FIN 301 Exam 2

managing current assets

* consider investment carefully bc there are associated costs - ex: carrying costs (EASY TO MEASURE) for inventory like warehousing, obsolescence, and insurance and capital costs to finance * costs rise with increase in current assets - shortage costs (HARD TO MEASURE) decrease with increase in current assets. if inventory levels fall, firm runs risk of losing sales if unable to meet demand for products - tight credit policy lowers levels of accts recievable but can lose sales *optimal dollar amount of investment in current assets = when shortage and carrying costs are equal

Moody's Bond Rating Categories

* credit ratings provide info to investors regarding probability of default on a bond. based on rating investors develop required ROR - bonds with higher credit ratings have lower coupon rates/yields Aaa: best quality. least risk. "gilt edged" protected interest payment bc large or stable margin. Aa: high quality by all standards. high grade bonds together with Aaa. Smaller margins of protection. Larger apparent risk A - favorable investment attributes. upper-medium grade. adequate security, but can be susceptible to impairment Baa - medium - grade obligations ( not highly or poorly secured). security is adequate for present but lacking in protection or unreliable. Ba - moderate protection but not well assured future. not well guarded during good/bad times in future B- not very desireable. small assurance of payments C- poor standing bc of default or other danger elements Ca - often default, have other shortcomes Caa - lowest grade, very poor prospects

Tax shield effect of debt

* financial managers have realized tax deductibility of interest makes Cost of debt financing cheap relative to selling shares of common stock *debt outstanding x interest rate x tax rate

Operating Cycle

* from the time firm purchases raw materials until it collects payment for final product 2 components: Days Sales Inventory (DSI) Days Sales Outstanding (DSO)/ Average collection period (ACP)

Capital Budgeting Process

* planning/budgeting - ID potential projects in strategic planning process *evaluation - projecting cash flows/applying capital budgeting techniques

Legal Insider Trading vs Illegal

- Executives can buy/sell their own stock through prearranged '10b5-1'trading plans - Recent research shows that some executives with 10b5-1 plans have made very good trades just before their companies released market-moving news Legal Insider Trading - Trading by Corporate Insiders Who have Non-Public Information - Permissible (Outside of Certain Dates) and a Sign of Insider Confidence in Company Illegal Insider Trading - Trading With 'Material, Non- Public Information' - SEC Rule 14e-3 * SEC = primary regulator of insider trading laws * can be legal or illgal * laws pertain to corporate insiders & outsiders * level the playing field = laws purpose * not very well defined laws

FB failed IPO

- FB declined from an IPO price of $38 to $30 on the offering day -FB declined further to $17, before taking off and now trades at $69 What Happened? Warnings in the Prospectus Questions About Sustainability of Growth Increase in Price Range Valuation Order Imbalances and NASDAQ Problems

Venture capital - filling a void

- MAJORIty goes to follow-on funding, not startups bc govt or large corps typically provide initial stage funding - small compared to other sources, but grown in size over years: 10 times larger than in 1980 (20 mil at time) - tech/biotech firms dominate these mkts acctg for 50% of VC financing

Investment decision criteria

- NPV = most popular * project earns in excess of firm's COC * expected cash flow discounted to present day -Internal rate of return (IRR) * financial manager find rate of return that makes project NPV = 0, set to 0, find discount rate -payback period * amount of time required for investment to generate enough cash to recover initial cost. investment acceptable if PP < # yrs specified by mgmt

Capital Mkts Organized Exchanges

NYSE, AMEX, and 8 Regional Exchanges Listing Requirements Trading floor Designated Market Maker (DMM) / Open Auction System - the Old Specialist 3,000 stocks traded

changes in stock prices

- SUPPLY and demand -movements in interest rates and economic events * when interest rates or rate of inflation increases, stock and bond prices go down and vice versa - company financial performance - industry performance - national/world news events * flight to quality: mkt reaction due to revaluation of risk in mkt

crowd funding/ JOBs act

- The collective effort of individuals who network and pool their money to support business or social efforts - Limitations on amounts unvested and raised - Allows individuals to become angel investors - Usually via the internet; Kickstarter, Indigogo, GoFundMe, RocketHub, etc JOBs: - JOBs Act 2013 (Jump Our Business Start-Ups) allows companies to raise online from investors with certain restrictions - Provides a a longer time period and larger number of investors before a company must register with the SEC - Limit regulatory and disclosure requirements for companies going public

Early Stages of Financial Life Cycle

- business started using capital provided by firm owners - owner's capital includes capital proved by founders, family, friends - actual cash put into business and doesn't include sweat equity owners-entrepeneurs put in

Capital Structure

- companies need capital to grow - for typical firm, 70% generated from operations * remainder raised from markets debt or equity? mix of LT debt/equity issued by firm goal: minimize weighted average cost of capital (WACC)

Stock picks of wall street analysts

- prices are efficient, info is already reflected in stock price

bonds

- debt, LT contractual obligation issued to borrow money. pays interest on borrowed funds at specified rate and pay principal on maturity. * bond indenture: interest/repayment provisions * corps, US govt, fed agencies, state govts, municipialities foreign firms, foreign gov'ts and international agencies issue them - par value/face value or amount issuer has agreed to pay on maturity. standard is $1,000 - promise to make periodic interest payments called coupon payments over life of bond. determined at time of issue based on securities w/ comparable credit quality and duration - maturity date: end of bond's life when principle and interest payments have been fulfilled - a call provision: gives issuer the right but not obligation to pay off bonds prior to maturity at pre-specified call price.

short run performance

- do well on first day trading, avg first day return over past 40 yrs has been in excess of 15% - first day of Internet IPOs in '90s was crazy high (VA Linux Systems soared 733% on the day it was issued) * unsustainable, extraordinary. many of the stocks crashed and burned

Ways to spot earnings mgmt

- earnings don't correlate with cash flows - earnings deviate from company's peers or industry norms - sudden changes in reserves - earnings growth is too consistent - large and frequent one time charges or gains

Preferred stock

- equity security: ownership claim senior to common stock - periodic dividend payment - not legally binding and B.O.D. can withhold dividends - always paid before common stockholders - equity investment, reps ownership claim on corporate assets. - no final repayment date - include provision for periodic retirement so dividend can be limited/retired

Convertible bonds

- financing instrument w/ characteristics of a bond/stock - periodic interest payments - can exchange for pre-determined # of shares of common stock. * price set at a premium to current stock mkt price so bondholders don't immediately take advantage. If price of CS never reaches premium, upon maturity, investor recieves principal repayment - small growing companies

nature of firm's assets

- firms with tangible assets (like utilities, airlines and hotels) use more debt but if value is more of a function of intangible assets like technology, use less debt

Bank financing

- first stage of outside capital used to finance growth * conservative lenders, only loan to stable and profitable companies/individuals to finance ST business ops & expansion - specified time frame, usually 1 or less yrs * borrower pays fixed amt/mo. including principal + interest * % rate on loan is high enough to cover bank cost of funds, operating expenses, profit margin, margin of safety in case of default good source of capital: - to finance specific large purchase/business opportunity that increases profit - when cash flow is strong, clear firm's income from operations will cover debt service payments to bank - when firm has sufficient collateral to cover value of loan in case of default * start up firms might not have access to bank financing bc they lack an operating history/assets to back them so banks are cautious. therefore they often seek venture capital to finance early growth

Initial Public Offering

- initial public sale of common stock to investors seasoned offerings: subsequent sales of common stock to investors, AKA secondary offering * The Average First Day Return (15%) is Evidence of Underpricing * The Winner's Curse - The Average Investor Does Not Get the First Day Return The Long-Term (3-Year) *Adjusted Performance of IPOs is Negative dot.com bubble bid increase in avg first day return Why Go Public? (IPO) Capital to Execute Business Plan Liquidity for Owners Stock for Compensation and Acquisitions Marketing and Branding Opportunity Capital Market Access Timing is critical to success in after mkt and reduction of potential loss to underwriting syndicate * best time for IPO is when new issue mkt is hot and demand for new issues is overwhelming (ie '95-'99) * when IPO mkt is poor, even best offers aren't well received by investors Disadvantages - expensive - orgs are forced to provide complete disclosure of operation -inside investors lose control over finances of company - B.O.D. must be appointed and paid - outside auditors must be hired and paid

Cash Management

- most liquid asset * firms purchase mkt securities with excess cash to earn rate of return on investment motives to hold cash/mkt securities: 1. transaction motive: make planned payments for items like materials/wages 2. safety motive: protect firm from being unable to satisfy unexpected demand for cash 3. speculative motive: be able to quickly take advantage of unexpected opportunities * achieve optimal balance b/w cash/mkt securities - too much cash = detrimental effects on profitability - too little cash = risk of being unable to pay bills/operate.

common stock

- represents ownership stake in a corp. provide funds to corp in exchange for expected future earnings/assets remaining (residual cash flow stream) after payment of expenses, debt, preferred stockholders. - can vote in corporate governance matters - residual claim = upon liquidation/bankruptcy, last investors to recieve claim on assets. paid after everyone else - limited liability = in event of corporate failure, maximum amount they can lose is original investment. not personally liable for obligations of firm - classes of common stock * A shares that individual investors can buy * B shares held by company insiders, have extra voting rights

Recording revenue too soon

- should be recognized once an exchange has occurred Shipping goods before sale is finalized 1. Billing in advance 2. Shipping defective goods 3. Using an aggressive revenue approach Recording revenue when important uncertainties exist 1. Is the sale with or without recourse? 2. Does the buyer have financing to pay? 3. Is there an obligation by the buyer to pay? Recording revenue when future services are still due 1. Booking future revenue Enron Booked PV of differences between 5 year sales contract to utility & 5 year purchase contract from supplier at time of inception.

Relative degree of business risk

- use less debt financing b/c sales/earnings = more volatile - difficulty meeting obligations and incur financial distress

Venture capital backed IPO

-outperform non-venture capital backed IPOs - possibly bc: stringent MGMT controls implemented by VC firms, additional capital availability, rep of venture capital firms that participate in startup

Anatomy of a Trade

1. Broker Obtains Bid/Ask Quotes on Stock from NASDAQ System 2. Broker Directs Order to Dealer Offering the Best Price (a) Buy Order - Lowest Ask Price (b) Sell Order - Highest Bid Price 3. Broker Confirms Trade The Inside Spread is The Combination Of the Lowest Ask and Highest Bid Prices

SOLVING IRR

1. Estimate NPV from the machine based on a discount rate. 2. Since the NPV calculated at step 1 is positive we increase the discount rate because IRR is the rate at which NPV of the project is 0. 3. We continue the process till we find the rate at which NPV is 0 4. We now compare the IRR calculated with a pre-determined required rate of return and apply the IRR rule to make the decision.

Traditional Floor Broker - Open Auction System

1. Orders Wired to Broker's Booth at Exchange 2. Floor Broker Takes Order to Specialists' Trading Post, seeks best price in crowd 3. Floor Broker Either Executes Trade with: (a) Another Floor Broker; or (b) the Stock's DMM *when mkt illiquid or trading sporadic, DMM must intervene as much as possible to minimize temp imbalances b/w mkt supply/demand *contrarian position: when mkt is selling, DMM is buying and vice versa 4. Floor Broker Reports Trade less than 20% trading

Financial shenanigans

1. Recording revenue too soon 2. Recording bogus revenue 3. Boosting income with one-time gains 4. Shifting current expenses to a later or earlier period 5. Failing to disclose all liabilities 6. Shifting current income to a later period 7. Shifting future expenses into the current period

Primary accounting issues

1. agressive - fraudulent revenue recognition 2. agressive - fraudulent capitalization of expenses 3. failure to record liabilities

Anatomy of a Deal

1. approval from B.O.D 2. due dilligence advising road shows and feasability studies 3. registration with SEC, 20 day waiting period (only reviews if rules followed, not if good or bad investment) known as Quiet Period - company can't comment publicly during this process * tombstone ads - final details of offering and investment banks that participated * syndicate forms and verbal commitments * red herring 4. price stabilization

Steps to compute WACC

1. compute mkt value of debt/equity capital (LT debt + common equity) 2. compute cap. ratios or proportions of debt/equity capital (debt/mkt value or CE/mkt value) 3. compute after tax cost rates. multiply cost rate by 1 minus tax rate. 4. compute weighted after tax cost rates. cap ratios x after tax cost rates 5.sum weighted after cost tax rates

NYSE

1792 - The NYSE Begins The Buttonwood Agreement initiated trading 1960s - Brokers Trade Face to Face - Seats (1,366 total) on the exchange sale price of $4 million in the 1990s 2012 - The Trading Floor is now Mostly Empty Electronic trading has taken over In 2007 the NYSE and Euronext Merged This brought together two of the largest exchanges in the world with plans to create the first Global Exchange ever In 2008 the NYSE Euronext acquired the American Stock Exchange This expanded the exchanges position in ETFs, Options, Small-Cap Equities and several other products end of AMEX (closed doors after 100 yrs), now will be NYSE In 2012 Intercontinental Exchange acquired NYSE Euronext This merged ICE's commodity marketplace with the New York Stock exchange creating one of the worlds global exchange groups Marks the rapid shift from human traders to electronic systems * 5 bil shares per day in '09 *200 bil+ shares, 3,000+ companies requirements: - mkt cap: 100,000,000 + - min # shareholders - certain trading vol - min annual earnings of 2.5 mi

tax advantaged investing for retirement

401(k) plans....named for paragraph 401(k) of the internal revenue code Traditional I.R.A. (Individual Retirement Account) Roth I.R.A.

cash conversion cycle

= DSI + DSO - DPO

valuing uneven cash flows: bonds

A bond is a debt instrument. Corporations, the US Government, and municipalities issue bonds. Bonds are payable from taxes from US government or the general revenues of a corporation. Cash inflows to an investor are bond interest payments, usually every 6 months, and repayment of principal.

Hedge Funds

A hedge fund is a private partnership that uses advanced investment strategies to generate high returns for wealthy investors and institutions There are an Estimated 6,000 HFs They Follow Different Investment Strategies Strategy is critical, but very few actually hedge There have been Great Successes (Soros, Icahn) but also Many Catastrophes - LTCM and Ponzie Schemes Lax Regulation Hedge funds are largely unregulated Exclusivity Usually in the millions of dollars Illiquidity Yearly Withdrawals "2 and 20 Fee Structure" 2% charged on assets under management 20% charged on performance Hedge fund managers are rewarded for good performance Fees are much higher than mutual funds, which usually charge around 1% Absolute Return Strategy Generate a Return Regardless of Market Return Carried Interest Tax Issue Hedge funds profits are taxed as capital Gains (15%) High Water Mark If a fund suffers losses, managers don't get paid performance fees until the losses are recovered

annuity

A life annuity is contract sold by pension funds and life insurance companies; Pays a specified amount of money per year to owner; Amortization schedule more complex than loans or mortgage. Investor makes a single payment or multiple payments then withdraws funds upon her retirement.

loan

A loan is an obligation under which a person borrows money from a lender; Terms of the loan state an interest rate and a repayment or amortization schedule.

valuing uneven cash flows: stocks

A stock represents ownership interest in a corporation. The cash inflows consist of dividends and increase (or decrease) in stock price. There is no maturity associated with a stock—the life of a stock is infinite. The risk of a stock is hard to quantify, making it difficult to determine the proper discounting rate.

Advantages/Disadvantages of Issuing Debt

ADV - interest = tax deductible DISADV - Incurr a Fixed Financing Obligation in the Form of Interest and Principle Payments Which can Lead to Financial Distress

Adv/Disadv of Using Common Stock to Raise Capital

Advantages - No Fixed Financing Obligation Disadvantages - Dilutes Ownership Interests - Higher Cost Than Debt

GAP

Aggressive accounting - A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not Earnings management - The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream Income smoothing - A form of earnings management designed to remove peaks and valleys from a normal earnings series, including steps to reduce and "store" profits during good years for use during slower years Fraudulent financial reporting - Intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil, or criminal proceeding Creative accounting practices - Any and all steps used to play the financial numbers game, including the aggressive choice and application of accounting principles fraudulent financial reporting, and any steps taken toward earnings management or income smoothing

Bonds

As interest rates go up, existing bond prices go........ DOWN

Chimp versus Frank Curzio

If the Chimp picks stocks as well as Curzio, What does that say about the stock market? * not rational What information does Curzio use to pick stocks? What information does the Chimp use to pick stocks? What does that say about public information? * reflected in prices, chimp is throwing darts so all info Curzio uses is not that useful

book rate of return

Book Rate of Return-an accounting ratio calculated by dividing the company's accounting profits by the book value of the company's assets. Book rate of return rule as an investment criterion: accept the investment if its book rate of return exceeds a predetermined target book return; reject the investment if its book rate of return is less than a target book return.

capital budgeting info

Capital budgeting-process of planning and managing a firm's long-term investment in projects and ventures Capital Budgeting involves estimating the amount, timing, and risk of future cash flows Capital budgeting: starts with estimation of incremental cash flows from a project; create a time line of expected cash flows; and compare the present value of the cash flows with cost of project

Role of Capital Mkts

Capitalism - Markets Allocate Capital What is Role of Government?? regulator or investor The Importance of Market Efficiency - Stock Price Reflect Stock Values - Operating Efficiency - Information/Price Efficiency Creating Shareholder Value - Manage for Value - Attract Capital Current Market Issues high freq trading

compounding

Compounding-going from a known value today, to an expected but unknown value in the future. Compounding-means multiply, over a number of time periods, by a number greater than 1.0. Future value-amount of money an investment will grow to by earning a certain rate of return over time. In practice: Estimating your portfolio's future value at the time of your retirement. Saving funds necessary to finance your child's education. Estimating a corporation's yearly budget to fund pension payment requirements.

s-1 registration statement

Company Management Products/Services and Markets Financial Condition Ownership Risks Use of $ must fill out to release an IPO

mortgage

Home mortgage: an obligation under which a person borrows money from a bank and uses the proceeds to purchase a house or condominium. Amortization schedule: Level payments over a long time period, usually 20 to 30 years.

DCF Valuation

DCF determines the value of an investment. The markets determine the price of an investment. You decide, based on price or cost, if the investment is undervalued, overvalued, or fairly-valued. Your buy/sell decision should be based solely on price versus value. The value of an investment (stock, bond, mortgage, etc.) equals the present value of its expected cash flows, discounted (reduced) for their risk and timing. Expected cash flows are the most likely cash payments (dividends, interest, capital gain or loss) that you can expect (not hope) to receive. Discount: multiply a number by less than one. Discount rate: a function of time and risk: discount rate = f (time, risk) Discount factor: a function of both time and the discount rate- [discount factor = f (time, discount rate)] Present value (PV) of an investment is the sum of the expected cash flows multiplied by their respective discount factors Level cash flows: the interest rate and cash flows associated with the loans, mortgages, and annuities are fixed and do not change;

Secondary Mkts Organized Exchanges

DMM - Specialist A Trader Who Makes a Market in One or More Securities and is Charged with Maintaining a Fair and Orderly Market Hold Inventory Buy/Sell Stock Maintain Limit Order *specialize in 1+ specific stock - buying/selling * firms willing to buy/sell shares of securities they rep whenever anyone is interested in trading in the issue *expected to stabilize stock price when possible by buying/selling stock out of own inventory acct * brokers or dealers Trading Post Position on Floor Where DMM (Specialist) Make Markets in Securities Supplemental Liquidity Providers High-volume trading members who add liquidity to markets Financially incentivized by exchanges to add liquidity

rule of 72

How long it takes an investment to double in value for a given interest rate. Divide 72 by the interest rate to get the number of years. Not exact.

Dealers vs brokers

Dealer Markets: Individuals or Firms Facilitate Trades Between Buyers and Sellers Earn Spread Between Bid and Ask Prices Brokered Markets: Brokers Serve As Agents to Bring Buyers and Sellers Together Earn a Commission or a Fee for Brokering Trades

DCF valuation steps/rules

Develop a set of expected cash flows; Estimate the discount rate and calculate the discount factors; Multiply the cash flows by the discount factors and add them to determine the value of the asset. Decision Rule: If the value of an asset is greater than its price—Buy it! If the value is less than its price—Sell it!

discounting

Discounting is the process of going from an expected future value to a present value Discounting also means to multiply by a number less than 1.0, over a number of time periods Present value is the current value of expected future cash flows discounted at the appropriate discount rate. The discount rate is the interest rate used to calculate the present value of a future cash payment The present value equation for discounting a one-time cash flow for one period is equal to: PV = FV / (1.0 + r) The PV Discount Factor (r,n) for finding the present value of a payment to be received in n periods, discounted at r rate is: PVDF (r,n) = 1/(1 + r)^n

Capital Structure and Firm Valuation

Does An Optimal Capital Structure Exist? - Can the Use of Debt Financing Increase Firm Value? The Static Trade-Off Theory - Trade-Off Between Tax Savings and Financial Distress Costs of Debt More Debt, the Cost of Capital Declines Because Interest is Tax Deductible More Debt, the Cost of Financial Distress Increases Risk and Hence the Cost of Capital Issues: - Early 2000s - Enron and Others - Financial Crisis - Ratings of Mortgage Bond Issues - 2011 - Downgrade of USA's AAA Bond Rating - Regulation

Electronic Communications Network

Electronic Markets That Match Buy and Sell Orders Provide for Extremely Fast and Low Cost Trade Execution Allow Trader Anonymity Major Players

Equity Trading is Changing

Electronic Markets and High Speed Trading has Changes How Equities Trade This has led to Fewer Trades on Exchanges Trades can be Matched (Buy-Sell Orders) at an Investment Firm, or at Oine of 13 Exchanges and 40 Dark Pools ("Off Exchange Trading Venues with No Public Stock Displays)

Stock Brokers

Full Service Brokers Provide Personal Investment Consulting Services 1% of assets Discount Brokers Execute Trades $29.95 per trade Online Brokers Execute Trades Online $5-7 per trade commission: stock brokerage members of NYSE employ them. buy/sell securities for general public, clients of firm. earn salary/comission independent: work for selves, handle orders for brokerage houses w/o FT brokers, brokers off floor or too busy

GAAP VS GAP

GAAP: Generally Accepted Accounting Principles Issued by FASB; Ultimate Regulation is by the SEC GAP: Games Accountants Play Actions or Omissions Intended to Hide or Distort the Real Financial Performance of a Business

High Frequency Trading

High-frequency trading (HFT) is the use of sophisticated technological tools to trade securities like stocks or options It is highly quantitative, employing computerized algorithms to analyze incoming market data and implement proprietary trading strategies Positions are Very Short-Term HFT is Sensitive to Processing Speed of Markets (Colocation) Provide Liquidity and Price Discovery Accounts for 50% of Trading in Stocks High-frequency trading may cause new types of serious risks to the financial system Algorithmic and high-frequency trading were both found to have contributed to volatility in the May 6, 2010 Flash Crash in which the DJIA dropped 1000 points in 5 minutes HFT also linked to $440M loss for Knight Capital on August 1, 2012 associated with a "technology breakdown"

Internal Rate Of Return

IRR-rate of return expected to be earned on a project. IRR-discounting rate that makes the net present value of an investment equal to zero IRR Rule as an investment criterion: if the investment has IRR that is higher than some pre- determined required rate of return, accept investment.

Recent Accounting Transgressions in Headlines

In 2011 Diamond Food's common stock fell over 40% after it was discovered that the Company had been timing payments to walnut growers so as to provide stable quarterly earnings Diamond had planned to buy Pringles from Pepsico using company stock Diamond fired their CEO, called off the Pringles acquisition, and restated earnings for two years and follow-up payments.

Role of Investment Banker

Investment Banking and Security Issuances 1. Advising (terms, price, timing) * mergers, aqcuqisitions, original capital structures 2. Origination (Securities Act of 1933) - Due Diligence, Registration Statement, Prospectus * purchases securities from issuer at fixed priced 3. Syndicate Formation, Underwriting, and Price Stabilization distributes/sells to public

Hybrid Mkt

Less Than 40% of NYSE-Listed Stock Now Traded on the NYSE In 2007 NYSE Moved to Hybrid Market Hybrid Market Facilitates Trading Through a Blend of an Automated Electronic Trading Platform and a Traditional Floor Broker System Effort to Compete with Electronic Markets

Modigliani and Miller Propositions

M&M - won Nobel prize - value of firm based on investment decision - portfolio of projects, investments, and cash flows generated. risk associated with cash flows related to risk of underlying assets - value of firm is PV of cash flows of assets - 2 firms with identical assets + operations but diff capital structures are the same - in perfect capital markets, value of firm independent of capital structure; cost of equity is linear increasing function of firms debt to value ratio; value increases as debt increases bc of interest tax shield

Types of Orders

Market Order An Order to Buy/Sell at the Best Price When the Order Reaches the Exchange *most individuals use bc executed immediately, size of trades not enough to affect price * stock can move adversely to investor b/w time entered and executed Limit Order An Order to Buy/Sell at a Specified Price * no worries about spending more/recieving less *buy = mkt price falls below fixed limit price *sell = mkt price exceeds designated price **** stock might never reach designated limit to trigger order and trade won't be executed

Role of financial mkts

Mobilize Savings and Allocate Funds to Users On Basis of Expected Risk-Adjusted Returns Facilitate Risk Transfer Provide Liquidity Crucial Role In Valuing Financial Assets Uniqueness of cap mkts: Debt Capital Markets: Raising Capital ($) by Issuing Bonds Interest Rates Reflect the Base Cost of Capital in Economy Equity Capital Markets Raising Capital by Issuing Stock Allocator of Risk Capital in Economy Essential to Finance Economic Growth Barometer of Economic Health

projects

Most real world investments such as projects, stocks and bonds do not have a single cash flow or level expected cash flows. A project or venture is an investment to produce a product or provide a service that will generate money in the future. Cash Inflows- additional revenues coming into the company as a result of the project. Cash Outflows- additional expenses being spent by the company as a result of the project.

net present value (NPV)

NPV of an investment-difference between the value and cost of investment. The value of any project is equal to the present value of its expected cash flows, discounted for risk and timing. NPV Rule-invest in projects if NPV is positive. Reject if NPV is negative

Purchasing and accounts payable

Old Paradigm: supplier is an adversary, key issue is lower prices New Paradigm: timeliness of delivery, more important than price? good purchasing includes terms, quality, and delivery cost of not taking discounts is prohibitive

Japanese Accounting Scandal

Olympus is a $10M Japanese manufacturer of optical equipment One of the biggest and longest-running loss-hiding arrangements in Japanese corporate history Exposed by Fired "Puppet" CEO Michael Woodford in 2011. Woodford had questioned details and payments made in Acquisition of British medical equipment maker Gyrus Olympus made a series of acquisitions since the 1990s and wrote up the value of assets to hide losses in operations

Profitability index

PI- The NPV of an investment, divided by its cost. PI is used to identify projects that will receive the best return associated with the amount of dollars invested by ranking the projects by PI PI rule is: accept the venture with the highest profitability index first; then accept ventures with lower and lower positive PI's until the projects expend the capital budget; do not accept projects with a negative PI.

present value

PV is used to calculate loan payments and lease payments PV is used by investors to estimate the value of bonds and stock PV is used by corporations to make major investment decisions

payback period

Payback period-length of time for the return on an investment takes to cover the cost of the investment. Payback period-involves only gross cash flows and not discounted cash flows. Payback rule as an investment criterion: accept the investment if its payback period is less than a predetermined number of years; reject the investment if its payback period is greater than the predetermined number of years.

Recording Bogus Revenue

Problems: - Recording Bogus Revenue - Recording cash received from lender as revenue - Recording sales lacking economic substance

SEC as a regulator

SEC Oversees Issuers Investment Firms Investors Markets Primary goals/roles: instill confidence in markets 1. Protect Investors - level playing field 2. Information Disclosure - make informed decisions regarding issue of new securities 3. Operational and Pricing Efficiency of Security Markets 4. Fair and Orderly * rules and regs, licenses securities pros, collect public disclosure info and provide full and fair info w/ annual and quarterly filling requirements, and enforce laws

Venture Capital Financing

Risk Capital Debt/Equity Capital Required for Growth Once Bank Financing is Unavailable Required Returns 20 - 50 Percent Expected Return Depending on Stage VC Exit Strategy (Sell/IPO) *Very risky in early stages of companies operating history!! Types of Financing Depends on Financing Stage - based on business plan/mgmt experience * to reduce risks, finances provided in stages w/ each stage of financing providing enough money to reach next stage. ultimate goal is to hold large stake of equity prior to firm selling shares to public and cashing in on stake when firm goes public through IPO

spinoffs, equity carve outs

SO: divestiture of business division through distribution of common stock of subsidiary to shareholders of parent company in form of stock dividend ECO: parent sells equity in form of IP in subsidiary of company motivation: percieved undervaluation of combo of business by stock mkt; or financial, HR or strategic reasons.

well functioning financial mkts

Secure Property Rights Contracts Easily Enforceable Transparent Financial Statements Accountability of Borrowers and Investors Market Players Bear Consequences of Their Decisions Financial Functions Mobilize Savings and Allocate Resources Risk Transfer Liquidity and Valuation Consequences Better Projects More Innovation Managerial Accountability Results Stronger Economic Growth Greater Consumer Satisfaction

Over the Counter Mkt

Security Dealer Security Firms Who Makes a Market in One or More Securities Known as Marketmakers: must buy and sell1 *no trading floor, no specialists *phones, computer NASDAQ Automated Quotation System Which Provides Dealer Bid and Ask Quotes not stock exchange market makers Bid Prices Price at Which Dealer will Buy Ask Prices Price at Which Dealer will Sell

Stages of Venture capital

Seed/Startup Funding Earliest stage of business, typically no operating history. Investment is based on a business plan, the management group backgrounds along with the market and financial projections. First Round Funding Typically funding that accomodates growth. Company may have finished R&D. Funding is often in the form of convertible bond. Intermediate/Second Round Funding Maturing company where a future leveraged buyout, merger or acquisition and/or initial public offering is a viable option. Later Stage Funding Mature company where funs are needed to support major expansion or new product development. Company is fitable or breakeven.

How compounding effects FV

Shortening the compounding period increases the Effective Annual Rate More frequent compounding is good for investors—higher effective annual rate.

Shift future expenses to current period

Should be; Charge Expenses Against Income in the Period in Which the Benefit is Received What is done: - Management accelerates discretionary expenses into the current period * Lower Current Earnings so as to Increase Future Earnings - Management has the firm "take the big bath" * New management often writes-off old projects to relieve future periods of the expenses * Large nonrecurring gains offset with large expenses, or vice versa

Shift expenses to later period

Should: Capitalize Costs that Produce a Future Benefit and Expense Those that Produce no Such Benefit Problem: Management improperly capitalizes costs 1. Start-up costs 2. R&D costs 3. Advertising expenditures 4. Administrative costs Management depreciates or amortizes costs too slowly 1. Excessively long amortization periods 2. Increases in depreciation /amortization schedules Key Issues: What is normal industry practice? Is the industry experiencing rapid technological change?

Boosting Income with one-time gains

Should: report gains only after exchange has taken place Problem: - Management sells undervalued asset - Recording gains selling assets recorded at deflated book value -Including investment income or gains as revenue or as a reduction in operating expenses

INTEREST PMTS

Simple Interest-interest to be paid only on the original principal invested. The interest is not reinvested. No interest is earned on interest. Compound Interest-accumulating interest on an investment for more than one period and reinvesting the interest. Interest is earned on interest.

Fail to Record/Disclose all Liabilities

What should be: A Firm incurs a Liability if it has an Obligation to make Future Sacrifices What is done - Failing to record expenses (and related liabilities) when future obligations remain - Recording revenue when cash is received, yet future obligations remain

Measures of Stock Mkt

The Dow Jones Industrials Average (DJIA) - 30 Stocks - Price-Weighted Index (Divisor) The S&P 500 - 500 Stocks - Market-Value Weighted Others - NYSE, AMEX & NASDAQ - Russell 2000 and Wilshire 5000

Capital budgeting

The Evaluation of Investment in Property, Plant, Equipment, Technology, Infrastructure, Products, and Markets, to Fuel Future Growth ****** CB = PROPERTY PLANT AND EQUIPMENT (PPE) = LT ASSETS FOR GROWTH * increase cash outflow/investment = increased profit/cash inflow * management should find projects/investments worth more to firm than cost of buying/building/operating *how much return expected, timing of return, and risk (how likely to receive return) * examples: expand facilities/infastructure, invest/develop/introduce new product/service, make acquisitions to fill out mkt/product niches, invest in technology to support customer service, upgrade aging equipment and facilities only invest in projects with positive NPV; offer firm highest risk adjusted return

LOAN CALCS

The PV of the payments on a loan equals the amount of the loan.

Reason to cook the books?

Top 5: according to CFO's influence stocks: 93% say this outside pressure to hit earnings bench marks: 93% inside pressure to hit earnings bench marks: 91% influence exec compensation: 89% senior mgmt fears for career: 80%

rules of valuing a bond/mortgage

Valuing a stock involves the same analysis as valuing a fixed-rate mortgage loan, or the U.S. Government Bond. However, in estimating future cash flows there are two important exceptions: The Bond and the mortgage have cash flows that are known with certainty, while the range of future cash flows for a stock can be enormous. Common stock represents ownership in a corporation, which has an infinite life unlike bonds and mortgages

Shift income/revenue to a later period

What should be: Record Revenue/Expenses in the Period in Which it is Earned What is done: - Management defers recognition of revenue through unearned revenue - Management engages in transactions to keep debt off the books - Management creates reserves to shift income to a later period: "cookie jar reserves" Key issue: increase future revenue and profits

NYSE Super display book system

Works in a similar way to the SuperDOT system just at much faster speeds SuperDOT: 350 milliseconds Display Book: 5 milliseconds Accounts for over 80% of securities traded on the NYSE order wired + executed at mkt price

liquidity

ability to cheaply, quickly and efficiently turn an asset into cash.

underpricing effect

abnormal one day return for IPOs. offering price set by underwriters for IPOs is below level where supply meets ST demand. result = excess demand for issue, sharp increase in price during first day trading. 3 reasons why IPOs are underpriced: - easier and less risky to sell - shares have never traded in mktplace,investors demand high ST rate of return to compensate higher risk - if offering increases in price and performs well in aftermarket, lower likelihood of shareholder lawsuits

leveraged buyouts

acquisition of a firm or division of a firm financed principally with borrowed funds

high yield bonds

aka junk bond - below investment grade by major rating agencies (i.e. Moody's Investor Services, Standard & Poor's and Fitch). Rate most domestic/international publicly traded bonds HYB = one of following: - fallen angel which was investment grade bond that has downgraded bc of poor performance - large co. bonds undergone significant capital structure change ie leveraged buyout (LBO) - bonds of growing company in need of capital that can't achieve investment grade rating.

Organized exchanges

all orders go through DMM but DMM involved in <10% trades

dividend payout ratio

annual dividend/annual earnings

Payment for transactions

cash: most favored. "cash is king" value doesn't fluctuate as much *problem - triggers taxable event for shareholders shareholders sell shares for cash and have to recognize gains or losses stock: more frequently use in takeovers. more acceptable bc of increasing equity valuation. easy to obtain, just issue additional shares approved by BOD and then can use this as currency. exchanging shares, not taxable. favorable implications for earnings of acquiring company. acquirer can account for as pooling of interests so firm doesn't have to acct for goodwill (price paid for firm in excess of book value of equity: non-cash LT expense that reduces NI)

Intermarket trading system

electronic communications network to link NYSE w/ all regional exchanges so investors can get best price possible when trading

financial slack

excess cash and unused debt capacity. enables mgmt of a company to move quickly to take advantage of mkt opportunities through investments/acquisitions.

managing current liabilities

firms require some form of financing to maintain changing amounts of assets (cost less but increase risk of liquidity) level of current liabilities depends on: * cash reserves: firm w/ high level of cash/mkt securities don't require much financing for other current assets * maturity hedging: strategy matches maturities of assets and liabilities. inv financed w/ ST loans while fixed assets paid with LT debt * relative interest rates: firms decision to use LT or ST financing depends on Interest rates. rates = lower for ST loans. decides which term of financing is best for purposes

merger and acquisition

friendly, agreed upon terms increased in 2000s - 2007 decreased greatly with financial crisis but now rebounded follow direction of stock mkt w/ 6 month lag consolidations have dramatically changed competitive landscape in energy, materials, telecommunications, utilities, banking, financial services, and media merger: 2 or more firms agree to combine with one acquiring the other to form a single surviving firm *surviving entity: acquirer * firm merged: target * combines all assets of firms involved Consolidation: 2 or more firms combine, form new firm separate from previous firms can also do strategic alliance. * ranges from mktg agreement to joint ownership of operations joint venture: 2 firms combine parts of individual operations to achieve common goal (shared research, cooperative R&D, shared distribution channels) * small scale merger

Proxy contest

group of outsiders try to gain control of corporation by persuading shareholders to oust current BOD and elect new BOD new directors, large shareholders usually, more sympathetic to group leading proxy and will proceed with strategy max shareholder value - used to change mgmt, mgmt strategy, or gain merger approval - time consuming, expensive *can avoid by staggering elections *forces PCs to extend over many yr periods until shareholders can elect adequate # of directors to ctrl firm

Equity loans and mezzanine financing

high risk hybrid types of financing which include aspects of debt and equity investments ownership position along w/ loan interim stage transaction that tides firm over while it preps for IPO. if mkt for IPOs is suffering, IPO might need to be postponed, and co. still needs to finance operations and VCs often may organize final round of private equity/Mezz debt private equity sold to financial institutions at return that is lower than 25-35% expected by VC but well above 8-12% return expected on normal risk stock. mezzanine debt financing = bridge bw later stage financing and IPO. bonds are issued that have high interest rate + 5-10 yr maturity but expectation that bonds will be retired w/ proceeds of IPO of firm expected w/i 18 months

classes of acquisition

horizontal: same line of business, same level of production vertical: same industry, diff production levels. firm buys suppliers or distributors conglomerate: unrelated lines of business. not as great performance as specialized firms, hard to regulate

Takeovers

hostile transaction. attempt to acquire is resisted by company mgmt personnel opposes transaction (they don't own). but if acquiring firm can purchase all or most shares from shareholders, may be able to acquire company anyway not common but lots of media attention, usually negative

effect of taxes

interest earned is usually taxable ATR= Before-tax rate*(1-tax rate) decrease value

Cost of Capital

invest in projects where ROI > COC * cost of obtaining financing for capital expenditures - minimum required rate of return

best efforts

investment bank doesn't commit to purchase shares from issuer just agrees to attempt best effort to sell to public.

underwriting

investment bank purchases newly issued securities from companies and guarantees fixed price potential risk of significant loss. can lose lots of capital to share risk, form a syndicate or group of other investment banking firms to underwrite gross spread/profits/losses divided b/w lead and rest of syndicate

Primary securities markets

involve sale of newly issued stock and bonds and proceeds flow from investors to issuer of security * highly regulated, overseen by SEC

financial intermediation

involves creation and sale of lower yielding secondary securities by financial institutions and using those proceeds to purchase higher yielding primary securities

Primary securities market

involves sale of newly issued stocks/bonds to investors Red Herring Preliminary Prospectus (offering document describing financing) "Tombstones" Issue Advertisement Green Shoe Underwriter Option to Sell 15% More Shares Negotiated Offerings - Underwritings - Best Efforts and Stand-by Offerings

secondary securities mkts

issuer doesn't receive funds from buyer in a trade. security changes hands and funds flow from buyer to seller (previous owner) * provides investors with liquidity * bring together interested parties, reduce search costs of buying/selling securities. reduces transaction costs/time required to trade financial assets. * if investors are willing to participate, market will facilitate trading *physical trading central location helps. for stocks/bonds, its called an exchange. goods and services = trading post. NOTHING MADE OR ISSUED, JUST TRADED

UnderWriting Syndicate

issuing firm -> managing investment bank (lead investment banker) -> selling group of brokers and dealers -> investors

Static trade off theory

main benefit of debt financing = less taxes but cost of financial distress makes us not so ready to pick debt - direct: associated with bankruptcy - indirect: fixed financing obligations impair business choices/performance 2 capital cost factors fight it out to arrive at optimal capital structure * optimal mix: overall COC is minimized, value is maximized

Working Capital Management

management of a company's short term assets (accts recievable, inventory) and liabilities (accts payable, bank loans). day to day activity, ensures firm has sufficient resources to continue operations/avoid costly disruptions related questions: 1. how much cash/inventory should be on hand? 2. credit terms to offer? 3. how to obtain ST financing? 4. if we borrow ST, how/where should we do it? Net Working capital = current assets - current liabilities *goal in WCM = minimize cost to maintain NWC position of company OLD PARADIGM: WC = good (liquidity). current ratio of 2 NEW PARADIGM: WC = bad, reflects poor planning, use of funds, WC/sales

AMEX

mid cap companies and trading of derivative securities S&P 500's depository receipts (SPIDERS) * most actively traded issue * inexpensive way to buy performance of S&P 500 Index w/o purchasing all stocks in index auction mkt w/ one specialist appointed to trade each issue 900 companies thousands of options/derivatives similar to NYSE trading floor = 3 areas. members trade diff type of financial instrument: equities, derivatives, bonds

money markets vs capital mkts

money: debt securities with original maturities of one year or less are traded. transfer funds from mkt participants w/ ST excess funds to gov'ts, corps and agencies that have ST needs for funds. temp investment to park excess cash prior to use for LT investment in business/capital asset * treasury bills, fed funds, commercial paper, CDs, repurchase agreements, bankers acceptances, other ST instruments traded in money mkt. *low risk liquid money mkt securities with ST excess monies *sold in large denoms (1 mil +) * low default risk * original maturity of = or<1yr *lower interest rates CAPITAL investors buy and sell debt securities with original maturity >1yr, common and preferred stock, mortgages + mortgage backed securities *issued by corps, govts, municipial entities, agencies * purchasers = financial institutions/individual investors *heavy price fluctuation

foreign exchange mkt

movements in value of foreign currencies can greatly increase or decrease corporation's revenues/profits rates at which currency in one country can be traded for currency of another spot exchange rates: ROE for immediate delivery of currencies forward exchange rates: rates of exchange for currencies at certain future dates, can be higher lower or equal to SERs *used to hedge risk of change in SER

stock exchanges

orgs where stocks are traded by members of the exchange formal, regulated by SEC. only official members can trade. to become a member, must buy seat on exchange: limited, determined by S&D

green shoe option

over-allotment option granted to investment banks which allows IB to sell up to 15% additional of offering to investors when demand for deal exceeds planned offering size

Venture capital - sufficient returns at higher risk

riskier the business = higher the return requirement usually investors are larger institutions that can afford to risk a small portion of their portfolio to earn returns much higher than market avg i.e. 25-30% over life of investment look for good INDUSTRIES then good ideas WITHIN industries with idea being if industry has high growth, just requires good execution plan to succeed. cuts down risk exposure structure deals that offer degree of security * written operating agreement venture capital fund can expect 5-10 fold increase in initial investment over a 5 yr period. VC firms recieve 2%-3% fee of assets under mgmt regardless of performance plus percentage of appreciation. Limited investors recieve 80% of capital gains and VC's get 20% of gains

Seasoned equity offerings

secondary offering, similar to IPO process issues new securities, sold to investors in primary market and issuer recieves cash unlike IPO, stock of firm already trades in mkt, investors know value of company stock don't need analysis to establish fair price or long roadshow (or even roadshow in general)

dividend decision and relation to cap budgeting/structure

stock prices tend to increase when dividend increases are announced by firms. * at first glance: investors find value in dividend and boost/penalize shares in reaction * date that divided is payed (ex dividend date) stock price falls by amount of dividend. price change at announcement NOT due to dividend itself, but information that divided change provides to investors. - mgrs only increase when expecting good performance * investors revalue shares higher in response to positive info dividends are more stable than earnings over time increase in stock repurchases has lowered dividend payout ratio * firm buys own shares with cash (alternative to distributing cash) * reduce # shares outstanding and shareholder's equity HIGHER EXPECTED GROWTH RATE = LOWER DIVIDEND YIELD

LR performance of IPOs

terrible. reflect decline in growth/operating performance

Cash Conversion Cycle

time between payment of cash for inventory/raw materials and receipt of cash from accts * ability to get credit from suppliers is important to cash mgmt, bc without it firm has to wait until it recieves cash payment for products before original investment is converted back to cash * 3 ways to reduce time 1. decrease avg collection period - get customers to pay early by offering discounts if they do 2. increase payment deferral period as much as possible 3. increase inventory turnover - accurately predict demand for product so it spends least amount of time in inventory as possible. (JIT) * co. w/ positive CCC effectively finances purchase of products for customers, requires ST financing to support CCC. - to reduce: increase inventory turnover, decrease avg collection period by giving discounts or increase payment deferral period as much as possible *co. w/ negative CCC (preferable or very short) = good bc company's avg pay period is longer than operating cycle * manu. compnanies have + CCC while non manu have - CCC bc they sell product faster

Firm Committment

type of underwriting. investment bank purchases all shares of offering from issuer at agreed upon price and takes responsibility of reselling to public

privatization

unique form of IPO gov't owned entity sold to investors in mkt gov't hires investment bank to complete underwriting and provide advice regarding transaction.

derivative securities mkts

value/payoff of derivative based on value of another security. stock option = derivative security bc value of option based on value of underlying stock. as value of underlying security changes, value of derivative security changes *consist of forwards, futures, swaps, and options contracts of more complex equity and debt securities embedded with contracts *traded on organized commodities and stock exchanges such as CBOT and American Stock Exchange *interest rate swaps/credit default swaps traded in over the counter mkt * easily traded/structured to manage/transfer risk *investors who use them to reduce risk= hedgers *use them to increase risk = speculators

Tender offers

when target firm rejects takeover offer, bidding firm can attempt to acquire controlling interest of company stock and force mgmt to accept offer may offer to buy shares directly from shareholders regardless TO: offer to buy portion of outstanding shares of firm at premium to current market price. usually must buy 50% of outstanding voting shares cash TO: quickest & best bc if long and drawn out: *competing bidders can prep and present better deal for target and include current mgmt of target *premium may increase *may lose bidding war *NO TERMS NEGOTIATED, NO SECURITIES REGISTERED. QUICK, EASY flexible compared to other methods *once large portion of shares are purchased, mgmt resistance to this now huge owner starts to decline and now a friendly negotiation can happen