FIN 432 Test 1

  1. proprietorship
    a business owned by 1individual; easily & inexpensively formed, subject to few gov't regulations, & no corporate income taxes (taxed as personal income); difficult to raise capital needed for growth, unlimited liability for business debts, & limited to the life of founder
  2. partnership
    when 2 or more people associate to conduct a business; if 1 dies then it dissolves; each is liable for the business's debts, so they can potientially lose all their personal assets; difficult to raise substantial amounts of capital
  3. corporation
    a legal entity created by state; separate & distinct from its owners & managers; unlimitied life, easy transfer of ownership, limitied liability (can only lose actual funds invested), easy to raise capital; double taxation & cost of set-up and report filing  
  4. charter
    the legal document that is filed with the state to incorporate a company; once filed it officially exists
  5. bylaws
    set of rules drawn up by the founders of a corporation; how directors are to be elected, whether exisiting shareholders will have the first right to buy any new shares the firm issues, & procedures for changing these themselves
  6. initial public offering (IPO)
    occurs when a closely held corporation or its principal stockholders sell stock to the public at large; raises cash & allows founders & beginning investors to "harvest" some of their wealth
  7. agency problem
    managers (agents) may act in their own interests & not on behalf of owners (stockholders)
  8. coporate governance
    the set of rules that controls a company's behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, & community; can help control agency problems
  9. free cash flows (FCF)
    the cash flow actually available for distribution to all investors (creditors & shareholders) after the company has made all investments in fixed assets & working capital necessary to sustain ongoing operations; sales revenues - operating costs - operating taxes - required investments in operating capital 
  10. weighted average cost of capital (WACC)
    the avg. rate of return required by all investors; proportion of debt, ps, & common equity (the firm's relative use of them as sources of financing) in the optimal or target capital structure; affected by interest rates, risk of the firm, & investors' overall attitude toward risk
  11. interest rate
    the price or cost of debt capital
  12. cost of equity
    the price or cost of equity capital; consists of the dividends & capital gains stockholders expect; equals required return
  13. country risk
    arises from investing or doing business in a particular country & it depends on the country's economic, political, & social environment; when these are stable= safe climate for investment; ex. changes in tax rates, regulations, currency conversion, & exchange rates
  14. exchange rate risk
    the fluctuation in exchange rates between currencies over time; non-dollar denominated investment's value depends on what happens to exchange rates
  15. stand-alone risk
    risk an investor would face if they held only this one asset (in isolation); measured by standard deviation (sigma); larger standard deviation, higher probability that returns will be far below the expected return = more risky
  16. expected rate of return
    the rate of return expected on a stock given its current price & expected future cash flows; if stock in equilibrium, the required rate of return will equal this
  17. coefficient of variation
    equal to the standard deviation divided by the expected return; allows comparisions between investments having different expected returns & standard deviations; shows risk per unit of return
  18. risk premium ( RP)
    the extra return (additional compensation) that an investor requires to hold risky stock instead of a risk-free asset
  19. correlation coefficient (p)
    measures how 2 variables change together; 1= they move up & down in perfect synchronization (positive); -1= they always move in opposite directions; 0= they are not related to one another, they're independent
  20. diversifiable risk (a.k.a. company-specific risk)
    that part of a security's total associated with random events not affecting the market as a whole; can be eliminated by proper diversification; caused by lawsuits, oil spills, strikes, winning/losing a major contract
  21. market risk
    that part of a security's total risk that CAN'T be eliminated by diversification; measured by the beta coefficient; these effect most firms= war, inflation, recessions, & high interest rates; how much risk this stock will add to the riskiness of the portfolio
  22. beta coefficient
    a measure of a stock's market risk; the extent to which the returns on a given stock move with the stock market; low= relatively unrelated to the market's returns, of little risk
  23. market risk premium ( RP)
    required by investors for bearing the risk of an average stock; must be added to the real risk-free rate of interest to compensate for interest rate risk; rM- rRF
  24. efficient portfolio
    provides the highest expected return for any degree of risk; provides the lowest degree of risk for any expected return
  25. efficient frontier
    the set of efficient portfolios out of the full set of potential portfolios; on a graph this constitutes the boundary line of the set of potiential portfolios
  26. indifference curve
    the risk-return trade-off function for a particular investor; reflect's that investor's attitude toward risk; the greater (steeper) the slope= the greater the investor's risk aversion
  27. characteristic line
    obtained by regressing the historical returns on a particular stock against the historical returns on the general stock market; the slope=beta (which measures the amount by which the stock's expected return increases for a given increase in the expected return of the market)
  28. Arbitrage Pricing Theory (APT)
    an approach to measure the equilibrium risk-return relationship for a given stock as a function of multiple factors; accounts for several factors like the GDP growth, expected inflation, tax rate changes, dividend yield, etc. in determining the required return for a particular stock
  29. Fama-French three-factor model
    includes factor for the market risk premium (rM - rRF), size effect (the return on a portfolio of small firms - big firms), & book-to-market effect (the return on a portfolio of firms w/ a high book-to-market ratio - firms w/ a low one)
  30. bond
    long-term contract under which a borrower agrees to make payments of interest & principal, on specific dates, to the holders; face value (paid at maturity) at $1,000
  31. call provision
    gives the issuing corp. the right to call the bonds for redemption; generally states that if the bonds are called the corp. must pay bondholders an amount greater than the par value=call premium
  32. sinking fund
    facilitates the orderly retirement of a bond issue; the company can call for redemption (at par value) a certain % of bonds each year or may buy the required amount of bonds on the open market; to pay off a loan over its life rather than all at maturity
  33. discount
    when a bond's required rate of return rD > coupon rate; less than $1,000
  34. premium
    when a bond's required rate of return rD < coupon rate; greater than $1,000
  35. current yield (on a bond)
    the annual coupon payment divided by the current market price; rate of return due to the interest payment; the amount of cash income that a bond will generate in a given year; YTM - capital gains yield
  36. capital gains yield
    rate of return due to changing prices; new price - old price / old price; YTM - current yield
  37. yield to maturity (YTM)
    the rate of interest earned on a bond if it is held to maturity; usually the same as the market rate of interest rD; current yield + capital gains yield; the bond's promised rate of return; assumes the bond will not default
  38. yield to call (YTC)
    the rate of interest earned on a bond if its called; if current interest rates are well below an outstanding callable bond's coupon rate, bond likely to be called
  39. inflation premium (IP)
    added to the real risk-free rate (r*) of interest to compensate for the expected loss of purchasing power; the avg. rate of inflation expected over the life of the security; expected in the future not experienced in the past
  40. nominal or quoted risk-free rate of interest (rRF)
    the real risk free rate (r*) + IP (for expected flation); approximated by the U.S. Treasury bill rate for the short-term and U.S. Treasury bond rate for the long-term
  41. indentures
    a legal document that spells out the rights of both bondholders & the issuing coporation
  42. restrictive covenants
    cover points in an indenture such as the conditions under which the issuer can pay off bonds prior to maturity, the levels at which certain ratios must be maintained if the co. is to issue additional debt, & restrictions against the payment of dividends unless earning meet certain specifications; designed to protect both the bondholder & the issuer even though they may constrain the actions of the firm's managers
  43. bond spread
    the difference between a bond's yield and the yield on some other security of the same maturity; Default Risk Premium (DRP) + Liquidity Premium (LP); vary w/ rating of security & increase as maturity increases
  44. maturity risk premium (MRP)
    must be added to r* to compensate for interest rate risk, which depends on the bond's maturity; selling a bond before maturity=capital loss, the longer the term to maturity, the larger the loss; long-term bonds must have a higher expected rate of return than short-term bonds, additional return is this
  45. reinvestment rate risk
    if interest rates fall, bondholder will suffer a reduction in his/her income= lower interest payments & ending value; high on callable bonds; shorter the maturity of a bond, the fewer years when the relatively high old interest rate will be earned, & the sooner the funds will have to be reinvested at a new low rate
  46. classified stock
    sometimes created by firm to meet special needs & circumstances; when special classifications of stock are used, one type designated "Class A", another "Class B", & so on
  47. founders' shares
    stock owned by the firm's founders that have sole voting rights but restricted dividends for a specified # of years
  48. tracking or target stock
    the dividends are tied to a particular part of the company as a whole; to separate cash flows, allow separate valuations of divisions, & its easier to compensate division managers
  49. market multiple method
    multiplies a market-determined ratio (called a multiple) by some value of the target firm to estimate the target's value; can be based on net income, earnings per share, sales, book value, or # of subscribers
  50. equilibrium
    the condition under which the intrinsic value of a security is equal to its price; when a security's expected return is equal to its required return 
  51. Efficient Markets Hypothesis (EMH)
    states that stocks are always in equilibrium, "fairly priced", and that is impossible for an investor to consistently "beat the market"; assumes that all important info. regarding a stock is reflected in the price of that stock; doesn't assume all investors are rational
  52. weak form EMH
    assumes that all info. in past price movements is fully reflected in current market prices; thus, info. about recent trends in a stock's price is of no use in selecting stock (can't tell us what it would do today or tomorrow)
  53. semistrong form EMH
    states that current market prices reflect all publicly available info; therefore, the only way to gain abnormal returns on a stock is to possess inside info. about the co. stock; no use to pore over annual reports looking for undervalued stocks; stock prices will respond only if the info. released is different from what had been expected
  54. strong form EMH
    assumes all info. pertaining to a stock, whether public or inside info, is reflected in current market prices; thus, no investors would be able to earn abnormal returns in the stock market; not true
Card Set
FIN 432 Test 1
Chapter 1-4