest rate. Fx. r = 0.12 (12 %), then it will take 72/12 = 6 years.
23
Q
Interest rate is also called what?
A
- Discount rate
- Cost of capital
- Opportunity cost of capital
- Required return
24
Q
What is the difference between an ordinary annuity and an annuity due?
A
- Ordinary annuity: first payment at the end of period 1
- Annuity due: first payment at time 0
25
**What is the formula for calculating annuity present value?**
Annuity present value = C \* ((1-(1/(1+r)^t))/r)
Where 1/(1+r)^t) = the present value factor.
For example if we have 3 periods and 10 % interest the present value factor is = 1/1.1^3 = 1/1.331 = 0.751315
26
**What is the formula for calculating the future value of an annuity?**
Future value of an annuity is = C\*(((1+r)^t)-1)/r
Future value of annuity is = C\* ((future value factor - 1) / r)
the future value factor = ((1+r)^t - 1) / r
27
**How do you calculate the present value of a perpetuity?**
Super simple.
PV for a perpetuity = C / r
28
**How do you calculate the present value of a growing perpetuity?**
P/(r-g) \* (1-(((1+g)/(1+r))^n))
29
**What is EAR?**
The effective annual rate = the interest rate expressed as if it were compounded once per year.
30
**How do you calculate EAR?**
EAR = ((1 + (quoted rate/m))^m) - 1
Quoted rate is 12 % and compounded monthly then:
((1+0.12/12)^12) - 1 = 1.26825 - 1 = 12.6825 %
31
**What is APR and how is it calculated?**
Annual percentage rate = the interest rate charged per period multiplied by the number of periods per year.
It does not tell us that much but is by law required to be computed and displayed for all consumer loans.
32
**What are the 4 different types of loans?**
* **Pure discount loans** (you pay interest and principal back in the end of the last period)
* **Interest-only loans** (you pay interest at the end of each period and pay both interest and the principal at the end of the last period)
* **Amortized loans** (You pay both interest AND part of your principal at the end of every period)
* **Amortized loans with fixed equal payments** (equal payments at the end of every period. In the beginning a larger proportion is interest payment, which declines over time while the proportion of principal increases)
33
**What** **are** **the different basis of interest calculation?**
* **Flat basis**: the principal of the loan is not reduced by the installment payments and interest is thus charged on the full principal borrowed
* **Annual rest basis**: the principal of the loan will only be reduced by the installment amount of at the end of every year. Thus, interest is charged on the balance at the beginning of the year.
* **Reducing balance basis**: the principal of the loan is reduced as and when the installment payments are made (best for the borrower)
34
**What is a balloon payment?**
It comes from partial amortization / bite the bullet loans.
You make for example a 15-year amortization. After the first 5 years with amortization, the borrower will have to pay a single lump sum paying off the rest of the loan.
35
**What are bond coupons?**
The stated interest payments made on a bond
36
**What is a level coupon bond?**
A bond where you pay a constant amount of interest every year.
37
**What is a bond’s face value?**
_Face value_ or Par value = the principal amount of a bond that is repaid at the end of the term.
Also called par value.
38
**What is a bond’s par value?**
Face value or _Par value_ = the principal amount of a bond
that is repaid at the end of the term.
Also called Face value
39
**What is a bond’s maturity?**
The specified date on which the principal amount of a bond is repaid
40
**When does a bond become more valuable: when the interest rate increases or decreases?**
Increases in society = worth less
Decreases in society = worth more
41
**What is YTM?**
Yield to maturity
The rate required in the market on a bond.
42
**If the market interest rate and the coupon rate of a bond are the same, how will the bond be priced?**
It will be priced at its face value / par value /principal amount
43
**When do we call a bond a ‘discount bond’?**
When it sells for LESS than its face value / par value
For discount bonds;
Par value \> bond price
Thereby also meaning that
YTM \> coupon rate
44
**When do we call a bond a premium bond’?**
When it sells for MORE than its face value / par value
For premium bonds;
Par value
Thereby also meaning that
YTM
45
**How do you calculate the value of a bond?**
Bond value = Present value of the coupons + Present value of the face amount
46
**When is interest rate risk high?**
All else equal, interest rate risk is higher when:
* There is a long time to the maturity of a bond
* The coupon rate of the bond is low
47
**What is current yield?**
A bond’s annual coupon divided by its price.
48
**What are debt and equity securities?**
It can be bonds issued by corporations.
49
**What are the three main differences between debt and equity from a financial point of view?**
* _POWER_: Debt does not give voting power = it is not an ownership
* _TAX DEDUCTIBLE_?: Interest on debt is considered a cost of doing business and is tax deductible while dividends paid to stockholders are NOT tax deductible.
* _BANKRUPT_?: Unpaid debt is a liability and can lead to bankruptcy. Equity can never lead to bankruptcy (dividends are not a liability).
50
**What are other words for debt securities?**
* Notes
* Debentures
* Bonds (_strictly speaking_ a bond is a secured debt)
51
**What does "bond" refer to in general?**
All kinds of secured and unsecured debt.
Strictly speaking (which is not the general meaning we use), a bond is a secured debt.
52
**What is the indenture?**
The written agreement between the corporation and the lender detailing the terms of the debt issue.
53
**What are some of the most important information an indenture includes?**
* Basic terms of the bond
* Total amount of bonds issued
* A description of property used as security
* The repayment arrangements / sinking fund provisions
* The call provisions (the company’s opportunities for repurchasing / calling back)
* Details of the protective covenants
54
**What does it mean that a bond is in ‘registered form’?**
That the registrar of the company records ownership of each bond will have the payment made to him/her.
Payment is made to the person in whose name the bond is registered.
55
**What does it mean that a bond is in bearer form’?**
Payment is made to the person who holds the bond (not name specific).
56
**What is a blanket mortgage?**
When all the company’s property is pledged to the mortgage as collateral.
57
**What is a debenture?**
An _unsecured_ debt usually with a maturity of _10 years or more_
58
**What is the term ‘note’ most often used for?**
An _unsecured_ debt usually with a maturity _under_ _10 years_.
59
**What does ‘seniority’ refer to?**
The preference in position over other lenders.
60
**What is a sinking fund?**
An account managed by the bond trustee for the purpose of repaying the bonds.
61
**What are call provision?**
An agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity.
62
**What is the call premium?**
The amount by which the call price exceeds the par value / face value of the bond.
63
**What is a deferred call provision?**
A call provision prohibiting the company from repurchasing the bond prior to a certain date.
For example not allowed in the first 10 years.
64
**What does call protection mean?**
When a bond cannot be repurchased by the corporation.
This can be for the entire lifetime of the bond or for a certain period if the bond is purchased under a deferred call provision.
65
**What are protective covenants?**
A part of the indenture limiting certain actions the company may wish to take.
This is a protection of the lender’s interest such that the company cannot take certain actions such as:
* Pay too high dividends
* Pledge assets to other lenders
* Merge with other firms
* Sell or lease major assets without the lender’s approval
* Issue additional long-term debt
Or positive covenants such as:
* MUST maintain working capital above a certain level
* MUST furnish audited financial statements to the lender
* MUST maintain any collateral or security in good condition
66
**What are examples of negative covenants?**
When the company CANNOT do something:
* Pay too high dividends
* Pledge assets to other lenders
* Merge with other firms
* Sell or lease major assets without the lender’s approval
* Issue additional long-term debt
67
**What are examples of positive covenants?**
When the company MUST do something:
* MUST maintain working capital above a certain level
* MUST furnish audited financial statements to the lender
* MUST maintain any collateral or security in good condition
68
**What are the three biggest credit rating agencies in the world and what is their high, medium and low grades?**
* Standard and Poor
* AAA, AA
* A, BBB
* BB, B
* Fitch
* AAA, AA
* A, BBB
* BB, B
* Moody’s (_***Moody** has a different system with small letter "a"s)*_
* Aaa, Aa
* A, Baa
* Ba, B
69
**What are municipal notes?**
Notes and bonds issued by state and local governments to borrow money.
Interest recerived is tax-exempt at the federal level ==\> Therefore municipal bonds sometimes give lower rates despite higher risk than treasury securities.
70
**What are zero coupon bonds and how are they priced?**
A bond that makes no coupon payments and it thus initially priced at a deep discount.
Thus much higher price risk while no reinvestment risk.
71
**What is Sukuk?**
Islamic bonds following Sharia law in which charging and paying riba/interest is illegal.
72
**What is the largest security market in the world?**
U.S. Treasury Market.
(Thus not the New York Stock Exchange)
73
**What is TRACE?**
Trade Report and Compliance Engine
A place in which corporate bond dealers are required to report trade information in order to create more transparency about prices and deal-making in the bond market.
74
**What is the "bell-wether" bond?**
The very last bond listed on a day of trading.
The yield of that bond is what will usually be reported in the news.
75
**What is the clean price?**
The price typically quoted which is the price of a bond NET of accrued interest.
Quoted price.
76
**What is the dirty price?**
The price you actually pay (the full/invoice price).
The price of a bond INCLUDING accrued interest.
Dirty price = quoted price + Accured interest
77
**What is the Fisher Effect?**
The relationship between nominal returns, real returns and inflation.
_Exact relationship:_ 1 + R = (1+ r) \* (1 + h)
r =((1 + R) / (1 + h)) - 1
_Approximate relationship:_ R = r +h
*h = expected inflation rate*
78
**When is the term structure of interest rates upward and downward sloping?**
* Downward: when short-term interest rates are higher than long-term interest rates
* Upward: when long-term interest rates are higher than short-term interest rates (MOST COMMON)
79
**What is inflation premium?**
The portion of a nominal interest rate that represents compensation for expected future inflation.
80
**What is the interest rate risk premium?**
The compensation investors demand for bearing interest rate risk (higher the longer the maturity)
81
**What 3 factors determine the term structure of interest rates and how can it be shown graphically?**
* Real rate
* Inflation premium
* Interest rate risk premium
82
**What are the 3 factors that** **increases** **the interest rate on a corporate bond (compared to treasury notes)?**
* Default risk premium (compensation for possibility of default)
* Taxability premium (compensation for unfavorable tax status)
* Liquidity premium (compensation for lack of an active market wherein a bond can be sold for its actual value)
83
**What is the default risk premium?**
The portion of a nominal interest rate or bond yield that represents _compensation for possibility of default_
84
**What is the taxability premium?**
The portion of a nominal interest rate or bond yield that represents _compensation for unfavorable tax status_
85
**What is the liquidity premium?**
The portion of a nominal interest rate or bond yield that represents _compensation for lack of liquidity_
86
**What are floating-rate bonds?**
Bonds where the coupon rate floats depending on some index value.
Often have a ‘collar’ = a pre-specified ceiling and floor.
Examples: adjustable rate mortgages and inflation-linked treasuries (ibond in HK).
Less price risk and maintain a fixed real return.
87
**What are income bonds?**
Bonds where the coupon payment is depending on the level of corporate income.
If earnings cannot cover interest payments, it is not owed (however this is rare).
88
**What are convertible bonds?**
A bond that can be converted into a specified amount of stock (company share) or sometimes into cash.
89
**Why are stocks more difficult to value in practice than bonds?**
* The cash flows are unknown in advance
* The investment has practically no maturity
* There is no way to easily observe the ROR that the market requires
90
**Can a company NEVER pay dividends?**
No.
If a company is said to not paying dividends it is for a period of time. If they had a rule about NEVER paying dividends the stockholders would vote against it or even worse, just run away.
Nobody wants to invest money into a company where nothing ever comes out - a black hole.
91
**What are the 3 special cases for stock value calculations?**
* Zero growth dividends such that P0 = D / R (like an ordinary perpetuity)
* Constant growth dividends such that P0 = D1 / (R - g) (like a growing perpetuity)
* the dividend growth model
* Nonconstant growth - fx. $1 in period 1, $2 in period 2 but $2.5 in period 3.
* Here you calculate the present value for each period and sum together
* Two-stage growth: a form of non-constant growth in which the growth rate is xx percent for x amount of years and then xx afterwards.
92
**What is the dividend growth model?**
A model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate.
*_CONSTANT DIVIDEND GROWTH MODEL:_*
P = D1 / (R - g)
Calculating in the future it will be:
P1 = (Dt x (1 + g)) / (R - g)
93
**What is dividend yield?**
A stock’s expected cash dividend divided by its current price.
D1 / P0
94
**What is capital gains yield?**
_The dividend growth rate_, or the rate at which the value of an investment grows.
95
**The expected return, R of a stock consist of which two parts?**
The dividend yield (dividend as percentage of stock price) + capital gains yield (expected growth rate of the investment’s value).
R = dividend yield + capital gains yield
R = D1 / P0 + g
96
**How do you calculate the PE ratio?**
Price per share / earnings per share
97
**What does a high PE ratio mean?**
That investors are willing to pay more for each dollar of earnings.
98
**What is the forward PE ratio of IPO and how is it calculated?**
Forward PE ratio of IPO = Offer price per share / Projected EPS
Used to compare the offered price to the estimated price at an IPO.
99
**How do you calculate the estimated share price for IPOs?**
Estimated share price = Average industry PE \* Projected EPS
100
**What is the price to sales ratio and when is it useful?**
Useful to assess start-up firms who have yet to generate earnings + good when working with firms with negative earnings.
Price-to-sales ratio = Price per share / sales per share
101
**What is the price-to-cash flow multiple and why is it useful?**
Price-to-cash flow ratio = price per share / cash flow per share
Helps minimize the impact of differences in accounting regulations across countries as it uses cash flow instead of earnings.
102
**What is the difference between cumulative and straight voting?**
With straight voting, a shareholder may cast all of his/her votes for each member of the board that has to be chosen (first 100 % of votes for 1 guy, then 100 % for the next guy and 100 % for the third and so forth) ==\> 1 board member chosen at a time
With cumulative voting, a shareholder can only use his/her share to vote one time and must thus split his/her votings on the candidates ==\> All board members chosen the same time
103
**Does a shareholder have to vote him/herself?**
No. The vote can be casted by a **_proxy_** = someone you grant the authority to vote for you.
104
**What is the preemptive right?**
That whenever a corporation wants to issue more stock, it has to first offer it to the current stockholders for them to be able to keep their proportionate ownership.
If they don't buy it, the company can then offer it to the public.
105
**What are the distinctive features of preferred stock?**
* Priority over common stock in payment of dividends and in distribution of assets in the event of liquidation
* Often no voting privileges
106
**What is NPV?**
Net present value which is the difference between an investment’s market value and it’s cost.
⇒ Is the investment worth undertaking? The gain higher than the cost?
107
**What is DCF valuation?**
Discounted cash flow valuation = the process of valuing an investment by discounting its future cash flow.
108
**What is the role of a CFO and what other name is used for CFOs?**
Coordinating the activities of the treasurer and the controller
The Vice-President of Finance
109
**What is the job of the controller?**
Oversee cost and financial accounting, taxes and information systems
110
**What is the job of the treasurer?**
Overseeing cash management, credit management, financial planning and capital expenditures
111
**What is the difference between general partnerships and limited partnerships?**
* General:
* Run business together
* Share in gains or losses
* Unlimited liability
* Limited (limited partner)
* Not running business together
* Limited liability according to the contribution to the partnership
112
**Explain direct and indirect costs associated with agency problems**
* Direct:
* Corporate expenditures
* Fx. bonuses (compensation) and auditory management fees
* Indirect:
* Sub-optimal decisions
* Rejecting risky projects to protect job security
113
**What is FVIF and how is it calculated?**
Future Value Interest Factor
(1 + r)^t = FVIF
FVIT(10%,4) = (1 + 0.1)^4 = 1.464
114
**What is PVIT factor and how is it calculated?**
Present Value Interest Factor
1 / (1 + r)^t = PVIT
PVIT(10%,4) = 1 / (1 + r)^t = 0.683
115
**What is a growing annuity?**
A growing stream of cash flows with a fixed maturity
116
**What is a coupon rate?**
The annual coupon divided by the face value of a bond, quoted as a % of face value
117
**Which two factors affect the level of interest rate risk?**
1. **Price risk**
1. Change in price due to changes in interest rates ==\> Longer term bonds & lower coupon rate bonds have more price risk
2. **Reinvestment risk**
1. Uncertainty concerning rates at which cash flows can be reinvested ==\> Shorter term bonds & higher coupon rates bonds have more reinvestment risk
118
**What are the four kinds of securities?**
**C-M-N-D**
1. **Collateral** - secured by financial securities
2. **Mortgage** - secured by real property (land and buildings)
3. **Notes** - unsecured debt with original maturity _less than 10 years_
4. **Debentures** - Unsecured debt with _10 or more years_ to maturity
119
**When is something considered to have an investment grade?**
With a rating of **_Baa/BBB and above_**
120
**What are treasury securities and what are the 3 types?**
**B-N-B**
Federal government debt
* **T-bills:** pure discount bonds with _less than 1 year_ original maturity
* **T-notes:** coupon debt with original _maturity of 1-10 years_
* **T-bonds:** coupon debt with original maturity _greater than 10 years_
121
**What are disaster bonds?**
Bonds issued by property and casualty companies to help fund excessive claims.
They pay interest and principal as usual UNLESS claims reach a certain threshold for a single disaster. At that point, bondholders may lose all remaining payments.
Thus a higher required return.
122
**What is special about "put" bonds?**
Shareholders can redeem for par at their discretion.
(can get their money back at par value whenever they want)
123
**What is interesting about the way Treasury bonds are quoted and how should you read bid 136:29 and asked 136:32 if the face value is $1000?**
Prices are quoted in 32nds (historical reasons).
Thus the smallest possible price change is 1/32 (the "tick" size).
Bid 136:29 = 136.29/32 % ==\> 132.906 % ==\> \*par value of $1000 = $1362.906
Difference from ask: 32-29 = 3 which is 3/32 of $1000 ==\> $93.75
124
What is the term structure of interest rates?
The relationship between time to maturity and yields, all else equal.
_Normal curve_: Longer time, higher yields
_Invert:_ long-term yields are lower than short-term yields
125
**What is a treasury yield curve?**
A plot of the yield on treasury notes and bodns relative to maturity, based on coupon bond yields.
Normal: up-ward sloping
Inverted: downward sloping
126
**What is a specialist?**
A specialist is a person who is member of a stock exchange (Fx NYSE), whose role is to facilitate trading in certain stocks.
Specialists must thus make a market in the particular stock/stocks they trade by displaying their best bid and ask prices to the market during trading hours.
127
**What is the formula for the non-constant dividend growth model and how does it differ from the constant DGM?**
_Non-constant DGM:_
Pt = Dt (1 + g) / (R - g)
_Constant DGM:_
Pt = Dt+1 / (R - g)
Pt = D1 / (R - g)
The non-constant growth model multiplies with "g", the dividend growth, in the nominator.
128
**Given the dividend and dividend growth rate, how do you calculate the required rate of return, R?**
**R = (D1 / P0) + g**
Stock seeling at $10.5 = P0
Just paid dividend of $1 = D0
Dividends growing with 5 % = g
R = ((1 + 0.05)/ 10.5) + 0.05 = 0.15
R = (D1 / P0) + g
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