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Finance
exam 3 (chps 4,8,9)
85
Business
Undergraduate 3
03/15/2011

Additional Business Flashcards

 


 

Cards

Term
percent of sales forecasting
Definition
estimating future budgets based on estimated sales
Term
pro forma
Definition
used for strategic purposes for two or three years
Term
cash budgets
Definition
short term, month, quarter, annual
Term
why financial forecasting?
Definition
given our expectations for future sales growth, how much debt or equity financing do we need for the next year, 5 years, or ten years
Term
DFN/EFN
Definition

descretionary financing needed/ external financing needed

 

DFN is based on percent of sales forecast method

 

how much we need to sustain future growth

Term
GIGO
Definition

garbage in garbage out

 

DFN is based on assumptions-make good ones

 

it helps us prepare for the future by what we know today, it helps prevent dumb mistakes

Term
two classes of people- those who don't know and those that don't know the don't know
Definition
John Kenneth Galbraith
Term
Percent of Sales Method Steps
Definition

1) project sales revenues and expenses

2)forecast change in spontaneous balance sheet accounts

3) Deal with discretionary accounts

4)calculate RE

5)determine total financing needs

6)calculate DFN

Term
who determines the projected sales?
Definition
marketing
Term
what three ways is the pro forma income statement linked to the balance sheet?
Definition

RE

depreciation-FA - depreciation

forecasted interest expense

 

Term

spontaneous accounts

 

Definition
changes directly with sales-CA, CL-accounts payabel, accruals (except for NP)
Term
non-spotaneous/discretionary accounts
Definition

do not increase automatically with sales- LTD, NP, CS

 

fixed Assets depend on full capacity or not

Term
dividend payout ratio
Definition
Div/NI
Term
retention or plowback ratio
Definition
RE/NI or (1-payout ratio)
Term
total financing need =
Definition
total assets
Term
DFN =
Definition
projected total assets-projected total liabilities-projected owners' equity
Term
plug figure?
Definition
DFN
Term
four possible ways to decrease DFN
Definition

1) slow sales-increase prices

2) Examine capacity constraints-outsource, lower projected FA

3) Lower Dividend payout

4) Increase net margin or cut costs

Term
SGR
Definition

sustainable growth rate- the only growth rate which allows the firm to maintain its present financial ratios and avoid the sale of new equity

 

SGR = ROE (1-b) = NI/S x S/E x A/E x (1-b)

 

How fast can the firm grow in a steady state the four ratios stay constant

 

the fastest steady rate that the firm can grow

Term

profitability

asset utilization

leverage

plowback

Definition

NI/S

S/A
A/E

(1-b)

Term
SGR in english
Definition

maximum sales growth a firm can have while maintaining a constant debt-to-equity ratio value without any new external equity financing.

 

(they can still get debt through AP, but they have to increase the equity through RE. to maintain the ratio)

Term
why of cash budgets?
Definition

good to negotiate with short-term lenders

 

it shows if they have enough cash in the short run how liquid they are

 

1) budgets indicate the amount and timing of future financing needs

 

2) make plans to take corrective action if they don't balance

3) provide the basis for performance evaluation

Term
Create a Cash Budget
Definition

1) determine cash receipts- sales projections and AR collection historical data

2) estimate outflows (logistics and demand)

3) Create the budget net CF + beginning cash borrowing requirement

Term
risk
Definition
uncertainty the chance that something good or bad will happen
Term
bankers year has how many days?
Definition
360-using 360/holding period annualizes the return
Term

expectational data (return)

 

 

 

historical data (return)

Definition

 

expected return = sum of (probability(i) * rate(i))

 

 

 

annualized return = ins/outs * 360/holding period

Term
nominal rate =
Definition

interest rate without inflation

 

(fisher effect)

Rnominal = Rreal + inflation

 

banks show you the nominal

Term
define risk
Definition
the possibility that the realized or actual return will differ from our expected return
Term
standard deviation
Definition
a measure of dispersion of possible outcomes about the mean
Term

std deviation equation

 

Definition

std dev = sqrt(sum(Ri-Rmean)^2*prob of i)

 

one std dev = 68% of observations

 

+2 -2 std dev = 95% of observations

 

(normal curve)

 

std dev measure the firms total risk

Term
systematic risk
Definition
market risk, the risk inherent in the economy as a whole, non-diversifiable, Beta is the measure of this risk
Term
unsystematic risk
Definition

diversifiable, idiosyncratic, firm specific

(not standard of measure)

Term
firm specific risk examples
Definition

company's labor force goes on strike

top management dies

oil tank burst and floods company

Term
market risk examples
Definition

unexpected changes in interest rates

business cycle changes

unexpected cash flow changes due to tax changes

Term
can beta or correlation be -1?
Definition
yes Beta gold is -1, perfect negative correlation
Term
lower correlation means?
Definition
greater diversification and lower risk
Term
NASDAQ
Definition
national association of securities dealers automated quotation system.
Term
lot of high systematic risk companies?
Definition
apple, high tech companies
Term
low systematic risk
Definition
utility companies, non luxury items
Term
the market beta will always equal?
Definition
1
Term
companies with high betas are known as beta>1
Definition
agressive assets
Term
companies with low betas < 1
Definition
defensive assets
Term
what has a beta of 0?
Definition
cash
Term
required rate of return
Definition

return on equity, the return on an investment required by investors given the investment's risk

 

Required rate of return = risk free rate(tbills) + Risk premium

Term
systematic risk principle
Definition
notion that the size of the risk premium is based on market risk
Term
SML
Definition
security market line, required rate of return as a function of the risk free rate and a risk premium determined by beta.
Term
CAPM
Definition
Ri = Rf + Beta(i)(Rm - Rf) - provides us with a way to price risk (not perfect)
Term
(Rm - Rf) =
Definition
market risk premium
Term
how can we determine over/under priced?
Definition

discount the future value after you've determined the require rate of return

 

or

 

HPR-holding period return = (p1-po)/po

Term
why would you use the build up method?
Definition

if there is a poorly diversivied investor like entrepreneurs

 

because this needs to take into account the firm risk

Term
Build-up Method
Definition
Bond yield + Equity Risk Premium + Micro-cap Premium + Start-up risk premium
Term
large cap stock =
Definition
bond yield + equity risk premium = base equity rate
Term
small but established company =
Definition
Bond yield + equity risk premium + micro-cap risk premium = micro-cap equity rate
Term
start-up company
Definition
between 17-25 % or higher returns
Term
ETF
Definition
elctronically traded fund-can be traded anytime
Term
risk premium =
Definition
Beta(Rm-Rf)
Term
What percent of fortune 500 companies use CAPM
Definition
90%
Term
Why use R^2?
Definition

it adjusts for the degrees of freedom

 

= % variation

 

average R^2 is between 20-25%

 

by central limit theorom you need at least 30 observations

 

 

R^2 will always be higher than adjusted R^2

Term
what are 2 assumptions for excel
Definition

dependant variable distribution must be normal

 

errors are not correlated, they have to be random

Term
ANOVA = ?
Definition
analysis of variance
Term
Short comings of capm
Definition
  • The model assumes that either asset returns are (jointly) normally distributed random variables or that investors employ a quadratic form of utility. It is however frequently observed that returns in equity and other markets are not normally distributed. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect.[3]
  • The model assumes that the variance of returns is an adequate measurement of risk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent risk measures) will likely reflect the investors' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature.
  • The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).[citation needed]
  • The model assumes that the probability beliefs of investors match the true distribution of returns. A different possibility is that investors' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001)[4].
  • The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).[citation needed]
  • The model assumes that given a certain expected return investors will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.[citation needed]
  • The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.[citation needed]
  • The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.[citation needed]
  • The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique.[5]
  • The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[citation needed]
  • CAPM assumes that all investors will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual investors: humans tend to have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio —
Term
Fama - French three-factor model
Definition

[image]

 

 

Term
significant F
Definition
1-sign F tells you how sure you can reject the null
Term
null hypothesis
Definition

the model has NO explanatory value

 

the alternative would be that it does have explanatory value

Term
P-value
Definition
same as signif F but for each variable
Term
T-stat
Definition
if t-stat is above 2 then we can reject the null for each variable (or it does have explanatory power)
Term
The return that shareholders require on their investment in the firm is called the:
Definition
cost of equity.
Term

financing decision

 

 

 

investment decision

Definition

Liabilities and equity

 

 

 

 

 

assets

Term
cost of capital
Definition

required return (investors)

 

cost of raising funds needed to operate the firm (financial managers)

 

coc - R (stockholders)

Term
flotation costs
Definition
transaction fees when you issue new debt or stocks
Term
pre-tax cost of debt
Definition
Kd
Term
after tax cost of debt
Definition
Kd(1-t)
Term
Gordon Growth Model
Definition
Vo = D1 / (kcs-g)
Term
external cost of equity
Definition

CAPM r * (1+float cost)

 

Build Up r * (1+float cost)

 

Gordon Growth P * (1-float)

Term
WACC
Definition

= Ci/V*(Kics) + Co/V*(Kocs) + P/V*(Kps) +

 

N/V*(Kn)*(1-t) + B/V*(Kb)*(1-t)

Term
DCF
Definition

Vo = sum( FCFFt/(1+WACC)^t)

 

 

k=WACC to solve for discounted cash flows

Term
NPV
Definition

tells you if you should invest in a project or not

 

Vo = sum((FCFt/(1+k)^t) - IO)

 

sometimes we can use WACC in this equation (when you are extending the firm-NOT for new projects)

Term
pure play
Definition
analyze a firm that is already in the market
Term
sharps ratio
Definition

S = stock return - risk free / std dev

 

if its the same time yo udon't have to take out the risk free

 

(abnormal return)

 

the higher the sharpe return the better

Term
Madligluani and Miller
Definition

theory of capital structure

 

(optimal D/E mix)

 

take debt until your WACC is minimized (until financial distress)

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