Exam 1 Study Guide

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Exam 1 Study Guide

Study Guide
University of Texas at Austin
Fin 320f - Foundations of Finance

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FIN 320F 1st Edition Exam # 1 Study Guide Chapters: 5– 7 Chapter 6: Debt 1. A financial instrument is a particular type of debt or equity that a company issues to the public to raise money. There are three basic types of financial instruments: debts (like loans and bonds), equities (as in stock) and derivatives (like stock options). a. Debt is borrowed money that must be repaid. i. The principal is the amount that must be repaid by the end of the term. The principal is also called the maturity value, par value, and/or face value. ii. The interest rate is the borrower’s cost of the debt. With bonds, the interest rate is called the coupon rate. With T-bills, the interest rate is called the both the discount rate and the risk-free rate, rRF. iii. The maturity date is when the principal must be repaid. iv. With bonds, the interest payment, INT, equals the par value of the bond, M, times the annual coupon rate, C, then divided by the number of payments per year, m. INT = (M  C) ÷ m. Almost all US corporate bonds pay coupon interest payments semi-annually; so in our class, m (for bonds) will always be 2. Almost all US corporate bonds have a face value of $1,000; so in our class, M will always be $1,000. v. In the event of liquidation, debt holders have priority over equity holders. Employees and customers are paid first, followed by the government, debt holders (aka creditors/lenders/debt investors), and equity holders (aka owners/equity investors/stock holders). vi. Debt holders do not have voting rights, but can exert some influence through bond indentures or loan contracts. vii. Federal government debt includes US Treasury bills, notes and bonds. These are considered to be default-free instruments. Since the federal government can simply borrow new money to pay its debts, it has never defaulted on its debt. As a result, we assume the federal government will never default. Thus, the Default Risk Premium (DRP) on a Treasury instrument is always 0%. viii. State and local government debt includes revenue-generating municipal bonds and general obligation municipal bonds (both are referred to as “munis”). Revenue-generating bonds are repaid with revenue generated by the project that the bond financed; general obligation bonds are repaid with property tax dollars. ix. Corporate debt includes commercial paper, term loans, junk bonds and investment grade bonds. (See “Types of debt” in the text for details.) When companies take out loans (a private placement of debt), they need only work with one or two banks to get the money. It’s a relatively fast and flexible process. When companies issue bonds (a public issue of debt), they need to work through an investment banker and borrow funds from potentially thousands of investors. The process is much more expensive and time consuming—but also makes it possible to borrow a lot more. 1. A bond indenture is the contract between the buyer and seller (or lender and borrower). The indenture specifies ...

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