MBA Interview Q&A (Part-4)

Financial terms

Green Shoe Option:-An option that allows the underwriting of an IPO to sell additional shares to the public if the demand is high.

Underwriters:-A company or other entity that administers the public issuance and distribution of securities from a corporation or other issuing body. An underwriter works closely with the issuing body to determine the offering price of the securities, buys them from the issuer and sells them to investors via the underwriter's distribution network.

Underwriters generally receive underwriting fees from their issuing clients, but they also usually earn profits when selling the underwritten shares to investors. However, underwriters assume the responsibility of distributing a securities issue to the public. If they can't sell all of the securities at the specified offering price, they may be forced to sell the securities for less than they paid for them, or retain the securities themselves.

Underwriting :-   1. The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).

2. The process of issuing insurance policies

Initial Public Offering(IPO):-The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded.

In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), best offering price and time to bring it to market.

Also referred to as a "public offering". IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value.

Prospectous:-1. A formal legal document describing details of a corporation. The prospectus is generally created for a proposed offering (usually an IPO), but it can still be obtained from existing businesses as well. The prospectus includes company facts that are vitally important to potential investors.

2. In the case of mutual funds, a prospectus describes the fund's objectives, history, manager background and financial statements. 

Red herring:-A preliminary registration statement that must be filed with the SEC describing a new issue of stock and the prospects of the issuing company.

There is no price or issue size stated in the red herring, and it is sometimes updated several times before being called the final prospectus. It is known as a red herring because it contains a passage in red that states the company is not attempting to sell its shares before the registration is approved by the SEC.

Minority interest:-A significant but non-controlling ownership of less than 50% of a company's voting shares by either an investor or another company.

In accounting terms, if a company owns a minority interest in another company but only has a minority passive position (i.e. it is unable to exert influence), then all that's recorded from this investment are the dividends received from the minority interest. If the company has a minority active position (i.e. it is able to exert influence), then both dividends and a percent of income are recorded on the company's books.

Consolidate:-To combine the assets, liabilities, and other financial items of two or more entities into one.

Annual Report:-A corporation's annual statement of financial operations. Annual reports include a balance sheet, income statement, auditor's report, and a description of the company's operations.

Cash Flow:- An accounting statement - the statement of cash flows - that shows the amount of cash generated and used by a company in a given period, calculated by adding non-cash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a company's financial strength.

Burn Rate:-The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations. In other words, it's a measure of negative cash flow.

Venture Capital:-Financing for new businesses. In other words, money provided by investors to startup firms and small businesses with perceived, long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets and typically entails high risk for the investor but has the potential for above-average returns.

Off balance sheet financing:-A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants

Lease:-An agreement in which one party gains a long-term rental agreement, and the other party receives a form of secured long-term debt.

Capital lease:-A lease considered to have the economic characteristic of asset ownership.

Operating lease:-A lease contract that allows the use of an asset, but does not convey rights similar to ownership of the asset.

Stock Option:-A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.

In the U.K., it is known as a "share option". 

American options can be exercised anytime between the date of purchase and the expiration date. European options may only be redeemed at the expiration date. Most exchange-traded stock options are American.

Derivative:- In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. 

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros. 

Forward Contracts:-A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.

Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest.   

Futures:-A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures

The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade.

Hedge:-Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

Leverage:-1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. 

Operating leverage:-A measurement of the degree to which a firm or project relies on fixed rather than variable costs.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. If the majority of costs for a company or project are fixed, then the costs will remain high while sales are dropping.

Over hedging:-A hedged position in which the offsetting position is for a greater amount than the underlying position held by the firm entering into the hedge. While hedging ensures price certainty, over-hedging can in effect become partly a hedge and partly a speculative investment and can unduly hurt a firm.  

1.  What is Mutual Fund?

Mutual Fund is a security that gives small investors access to a well-diversified portfolio of equities, bonds and other securities. Each shareholder participates in the gain or loss of the fund. Shares are issued and can be redeemed as needed. The fund's net asset value (NAV) is determined each day. Each mutual fund portfolio is invested to match the objective stated in the prospectus.

2.  What is meant by Portfoilo Management?

The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance. Portfolio management is all about strengths, weaknesses, opportunities, and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and numerous other trade-offs encountered in the attempt to maximize return at a given appetite for risk.

3.  What are Primary Markets and Secondary Markets?

Primary Markets: Primary Markets are places where a newly issue security is first offered. All subsequent trading of this security occurs is done in the secondary market. Secondary Market is a place where securities are traded after they are initially offer in the primary market. Most trading  occurs in the secondary market. The NYSE, as well as all other stock exchanges and the bond markets, are secondary markets. seasoned securities are traded in the secondary market. Security is a piece of paper that proves ownership of stock and other investment

4.  What is meant by Amortization and Impairment?

Amortization

Definition 1: The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time. Such payments must be sufficient to cover both principle and interest.

Definition 2: Writing off an intangible asset and investments over the projected life of the asset.

Negative amortization: A gradual increase in mortgage debt that occurs when the monthly payment is insufficient to cover the interest due, and the balance owed keeps increasing (at least in the first few years).

Amortization method: A distribution  calculation method for making penality-free early withdrawal  from retirement accounts. An assumed earnings rate is applied over the duration of the individual's life expectancy, while the life expectancy is determined using IRS tables. Generally, the rate must be within 120% of the applicable federal long-term rate. Once the rate is determined, the withdrawal remains fixed each year.

Impairment

The amount by which, stated capital is reduced by distributions and losses is called impairment.

5.Definition of buyout

      Buyout is defined as the purchase of a company or a controlling interest of a corporation's shares or product line or some business. A leveraged buyout is accomplished with borrowed money or by issuing more stock.

      Definition of leveraged buy-out - LBO

      Leveraged Buy-out or LBO is an acquisition of a business using mostly debt and a small amount of equity. The debt is secured by the assets of the business. In LBO, the acquiring company uses its own assets as collateral for the loan in hopes that the future cash flows will cover the loan payments.

      Definition of management buy-in - MBI

      Management Buy-in or MBI is the purchase of a business by an outside team of managers who have found financial backers and plan to manage the business actively themselves.

      Definition of management buy-out – MBO

      Management Buy-out or MBO is the term used for the funds provided to enable operating management to acquire a product line or business, which may be at any stage of development, from either a public or private company.

6.Recapitalisation

recapitalization - Recapitalization is a financing technique used by companies to defend against hostile takeovers. By recapitalization, a company restructures it's debt and equity mixture without affecting the total amount of balance sheet equity.

7. seed capital

Seed Capital is the money used to purchase equity-based interest in a new or existing company. This seed capital is usually quite small because the venture is still in the idea or conceptual stage.

8.  Definition of escrow

Escrow is a way of transferring or exchanging property and/or money using a neutral third party. the escrow process is covered by significant regulation and protection through the use of licensing and/or bonding.


**The holding of funds, documents, securities, or other property by an impartial third party for the other two participants in a business transaction. When the transaction is completed, the escrow agent releases the entrusted property.
Escrow is most commonly associated with real estate transactions. When a home or property changes hands, the seller of the property transfers the property title to the escrow agent. Similarly, the buyer either transfers funds or has a bank transfer mortgage proceeds to the escrow agent. When all conditions of the purchase agreement are met, the escrow agent assigns the property title to the purchaser and distributes the funds to the seller.
With the Internet age, escrow services have gone digital. Many online businesses allow geographically remote buyers and sellers to purchase goods and services from each other. With large purchases, the potential for fraud is significant. To deal with this issue, online escrow services have been established to provide a reliable third-party means of completing a sale. In response, fraudulent operators have increased their own level of sophistication and established illegitimate escrow services; it is vital that anyone using such a service proceed with caution!
Escrow can also be used to exchange non-tangible goods. In the sale of intellectual property such as software or industrial designs, a balance must be struck between how much detail is revealed by the seller while simultaneously confirming the legitimacy of the potential buyer. With each side opening its position to an escrow agency instead of to each other, everyone remains protected. Software escrow can also be used to hold source code in escrow in case a licensee runs into a problem the licensor won’t or can't fix. If such a situation occurs, the escrow agent can release the source code to the licensee, allowing them to fix the problem for themselves