Finance Final Exam Review

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9 Dec 2013
Finance Final Exam Review
December 2013
Chapter 1 / Lecture 1 & 2
Finance the study of how and under what terms savings (money) is allocated
between lenders and borrower
Capital budgeting (capital expenditure) the process of making and managing
expenditures on long lived assets
Capital structure represents the proportions of the firm’s financing from current
and long term debt and equity (think of the firm like a pie, composed of debt and
Creditors the persons or institutions that buy debt from the firm
Shareholders the holders of equity shares
Value of the firm = debt + equity
-the shareholders’ claim on firm value at the end of the period is the amount that
remains after the debtholders are paid they get nothing if the firm’s value is equal
to or less than the amount promised to debtholders, or they get the residual of the
firm’s value over the amount promised to debtholders if the firm’s value is greater
than the amount promised to debtholders
-debt and equity are contingent claims on the total firm value
Arbitrage exploiting price differences to earn riskless profit. There must be an
absence of arbitrage as soon as different interest rates are offered for essentially
the same risk free loans, arbitrageurs will take advantage of the situation by
borrowing at the low rate and lending at the high rate. The gap between both rates
will be closed quickly. i.e. Seinfeld video in class travelling across state border to
get more money for beer cans
Sole proprietorship a business owned by one person
-cheapest to own, no corporate income taxes, unlimited liability, the life extends
over the length of the sole proprietor, equity money limited to proprietor’s personal
General partnership business in which any two or more partners agree to
provide some fraction of the work and cash to share the profits and losses. Each
partner liable for debts
Limited partnership permit the liability of some of the partners to be
limited to the amount of cash each has contributed to the partnership.
-partnerships are inexpensive & easy to form, have life the length of any general
partner, taxed as personal income, difficult to raise large amounts of cash
Corporation a business that is a distinct legal entity that can issue stocks, does not
hold any shareholder personally liable, has a perpetual life, and has corporately
taxed income
Agency costs the costs of resolving the conflicts of interest between managers and
Direct agency costs costs of things like job perks (corporate jet), monitoring you
are spending $$
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Indirect agency costs costs of a missed opportunity i.e. management buys the CEO
an expensive painting, missing the opportunity of a profitable investment
-managerial goals are different from those as shareholders the principal hires the
agent (management) to represent his interest, but agents have a tendency to be
motivated by their expenses (like company cars, company dinners etc) which
definitely don’t maximize shareholder wealth
-shareholder wealth maximization is considered the most appropriate goal to guide
agents (NOT accounting profit maximization, since it changes with depreciation and
ignores timing)
-shareholders (owners) don’t necessarily control managers; depends on the costs of
monitoring management, the costs of implementing control devices, and the
benefits of control
How can you address the conflict of interest?
a) Compensation plans i.e. stock options
b) Have a board of directors chosen by shareholders, choose the management
c) Market discipline i.e. lay-off, hostile takeover
Financial Institutions facilitate flows of funds from savers to borrowers i.e.
banks, insurance companies, etc.
Financial Markets markets where you can trade financial instruments (or
- short-term debt securities are bought and sold in money markets
- long-term debt and shares of stock are sold in capital markets
Primary markets refer to the original sale of securities by governments and
corporations (i.e. an IPO)
Secondary markets markets where these securities are bought and sold after the
original sale, either in an exchange or over the counter in a dealer market
Foreign exchange market the market where one country’s currency is traded for
Direct financing involves financial intermediaries, whereas indirect financing does
2 Major Categories of Financial Securities
Debt Instruments
Equity Instruments
Commerical Paper
T-bills and notes
Mortgage loans
Common stock
Preferred stock
Chapter 4/Lecture 2
Financial intermediaries institutions that match borrowers and lenders
Market clearing the total amount of people who wish to lend to the market must
equal the total amount of people that wish to borrow from the market. If lenders
wish to lend more than the borrowers wish to borrow, the interest rate is too high,
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and vice versa. The interest rate that clears the market is the equilibrium rate of
Investment Rule Basic Principle an investment must be at least as desirable as
the opportunities available in the financial markets (i.e. you won’t take on an
investment whose return is 5% if the interest rate in the markets is 7%)
A Competitive market has three qualities:
1) trading is costless
2) information about borrowing and lending opportunities is readily available
to all market participants
3) there are many traders, and no individual can move market prices (price
Example 1. A person has an income of $50 000 this year and $60 000 next year. The
interest rate r = 10%. The figure shows all possible consumption opportunities open
to the person through borrowing and lending
Point A represents consuming nothing this year (lending $50,000), and everything
(second year income & proceeds from the loan) next year:
A = 60,000 + 50,000 (1 + .10)
Point B represents spending everything this year, including taking out a loan to
spend next year’s income:
B = 50,000 + 60,000/1.10
Point C represents spending $40,000 of this year’s income this year and saving
-next year you would be able to spend $60,000 + 10,000(1.10)
The line has a slope of (1+r), so that for each additional dollar spent today, (1+r)
less dollars can be spent next year
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