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Comm 121- Final Review Package.docx

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COMM 121
Fabio Moneta

Chapter 1  Goal of firm is to maximize value of SH wealth Firm must create wealth: 1) Buy assets that generate more money than they cost 2) Sell securities that generate more money than they cost Three objectives of Finance 1) What should we invest in?  Capital Budgeting 2) How should we make these investments?  Capital Structure 3) How should we manage short term operational cash flows?  Net working capital = current assets – current liabilities Balance Sheet Model of Firm Total Value of Assets Total Value of Firm to Investors Current Assets Current Liabilities Assets with short lives Short-term debt that must be repaid within a year Long-Lived Assets Long-Term Debt Assets with long lives Long-term debt that does not have to be Tangible or intangible repaid within a year *In order to purchase long-lived Shareholders’ Equity assets, firm must obtain financing Difference between assets and debt Capital Structure Creditor: person/institution that buys debt from firm (B) Shareholder: holder of equity shares (S) The size of the firm is value of firm as determined by financial markets  V = B + S Capital Budgeting Process of making and managing expenditures of long-lived assets Important variable: cash flow to firm, NOT shareholders Two Important Considerations in Finance 1) Timing of cash flows - The value of investment depends on timing of cash flows - Prefer to receive sooner 2) Risk of cash flows - Important to consider Debt and Equity as Contingent Claims If value of firm is greater than or equal to F, debtholders get F If value of firm is less than F, debtholders get X Shareholders’ claim on value of firm is residual amount after debtholders have been paid  if value of firm is less than amount promised to debtholders, SH get nothing If value of firm is greater than amount promised to debtholders, SH get residual amount If value of firm is less than amount promised to debtholders, SH get nothing and debtholders get value of firm Corporation - Distinct legal entity - Three sets of distinct interests: SH, Board of Directors, corporate officers - Agency costs  cost of resolving conflicts of interest between SH and management - Set-of-contracts perspective  firm can be seen as nothing more than set of contracts - Principle-agent relationship  management (agent) is responsible for managing firm in best interest of principles (SH) - Advantages: 1) Ownership through shares  easily transferable 2) Unlimited lives  corporation separate from owners 3) Limited liabilities  liability limited to amount invested 4) Easy to raise cash - Disadvantages: costly (start-up, taxes) Money vs. Capital Markets Money Market Short-term debt securities Actually own commodity ”Dealer market” Capital Market Long-term debt and equity Don’t own commodity NYSE, TSX Primary vs. Secondary Capital Markets Primary: original sale of securities 1) Public offering  selling to public 2) Private placement  negotiated sale Secondary: selling or buying after original sale 1) Auction market  physical location, limited use of dealers, NYSE 2) Dealer market  connected electronically, use of dealers, “over-the-counter market”, NASDAQ Chapter 4 Fisher Separation Theorem Important: 1) motivates existence of financial markets 2) motivates NPV rule  invest in positive NPV projects SH can ensure that managers follow rule 3) motivates idea of separation between investment and consumption decisions Anonymous Market - Financial markets facilitate lending and borrowing - Financial intermediaries match lenders to borrowers - Need to ensure market clears  # of lenders = # of borrowers  achieved with equilibrium interest rate - If interest rate is too high, lenders will be willing to supply more than what borrowers demand - If interest rate is too low, borrowers will demand more than what lenders are willing to supply Competitive Market - Assume perfectly competitive market  price takers - Firms have no effect on prices or rates  equilibrium interest rate - If two or more interest rates, arbitrage will occur - Arbitrageurs will take advantage of the situation by borrowing at low rate and lending at high rate  creates a gap in the market that dealers must pay for - Unsustainable; equilibrium persists in LR Basic Principle: interest rates serve as benchmark for investment decisions  any investment must be at least as good as what is available in the market NPV Rule -investment + payoff (1+r)n if positive NPV, accept if negative NPV, reject Separation Theorem: all investors will either accept or reject an investment based on the NPV rule regardless of consumption preferences Chapter 5 Time Value of Money – Lump Sum of Cash Flows PV = FV  PV and discounting; PV of all future cash flows (1+r) n n FV = PV (1+r)  FV and compounding; FV of all cash flows received We can earn simple interest  C x r T We can earn compound interest  r Perpetuity - Constant stream of cash flows without end - Never receive face value - Ex: preferred equity, British Consols PV =tc t+1 r Growing Perpetuity - If cash flow is growing at g percent per year indefinitely PV = c , r > g t t+1 r – g Annuity - Constant stream of payments for fixed number of periods - Ex: pension, mo
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