Finance Final Exam Review

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Business Finance I (Carleton University)

StuDocu is not sponsored or endorsed by any college or university

Finance Final Exam Review

Business Finance I (Carleton University)

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Chapter 1

3 major forms in Canada:

1. Sole Proprietorship

2. Partnership (General or Limited)

3. Corporation

1. Sole Proprietorship

Advantages Disadvantages

Easiest to start Unlimited liability

Least regulated Limited to life of owner

Single owner keeps all the profits Equity capital limited to owner’s

personal wealth

Taxed once as personal income Difficult to sell ownership interest

2. Partnerships

General- all the partners share in gain or losses and all have unlimited liability for all

partners debt, not just some particular share

Limited- one or more general partners, has unlimited liability and runs the business for

one or more limited partners who do not actively participate in the business

Advantages Disadvantages

Two or more owners Unlimited liability for GENERAL

partnership

More capital available Limited partnership

Relatively easy to start Partnership dissolves when one

partner dies or wishes to sell

Income taxed once as personal

income

Difficult to transfer ownership

3. Corporation

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Advantages Disadvantages

Limited liability Separation of ownership and

management

Unlimited life Double taxation (income is taxed

at the corporate rate and then

dividends are taxed t the personal

rate)

Separation of ownership and

management

Transfer of ownership is easy

Easier to raise capital

Primary Goal of Financial Management

To Maximize shareholder wealth

To Maximize share price

To Maximize firm value

The agency problem

Agency relationship

Stockholders (principals) hire managers (agents) to run the company

Agency Problem

Conflicts of interest can exist between the principal and the agent

i.e, CP Rail’s (train company) executive and one of its major

shareholders

2 types of Agency costs

1. Direct agency costs

a. The purchase of something for management that can’t be

justified from a risk-return standpoint, monitoring costs

2. Indirect agency costs

a. Management’s tendency to sacrifice risky or expensive projects

that could be justified from a risk-return standpoint

Money Market vs. Capital Markets

Money market

Deals with the buying and selling of short-term debt securities (less than

a year to maturity)

“Money market instruments”

 Bankers acceptances, Treasury Bills (T-bills), Dealer market-chartered

banks, investment Dealers

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Capital market

Markets for the buying and selling longer term debt and shares of stock

i.e, TSX, New York, London, Tokyo, Hong Kong

TSX is owned by the Major Canadian Financial Institutions

Main players- Bank, investment dealers

Primary Markets vs. Secondary Markets

Primary Markets

The corporation is the seller and the transaction raises money for the

corporation

Corporations engage in 2 types of primary markets:

Initial Public Offering (IPO)

oTo the general public

oAre underwritten –investment dealers (must be registered)

oi.e. Facebook

Private Placement

oSmaller Amounts, often used in mining and oil exploration

industry

Secondary Market

Means of transferring ownership of securities

The issue company does not receive additional funds from this

transaction

2 types of secondary markets:

Dealer markets

oReferred to as “Over-the-counter” market (OTC)

oTrading in debt securities takes place over the counter, with

much of the trading now conducted electronically

Auction markets

oPhysical location

oMatching of buyers and sellers

Chapter 5-6

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Present Value – the current value of future cash flows discounted at the

appropriate discount rate

Future Value – The amount of an investment worth after one or more

periods. Also compounded value

Interest Rate – “exchange rate” between the PV and FV

oDiscount rate – the rate used to calculate the PV of future cash

flows

oCost of Capital – refers to the opportunity cost of making a

specific investment

oRequired Rate of Return (RRR) – the minimum annual percentage

earned by an investment that will persuade individuals or

companies to put money in a particular security or project

FV- important relationships

oFor a Given Time Period , é Interest rate é FV and vice versa

oFor a Given Interest Period, éTime period é FV and vice

versa

PV- important relationships

oFor a Given Interest Rate, éTime Period ê PV and vice versa

oFor a Given Time Period, ê Interest Rate é PV and vice versa

Annuity – A level stream of cash flows for a fixed period of time

oIf first payment occurs at the END of the period, it is called

Ordinary Annuity

oIf the fist payment occurs at the BEGINNING of the period, it is

called Annuity Due

Perpetuity – An annuity in which the cash flows continue forever

Growing Perpetuity – A constant stream of cash flows without end that is

expected to rise infinitely

Growing Annuity – A finite number of growing annual cash flows

Effective Annual Rate (EAR) – the interest rate expressed as if it were

compounded once per year

 Annual Percentage Rare (APR)- the interest rate charged per period

multiplied by the number of periods per year

oNEVER divide EAR by the number of periods (n)

Chapter 7

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Bond – basically an interest-only loan; other words, borrower pays the

interest every period, but none of the principal is repaid until the end of

the loan

Coupon – the stated interest payment made on a bond

Par value (face value) – The principal amount of a bond that is repaid at

the end of the term. Also par value

Coupon rate – the annual coupon divided by the face value of a bond

Maturity date – specified date at which the principal amount of a bond is

paid

Yield to maturity rate (YTM) – The market interest rate that equates a

bond’s PV and principal repayment with its price

Relationship between Coupon Rate and Yield to Maturity (YTM)

If YTM=coupon rate, then par value=bond price

If YTM>coupon rate, then par value>bond price

oCalled DISCOUNT BOND

IF YTM<coupon rate, then pa value<bond price

oCalled PREMIUM BOND

Interest Rate Risk

Price risk

oChange in price due to changes in interest rates

oLong-term bonds have more price risk than short-term bonds

Reinvestment Rate Risk

oUncertainty concerning the interest rates at which cash flows

can be reinvested

oShort-term bonds have more reinvestment rate risk than long-

term bonds

Longer the time to maturity, the greater the interest rate risk

The lower the coupon rate, the greater the interest rate risk

Yield to Maturity is not the same as the Coupon Rate

Debt vs. Equity (Table)

Debt

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Not an ownership interest in the firm

Creditors (bondholders) do not have voting rights

Interest is considered a cost of doing business

Dividends paid to shareholders are tax deductible

Unpaid debt is a liability of the firm

Equity

It is an ownership interest in the firm

Common shareholders vote for the board of directors and other issues

Dividends are not considered a cost of doing business

Dividends paid to shareholders are not tax deductible

Dividends are not a liability of the firm

An all equity firm can not go bankrupt

Bonds Equity

Ownership No Yes, vote for management

Tax Interest Deductible Dividends not deductible

Legal Rights Yes No

Bankruptcy Too much debt-increases

risk

All equity financed risk-

smaller risk

Indenture – written agreement between the corporation and the lender

detailing the terms of the debt issue; it includes

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