Finance Test 1
Corporation
"an artificial being, invisible, intangible, and existing only in the contemplation of law" -This entity legally functions separate and apart from its owners. -Corporation can sue, be sued, purchase, sell, and own property •Owners (shareholders) dictate direction and policies of the corporation, through elected board of directors. •Shareholder's liability is restricted to amount of investment in company. •Life of corporation does not depend on the owners. Corporation continues to be run by managers after transfer of ownership through sale or inheritance.
primary markets vs secondary
(initial issue)- the market in which new issues, as opposed to previously issued, of a securities are sold/traded to initial buyers. This is the only time the issuing firm ever gets any money for the securities. Securities are first offered for sale in a primary market. For example, the sale of a new bond issue, preferred stock issue, or common stock issue takes place in the primary market. These transactions increase the total stock of financial assets in existence within the economy. For example, Google raised $1.76 billion through sale of shares to public in August 2004 If Google issues a new batch of stock, this issue would be considered a primary market transaction. In this case, Google would issue new shares of stock and receive money from investors.
secondary market
(subsequent trading) The market in which previously issued securities are traded. It is where currently outstanding securities are traded. - If a person who bought some shares of the Google stock subsequently sells them, he or she does so in the secondary market. Those shares can go from investor to investor and Google never receives any money when they are traded. All transactions after the initial purchase in the primary market take place in the secondary market. These sales do not affect the total amount of financial assets that exist in the economy today. The issuing corporation does not get any money for stocks traded on the secondary market. For example, trading among investors today of Google stocks. -all transactions occur after IPO between individual investors. If I have 100 shares of Microsoft, and you buy my 100 shares of Microsoft=secondary transaction. Microsoft does not get any of the money. When I buy the house from the builder, the builder gets the money(primary market) and if you buy the house from me the builder does not get any money I just get my money back.(secondary)
Short term debt (current liabilities)
*Accounts payable* (Credit extended by suppliers to a firm -when it purchases inventories) -*Accrued expenses* (Short-term liabilities incurred in the firm's operations but not yet paid for) -*Short-term notes* (Borrowings from a bank or lending institution due and payable within 12 months)
How the Primary and secondary markets are regulated
- Firms have to get approval from SEC before the sale of securities in primary market. -Firms must report financial information to SEC on a regular basis (ex. financial statements) to protect investors. -job of the SEC to make sure that the information provided to investors is adequate and accurate. -The SEC also regulates the secondary markets, making sure that investors are provided with enough accurate information o make intelligent decisions when buying and selling in the secondary markets.
interest rate levels
-A *direct relationship between inflation and interest rates*. -The returns are affected by the degree of inflation, default premium, maturity premium, and liquidity premium.
Money has a time value
-A dollar received today is worth more than a dollar received in the future. -Since we can earn interest on money received today, it is better to receive money sooner rather than later. -We can invest the dollar we have today to earn interest so that at the end of one year we will have more than one dollar.
S corporation limitations
-A number of restrictions accompany the S-corporation that detract from the desirability of this business form. An S-corporation cannot be used for a join venture between two corporations. Owners must be people so cannot be used for a joint ventures between two corporations form has been losing ground in recent years in favor of the limited liability company
The goal of the firm
-Create value for the firm's legal owners (shareholders). -"Maximize shareholder wealth" by maximizing the price of the existing common stock. -This goal benefits the shareholders of the company and provides benefits to society as scarce resources are directed to their most productive use by businesses competing to create wealth. -all financial decisions ultimately affect the firm's stock price.*
How savings are transferred to those who need the money. There are three ways that savings can be transferred through the financial markets to those in need of funds.three ways to transfer capital in the economy:
-Direct transfer -Indirect transfer using the investment banker -Indirect transfer using the financial intermediary
2.Establishing and publicizing fair security prices
-Establishes and publicizes fair security prices an organized exchange permits security to be set by competitive forces. They are not set by negotiations off the floor of the exchange, where one party might have a bargaining advantage over the bidding process from from the supply and demand underlying each security. This means the specific price of a security is determined in the manner of an auction.
Data published by the SEC have consistently revealed two relationships about flotation costs
-First, the costs associated with issuing common stock are notably greater than the costs associated with preferred stock offerings. In turn, preferred stock costs exceed those of bonds. -Second, flotation costs (expressed as a percentage of gross proceeds) decrease as the size of the security insurance increases.
Finance and The Multinational Firm: The New Role
-In the search for profits, U.S corporations have been forced to look beyond our country's borders. •U.S. firms are looking to international expansion to discover profits. Coca-Cola earns over 80% of its profits from overseas sales •In addition to US firms going many foreign firms making their mark in the US. For example, domination of auto industry by Honda, Toyota, and Nissan.
fixed assets
-Include assets that will be used for more than one year. include•Machinery and equipment, Buildings, Land
dutch auction
-Investors place bids indicating how many shares they are willing to buy and at what price. The price the stock is then sold for becomes the lowest price at which the issuing company can sell all the available shares.
best efforts
-Issue is not underwritten, i.e., no money is paid upfront for the stocks. Investment bank, acting as an agent, rather than as a principle, attempt to sell the stocks in return for a commission -the securities are not underwritten. The investment banker attempts to sell the issue in return for a fixed commission on each security actually sold. Unsold securities are then returned to the corporation.
negotiated purchase
-Issuing firm selects an investment banker to underwrite the issue. The firm and the investment banker negotiate the terms of the offer. -The firm that needs funds makes contact with an investment banker and deliberations concerning the new issue begin. A method is negotiated for determining the price the investment banker and notes syndicate will pay for the securities. -the negotiated purchase is the most prevalent method of securities distribution in the private sector. It is generally thought to be the most profitable technique.
direct sale
-Issuing firm sells the securities directly to the investing public. -No investment banker is involved. -this procedure is relatively rare
revenue(sales)
-Money derived from *selling the company's product or service* Equal to the selling price of the products or services to be sold times the number of units sold (selling price x units sold=total sales)
debt (liabilities)
-Money that has been borrowed from a creditor and must be repaid at some predetermined date. -Debt could be current(must be repaid within twelve months) orlong-term(repayment time exceeds one year).
investment banking function Investment Banker/Underwriter
-Most managers are unfamiliar with the subtleties of raising long term funds, they enlist the help of an expert-an investment banker. •They are financial specialists involved as an intermediary in the sale of securities (stocks and bonds). They buy the entire issue of securities from the issuing firm and then resell it to the general public. •It is with the help of an investment banker serving as the underwriter that stocks and funds are generally sold in the primary markets. The underwriting process involves the purchase and subsequent resale of a new security issue with the risk of selling the new issue at a satisfactory price being assumed by the investment banker. The difference between the price the corporation gets and the public offering price is called the underwriter's spread.
distributing
-Once the securities are purchased from issuing firm, they are distributed to ultimate investors. -this is the distribution or selling function of investment banking -the syndicate can properly be viewed as the security wholesaler, and the dealer organization can be viewed as the security retailer.
competitive bid purchase
-Several investment bankers bid for the right to underwrite the firm's issue. The firm selects the banker offering the highest price. the firm does not directly select the investment banker but the investment banker that underwrites and distributes the issue is chosen by an auction process. The one willing to pay the greatest dollar amount per new security will win the competitive bid.
privileged subscription
-The firm may feel that a distinct market already exists for its new securities -Investment banker helps market the new issue to a select group of investors such as current stockholders, employees, or customers of the firm. -Distributions directed at current stockholders are the most prevalent. Such offerings are called rights offerings. -In a privileged subscription the investment banker may act only as a selling agent. It is also possible the the issuing firm and the investment banker might sign. standby agreement, which obligates the investment banker to underwrite the securities that are not purchased by the privileged investors.
flotation cost
-The firm raising long term capital incurs two types of flotation costs refers to transaction cost incurred when a firm raises funds by issuing securities: -Underwriter's spread(difference between gross and net proceeds) Of these two the underwriter's spread is the larger. -Issuing costs(printing and engraving of security certificates, legal fees, accounting fees, trustee fees, other miscellaneous expenses)
underwriting
-Underwriting means assuming risk of selling a new security issue at a satisfactory(profitable) price. Since money for securities is paid to the issuing firm before the securities are sold, there is a risk to the investment bank(s). A satisfactory price is one that generates a profit for the investment banking house -the managing investment banker and its syndicate will buy the security issue from the corporation in need of funds. The syndicate is a group of ofter investment bankers the that is invited to help buy and resell the issue to the investing public (hopefully) at a higher price than paid.
1. What is one of the three mechanism that is used to transfer savings from savors to borrowers in the economy.
-direct investment -indirect investment through investment bankers -indirect investment through financial institutions
What is the purpose of time value of money
-helps to evaluate decisions -enables you to look at future benefits vs future costs and make a decision -time value of money drives all decisions that are long term big picture decision. You look at the cash flows you will receive under a particular scenario compared to the cost. It lest us make a decision of whether we should make an investment in a borrower. We look at expected cash flows vs. how much we will have to spend in the first place
Outside the company, financial ratios can be used by
-lenders: to decide whether or not to make a loan to the company -credit-rating agencies: to determine the firm's creditworthiness -investors-(shareholders and bondholders) to decide whether or not to invest in a company -major suppliers: to decide whether or not to grant credit to a company and/or in designing the specific credit terms to a company
3. If Bob calls his broker and wants him to buy shares in the IPO next week is that primary market, secondary market transaction, credit transaction or direct transaction
-primary market transaction
2.if Bob calls a stockbroker and asks him to buy 100 shares of Microsoft what type of transaction is that -secondary transaction -primary marketer transaction -credit market transaction -direct transaction
-secondary market transaction
spot markets versus future markets
-spot markets Cash markets are where something sells today, right now, on the spot- -Future markets are where you can buy or sell something at some future date. You sign a contract that states what you are buying, how much of it you are buying at what price you are buying and when you will actually make the purchase. -you get the euros you purchased in spot market today and you get the euros you purchased in the future market seven months later.
advising
-the investment banker is an expert in the issuance and marketing of securities. A sound investment banking house will be aware of prevailing marketing conditions can relate those conditions to the particular type of security and the price at which it should be sold at a given time. on timing of sale, type of security etc.
1. What is the primary goal of a publically owned corporation
-to maximize shareholder's wealth. Companies have high stock prices-its not making money now, it will make money in the future. Goal is long term wealth.
Principal 4: Market prices are generally right
-to understand how securities such as bonds and stocks are valued or priced in the financial markets, it is necessary to have an understanding of an efficient market. •In an efficient market, the *market prices of all traded assets* (such as stocks and bonds) fully *reflect all available information* at any instant in time. -security markets such as the stock and bond markets are particularly important t since these markets are the place where firms can go to raise money to finance their investments. Whether a security market such as the (NYSE) is efficient depends on the speed with which newly released information is impounded into prices. Efficient stock market is characterized by a large number of *profit-driven individuals* who act very quickly by buying (or selling) shares of stock in response to the release of new information. •Stock prices are a useful indicator of the value of the firm.
Behavioral biases
-we understand only a small portion of what may be going on. Behavioral biases have an impact on our financial decisions. People tend to be *overconfident and many times mistake skill for luck.* People take more risks than they should.
private debt placements
. Each year, billions of dollars of new securities are privately (directly) placed with final investors. In a private placement, a small number of investors purchase the entire security offering. Most private placements involve debt instruments. 2. Large financial institutions are the major investors in private placements. These include (l) life insurance firms, (2) state and local retirement funds, and (3) private pension funds. refers to raising money directly from prominent investors such as life insurance companies, pension funds. -It can be accomplished with or without the assistance of investment bankers.
Stock exchange benefits
1. Providing a continuous market 2. Establishing and publicizing fair security prices 3. Helping business raise new capital
return that satisfies two requirements.
1. a return for delaying consumption 2.An additional return for taking on risk
These companies are not appealing to the broader public markets owing to their
1. small absolute size 2.very limited or no historical track record of operating results 3.obscure growth prospects 4. their inability to sell the stock easily or quickly Most venture capitalist invest for 5 to 7 years in the hopes of selling the firms or raking them public through an IPO.
private debt placements-3 advantages
1.Faster to raise money through a private placement than a public offering. The major reason is that registration of the issue with the SEC is required 2.Reduces flotation costs-These savings result because the lengthy registration statements for the SEC does not have to be prepared, and the investment-banking underwriting and distribution costs do not have to be absorbed. 3.Offers financing flexibility-in a private placement the firm deals on a face to face basis with a small number of investors. This means that the terms of the issue can be tailored to meet the specific needs of the company.
private debt placements disadvantages
1.Interest costs are higher than public issues 2. the imposition of several restrictive covenants in the financing contract,- a firm's dividend policy, working-capital levels, and the raising of additional debt capital may all be affected by provisions in the private placement contracts. Rather, the firm's financial officer must be alert to the tendency of these covenants to be especially burdensome in private contracts. 3.the possibility that the security may have to be registered some time in the future at the lender's option.-If the lender(investor) should decide to sell the issue to a public buyer before maturity, the issue must be registered with the SEC. Some lenders, then, require that the issuing firm agree to a future registration at their option.
5.If the average yield on three month treasury bill is 3.85%, inflation is 2.92%. 30 year Corporate bond rate is 7%. What is the real short term interest rate
3.85T bill-2.92inflation=real risk free rate. 0.93
Limited Liability company benefits
A cross between a partnership and a corporation. Just as with a S corporation, the LLC retains limited liability for its owners but runs and is taxed like a partnership. It provides more flexibility than the S corporation. Corporations can be owners in an LLC.
return on equity
A firm's net income divided by its common book equity. This ratio is the accounting rate of return earned on the common stockholders' investment.
Present Value of a Perpetuity
A perpetuity is an annuity that continues forever; that is, every year from now on, this investment pays the same dollar amount. A. Perpetuities An example of a perpetuity is preferred stock which yields a constant dollar dividend infinitely. B. The following equation can be used to determine the present value of a perpetuity: PV = where PV = the present value of the perpetuity pp = the constant dollar amount provided by the perpetuity r = the annual interest or discount rate
liquidity-risk premium
Additional return required by investors in securities that *cannot be quickly converted into cash at a reasonably predictable price*
other assets
Assets that are neither current assets nor fixed assets. -They include long-term investments and intangible assets such as patents, copyrights, and goodwill.
Which organizational form should be chosen?
Because of the limited liability, the ease of transferring ownership through the sale of common shares, and the flexibility in dividing the shares, the corporation is the ideal in attracting new capital. The unlimited liabilities of the sole proprietorship and the general partnership are deterrents to raising equity capital. The limited partnership does provide limited liability for limited partners, which has a tendency to attract wealthy investors. Having a large number of partners and the restricted marketability of an interest in a partnership prevent this form of organization from competing effectively with the corporation.
Long term debt
Borrowings from banks and other sources for more than one year
Public Offering
Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The securities are usually made available to the public at large by an investment banking firm which is a firm that specializes in helping other firms raise money. This process of acting as an intermediary between an issuer of a security and the investing public is called underwriting and the investment firm that does this is referred to an an underwriter. The issuing firm never actually meets the ultimate purchaser of securities. Very impersonal market and the issuing firm never actually meets the ultimate purchasers/investors of the securities. face to face tales place in the public market
Principle 5
Conflicts of Interest Cause Agency Problems
The Legal Forms of Business Organization: Corporation
Corporation is the most logical choice for a firm that is large or growing. It is the dominant business form in terms of sales in this country. As the firm grows, the advantages of the corporation begin to dominate.
Balance sheet terms: assets
Current assets-comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. -*Cash* -*Accounts Receivable* (payments due from customers who buy on credit) -*Inventory* (raw materials, work in process, and finished goods held for eventual sale) -*Other assets* (ex.: Prepaid expenses are items paid for in advance)
REVIEW
Different mechanisms for transferring money in the economy 1.-direct method 2. indirect method with investment banks 3.indirect investment with financial intermediaries
Question 2: Are firm's managers generating adequate operating profits from the company's assets
Do the firm managers produce adequate profits from the company's assets? One of the most important ways managers create shareholder value is to earn strong profits on the assets in which they have invested
Home Depot example
Home Depot = $13,479M ÷ $10,122M = 1.33 •Home Depot has $1.33 in current assets for every $1 in current liabilities. Home Depot's liquidity is marginally lower than that of Lowe's, which has a current ratio of 1.40.
Home depot example
Home Depot = ($1,085M) ÷ ($20,399M/365) = 19.41 days •Home Depot (at 19.41 days) is slower than Lowe's (at 16 days) in collecting accounts receivable.
home depot example
Home Depot = ($10,625M) ÷ ($44,693 ÷ 365)= 86.77days •Home Depot carries inventory for a shorter time than Lowe's (95.80 days).
Home depot example
Home Depot = ($545M + $1,085M) ÷ ( $10,122M) = 0.16 •Home Depot has 16 cents in quick assets for every $1 in current debt. Home Depot is more liquid than Lowe's, which has 12 cents for every $1 in current debt.
Limited Liability company limitations
However, because LLSc operate under state laws, both states and the IRS have rules for what qualifies as an LLC, and different states have different rules. But the bottom line in all this is that the LLC must not look too much like a corporation or it will be taxed as one.
Specifically, managers can expect their company's share prices to respond quickly to investors' assessment of their decision.
If investors on the whole free that the decision is a good one that creates value, then they will push up the price of the firm's stock to reflect that added value. If investors feel that a decision is bad for share prices, then the firm's share value will be driven down. Pr -stock markets are reasonable at valuing assets on assets overtime.
Cash flow is what matters
In accounting, a company's profits can differ dramatically from its cash flows. •Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books. •Cash flow represent money that can be spent and determine the value of a business. When we analyze the consequences of a managerial decision, we focus on the resulting cash flows, not profits. •We should always look at marginal or incremental, cash flows when making a financial decision. -We value all assets based on the cash flow they throw off. Accounting profits is not an effective tool for valuation
Seasoned Equity Offering (SEO)
It refers to sale of additional shares by a company whose shares are already publicly traded. For example, Google raised $4.18 billion in September 2005.
Conflicts of Interest Cause Agency Problems
Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth and actually lead to a decrease in the value of the firm's shares. It may be the case that shutting down an unprofitable plant is in the best interests of the firm's stockholders, but in so doing managers will find themselves out of a job. Management may continue running the plant at a loss. That is managers are the agents of the firm's stockholders(the owners) and if the agents do not act in the best interests of their principal, this leads to an agency cost. *The separation of management and the ownership of the firm creates an agency problem*. A large firm may be run by professional managers or agents who have little or no ownership in the firm. They may approach work less energetically and attempt to benefit themselves in terms fo salary and perquisites at the expense of shareholders. -If the market feels management is damaging shareholder wealth, there may be a positive reaction in stock price to the removal of that management. -management selects the board of director nominees and then distributes the ballots. Shareholders are offered a sale of nominees selected by the management. Board of directors not monitoring managers on behalf of the agency as it should. . -What is good for shareholders must also be good for managers. .
The trade-offs corporate form Drawbacks
No secrecy of information, may be delays in decision making, greater regulation, double taxation. Control of corporation not guaranteed by partial ownership of stock -Most difficult and expensive form of business to establish The firm first pays taxes on the income it earns; after taxes have been paid on this income, it is paid to investors in the form of dividends. The investor then pays personal taxes on that dividend income. -This double taxation of earnings does not take place with proprietorship + partnership.
2. Indirect transfer using investment banks/investment banking firms) indirect investment
Once companies get bigger -An investment banking firm is a financial institution the helps companies raise capital, trades in securities and provides advice on transactions such as mergers and acquisitions. -In helping firms raise capital, an investment banker frequently works together with other investment bankers in what is called a syndicate. The syndicate will buy the entire issue of securities from the firm that is in need of financial capital. The syndicate will then sell the securities at a higher price to the investing public (the savers) than it paid for them. investors sends money to investment bank and investment bank sends money to borrowers and in exchange borrowers send shares of stock to the investment bank who sends it to investors. Investment banks include Goldman Sax. Here the investment bank acts as a link between the firm (needing funds-borrowers) and the investors (with surplus funds)
Limited partnership
One or more partners can have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm. Aa limited partnership provides limited liability for a partner who is purely an investor.
private placement and venture capitalist
Private placements can involve issuing both debt and equity, and "venture capitalists" can play an active role in both placements. b. For startup companies or companies in the early stages of business, as well as firms in "turnaround" situations, venture capital is a prime source of funds. The venture capital firm will frequently acquire a meaningful dollar state in the startup firm.
Principle 3
Risk requires a reward: There are an unlimited number of investment alternatives to consider. Investors will not invest if they do not expect to receive a return on their investment. -in order to take on more risk you got to have more return. We expect that we will get a higher return on a riskier stock but it doesn't mean every day its going to go up.
-An additional return for taking on risk:
Risky investors are less attractive-unless they offer the prospect of higher returns. The more unsure people are about how an investment will perform, the higher the return they will demand for making that investment. If you are trying to persuade investors to put money into a risky venture, you will have to offer them a higher expected rate of return. -Investors expect a return when they *deposit* their savings in a bank (ex. delayed consumption) and they expect to earn a relatively higher rate of return on *stocks* compared to a bank savings account (ex. taking on risk).
3. Indirect Transfer using the financial intermediary Indirect investment. alternative to method #2
The financial intermediary (such as mutual funds) collects funds from savers in exchange of its own securities (indirect). The collected funds are then used to acquire securities (such as stocks and bonds) from firm. -this is the type of system life insurance companies, mutual funds, and pension funds operate within. -investors move money to financial institutions and financial institutions loan out that money to borrowers. Its called a bank. You take your money down, you put it into a savings account, thee bank lends the money to someone else. I open up a savings account with 100,000 and bank takes 1000,000 and sends it to borrowers. Bank makes money-investor gets interest. They get a small amount of interest like 1%, The borrower pays the financial institution interest. They might pay 4%. The difference between the two is the spread. If you are a bank and you have 100b in funds in bank account you can lend that out at 3% spread. 100B x 3%=3B dollars.
IPO
The first time company issues stock/sells stock to the general public is referred to as an IPO, initial public offering. IPO is a way for the firm to raise money. Say company does IPO at 25 million dollar valuation-whole company is worth around 25B. Co. has already raised money through method #1. Under typical vc dealt will have 20% of the firm left. Other 80% will belong to vc. Maybe we will sell another 20% sell share of stock. The firm, we , get 5B in cash investors get 20% of company. Overtime they could sell more pieces but never sell whole company. In essence, when you do an IPO you are just selling part of the company. Company does this because it gives them more money to turn around and invest in their business. Investors are giving 5B to investment bank the IB will turn around and give 4.9 B of that to company. they get to keep the other 100M. IB to make more than 100M-co will send shares to investment bank $10/share. you got 5B in cash coming in less 100M. Co send 500M shares to the investment bank at $10/share. $10 x 5M shares=5B dollars.Co issues 500M new shares in exchange for 5B dollars. Goldman sax buy $10/share and sell it at a higher price say $11/share(like wholesaler) Goldman sax gets the shares at a lower price and turn around and sells to investors at a higher price. Now they put in an addition 500M into pocket for total fees of 60oM dollars. Thought bout it at $10/share they sell it to outside investors for $11/share there is an extra 500M. This is how investment banking works. a primary market transaction. the company gets the money. This is what happened with Google in 2004 when it first sold its common stock to the public at $85 per share and raised $1.76 billion dollars. When Google went back to the primary market in September 2005 and sold more Google stock, worth an additional $4.18 billion, it was considered a seasoned equity offering or SEO. When investment bank does their thing on behalf of borrowers essentially they are doing an IPO.
How is the firm financing its asset
The key issue in management's choice between financing with debt or with equity. To begin, we want to know what percentage of the firm's assets is financed by debt equity, including both short term and long term debt, realizing that the remaining percentage must be financed by equity. To answer this question, we compute the debt ratio as follows debt ratio=total debt/totaal assets
price/book ratio
The market value of a share of the firm's stock divided by the book value per share of the firm's reported equity in the balance sheet. Indicates the market price placed on $1 of capital that was invested by shareholders.
The term structure of interest rate
The relationship between a debt security's rate of return and the length of time until the debt matures is known as the term structure of interest rates or the yield to maturity. •The graph could be normal upward-sloping yield curve (indicating longer-term securities command higher returns), flat (equal returns for long- and short-term securities), or inverted (longer-term securities command lower returns compared to short-term securities). The term structure reflects observed rates or yields on similar securities, except for the length of time until maturity, at a particular moment in time. -Term structure-what does the relationship between maturity and interest rate look like? normal Further out with maturity higher the interest rate
Private or Direct Placement
The securities are offered and sold directly to a limited number of investors. The firms will usually hammer out, on a face to face basis with prospective buyers, the details of the offering. The investment banking firm may act as a finder by bringing together potential lenders and borrowers. More personal market than its public counterparts. The specific details of the issue may actually be developed on a face-to-face basis among the potential investors and the issuer.
The Role of the Financial Manager
The vice president for finance, also called the *chief financial officer* (CFO) lies under the firm's chief executive officer (CEO) and is responsible for *overseeing financial planning, strategic planning, and controlling the firm's cash flow*. A treasurer and controller serve under the CFO. In a smaller firm, the same person may fill both roles, with just one office handling all the duties. The *treasurer handles the firm's financial activities*, including cash and credit management, making capital expenditure decisions, raising funds, financial planning and managing any foreign currency received by the firm. The *controller* is responsible for *managing the firm's accounting duties*, including producing financial statements, cost accounting, paying taxes and gathering and monitoring the data necessary to oversee the firm's financial wellbeing.
inefficiencies in the market
There are inefficiencies in the market that may distort the market prices from value of assets. Such inefficiencies are often caused by *behavioral biases*. Our decision making is not always rational.
capital market
This is the market for long-term financial securities (maturity greater than one year). Examples: Corporate bonds, common stocks, Treasury bonds, term loans, and financial leases. include equities and bonds (corporate debt and US government debt) -long term investment markets
1.Providing a continuous market
This may be the most important function loan organized security exchange. A continuous market provides a series of continuous security prices. Price changes from trade to trade tend to be smaller than they would be in the absence of organized markets. The reasons are that there is a relatively large sales volume of each security traded, trading orders are executed quickly and the range between the price asked for a security and the offered price tends to be narrow. The result is that price volatility is reduced
Rates of return in the financial markets
To raise those funds a firm must offer a rate of return competitive with the next best investment alternative available to that saver (investor)- known as the investor's opportunity cost of funds.
secondary
Trading in currently existing securities takes place in the secondary market. The total stock of financial assets is unaffected by such transactions.
public offerings versus private placements
When a corporation decides to raise eternal capital, those funds can be obtained by making a public offer or a private investment.
The essential elements of ethics and trust
While not one of the five principles of finance, ethics and trust are essential elements of the business world. Without ethics and trust nothing works. -Acting in an ethical manner is a necessary ingredient to long term business and personal success.ethical behavior --> "doing the right thing" We can think of laws as a set of rules that reflect the values of a society as a whole. Unethical behavior destroys trust and businesses cannot function without a certain degree of trust.
A return for delaying consumption
Why would anyone make an investment that would not pay them something for delaying consumption? They won't even if there is not risk. Investors will want to receive at least the same return that is available for risk free investments, such as the rate fo return being earned on U.S government securities.
investment banker
a financial specialist who acts as an intermediary in the selling of securities. He or she works for an investment banking firm (house).
inventory turnover
a firm's cost of goods sold divided by its inventory. The ratio measures the number of times a firm's inventories area sold and replaced during the year, that is, the relative liquidity of the inventories inventory turnover =cost of goods sold/inventory
accounts receivable turnover ratio
a firm's credit sales divided by its accounts receivable. This ratio expresses how often accounts receivable are "rolled over" during a year. annual credit sales/accounts receivables
time interest earned
a firm's operating profits/interest expense. The ratio measures aa firm's ability tot meet its niters payments from its annual operating earnings.
Question 1: How liquid is the firm can it pay its bills
a liquid asset is one that can be converted quickly and routinely into cash at the current market price. The liquidity of a business is a measure of its ability to have cash available when needed to make financial obligations. Measures a firm's ability to pay its bills on time. It indicates the ease to which non-cash assets can be converted to cash tot meet the financial obligations.
ratio
a relationship between two numbers ex A:B=30:10 which means A is 3 times B
annuity
a series of equal dollar payments made for a specified number years
mortgage
a specific type of loan that is used to buy real estate. you get a mortgage you buy a house. When you buy your house with the mortgage the bank loans you money, you have to repay the bank overtime. On mortgage you have an option to re-finance it. -Bank gives you a big stack of money. You are giving bank 5% interest each year. Then there is a FED Originally interest rates were 5% Now FED lowers rates from 5% two 4%. You are still paying 5% you could be paying 4% if you got your mortgage right now. Paying more than you need to. You could go across the street to rival bank and they are going to give you a new mortgage and you pay them 4% you take their stack of money and give it to bank. You now have a 4% interest rate instead of 5% interest rate. You save money going from 5 to four percent. Refinance when interest rates are lower than what you paid. Every time you refinance you pay some fees. you make payments along the way.
Sample of private placement
a venture capital firm is an example of investors who are active in the private placement market. A venture capital firm first raises money from institutional investors and high net worth individuals, to then pool the funds and invest in start-ups and early state companies that have high-return potential but are also very risky investments.
All of the following statements about agency problems are true except for what a. agency problems interfere with the goal of maximizing shareholder value b. agency costs are paid by the mangers who do not act in shareholder's best interest c. Agency problem result from the separation of management and ownership of a firm d.the root cause of agency problem is conflicts of interest
agency costs are paid by the mangers who do not act in shareholder's best interest
NYSE is a hybrid market
allowing for face to face trading between individuals on the floor of the stock exchange in addition to automated trading
tax expenses
amount of tax owed, based upon taxable income
ordinary annuity
an annuity where the cash flows occur at the end of each period
The argument in favor of competitive bids is that
any undue influence of an investment banker over the firm is mitigated and the price received by the firm for each security should be higher. Thus, the cost of capital in a competitive bidding situation would be less than in a negotiated purchase situation. -One problem with the competitive bidding purchase as far as the fund raising firm is concerned is that the benefits gained from the advisory function of the investment banker are lost. It may be necessary to use an investment banker for advisory purposes and then by law exclude the banker from the competitive bid process.
3. Helps businesses raise new capital
because a continuous secondary market exists, it is easier for firms to float, or issue, new security offerings at competitively determined privies. This means that the comparative values of securities offered in these markets are easily observed.
Investors react to poor investment or dividend decisions
by causing the total value of the firm's stock to fall, and they react to *good decisions* by *pushing up the price of the stock*. Good financial decisions increase stock price and poor financial decisions will lead to a decline in stock price.
We answer this question Liquidity is measured by two approaches
by comparing a firm's assets that can be converted quickly and easily into cash-current assets-with the firm's current liabilities. In our analysis we are interested in both 1. comparing the amount of the firm's current assets relative to current liabilities and 2. the quality of the individual current assets that will be used in setting current debt payments -examining the firm's ability to convert accounts receivables and inventory into cash on a timely basis.
five principles guide the financial manager
cash flow is what matters .money has a time value .risk requires a reward .market prices are generally right .conflicts of interest cause agency problem.
4. Define inflation
change in prices overtime
Criticizing SOX
criticized for imposing additional compliance costs on the firms. Some firms have responded by delisting from major exchanges or choosing to list on foreign exchanges. Inhibits firm from listing on U.S stock markets.
retained earnings
cumulative total of all the net income over the life fo the firm less common stock dividends that have been paid out over the years. Note that retained earnings are not equal to hard cash.
Compare a firm's current assets with current liabilities using
current ratio acid test or quick ratio
2. The 5 basic principles of finance include of the following except a.cash flow is what matters b.money has a time value c.risk requires a reward d.incremental profits determine value
d.incremental profits determine value
Converting inventories to cash
days in inventory-how long is the inventory held before being sold -inventory/daily cost of goods sold. Measures the number of days a firm's inventories are held on average before being sold; it also indicates the quality of the inventory
Financial management
deals with the maintenance and creation of economic value or wealth by focusing on decision making with an eye toward creating wealth
compound annuity
depositing an equal sum of money at the end of each year for a certain number of years and allowing it to grow
Dunkin donuts primary secondary market
dunkin donuts does not grow their own coffee, they get it from someone else. Dunkin has a supplier. If I buy coffee from dunkin donuts, they get the money. -*Me buying coffee from dunkin primary market*. You buying my cup of coffee is a secondary market.
operating expenses
expenses related to marketing an distributing the product or service, general administrative expenses and depreciation expense
Long term assets
fixed assets and other assets
Financial ratios
give us two ways of making meaningful comparisons of a firm's financial data . 1. we can examine the ratios across time(say for the past 5 years) to compare a form's current and past performance 2.we can compare the firm's ratios with those of other firms
acid test/quick ratio ratio
given that a company's inventory by its very nature is less liquid than its accounts receivable-it must first be sold before any cash can be collected-a more stringent measure of liquidity would exclude the inventories and include only the firm's cash and accounts receivable in the numerator. The revised ratio is called the acid test (or quick) ratio cash+accounts receivable/current liabilities •Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.
A ratio by itself
has no meaning. Hence a given ratio is compared to -ratios from previous years -ratio of other firms and/or leaders in the same industry
liquidity risk premium
how easy is it to turn my money into cash from that investment If I buy real estate its hard to turn into cash. The harder it is to get my money back(riskier), the higher interest rate (return the risk has to be.) Stocks into cash easier. Checking account get money when you want
Maturity
how long it takes to get my money back. Maybe I feel good about you paying me back In a year vs. 30 years. Longer maturity, higher interest rate.
Within the firm, managers use financial ratios to
identify deficiencies in the firm's performance and take correction action -evaluate employee performance + determine incentive compensation -compare the financial performance of the firm's different divisions within the firm -prepare, at the firm and division levels, financial projections such as those associated with the launch of a major supplier -understand the financial performance of the firm's competitors -evaluate the financial condition of a major supplier.
Simple interest
if you only earned interest on your initial investment it would be referred to as simple interest
financial markets
institutions and procedures that facilitate financial transactions.
money market
institutions and procedures that provide for short-term debt instruments (maturity-until you get your money back- periods of one year or less-short maturity periods). Typically a telephone and computer market (rather than a physical building). "Short-term" means that the securities traded in the money market have maturity periods of not more than one year. -short term securities are generally issued by borrowers with very high credit ratings. Equity instruments are not traded in the money market. Examples: Treasury bills (issued by federal government), commercial paper, negotiable certificates of deposit, bankers' acceptances. -stocks either common or preferred are not traded in the money markets -short term investment markets
Two best jobs in finance
investment bankers and VC- after you know a group of investors its vert profitable. You don't have to spend a lot of money on factories If you are an investment bank you collect a small percentage/fee whenever a company raises money. You get a fee based on transfer of funds. Investment banking includes sales and trading as part of it.
One of the problems that entrepreneurs and business owners face
is that they need the benefits of the corporate form to expand, but the double taxation of earnings that comes with the corporate form makes it difficult to accumulate the necessary wealth for expansion. The government recognizes this problem and has provided two business forms that are crosses between a partnership and a corporation with the tax benefits of partnership(no double taxation fo earnings) and the limited liability benefit of corporations (your liability is limited to what you invest.)
the real rate of interest
is the nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment -It tells you how much more purchasing power you have.
the operating profit margin
is the result of how a company manages its day to day operations(operating management) and the total asset. turnover is the result of how efficiently the company's assets are being managed (asset management) Let's consider managing operations and asset management in turn
Finance
is the study of how people and businesses evaluate investments and raise capital to fund them.
present value
is the value in today's dollars of a future payment discounted back to present discounted back to present at the required rate of return
Sometimes the yield curve can be funky
it can be flat/downward sloping-bad -this is an indicator or a recession-an inverted yield curve/flat yield curve. If you have a ten year loan/bond and you can sell it for 1% and sell 6 month bond for 1% its flat. if later is less-inverted
Why do we have secondary market transactions
it drives liquidity for investors. Most trading is secondary market transaction only a few IPOS in a given week. IPO goes on sale, I buy 100 shares I give the IB 1,000 for my 100 shares -if you buy the shares from me..they are my shares you give me money investment bank doesn't get any money after that. only when the shares are sold. investment banker acts as a wholesaler
Without recognizing the existence of the time value of money
it is impossible to evaluate projects with future benefits and costs in a meaningful way.
How are interest rates in the market set?
its going to be based on level of risk risk requires a return nominal vs real. nominal=real+inflation nominal-inflation=real nominal interest rates=inflation
money market funds
like savings accounts for businesses. You have 100B in Apple. you have a money market and this pays you nominal inters. You can take money out and put it in at will like savings account but its for businesses.
capital markets
long term sources of financing, such as bonds and common stock, are raised in the capital markets. Capital markets-all the financial institutions that help a business raise long-term capital-security within a maturity date of more than one year. Most companies are in the business of selling products and services to their customers and do not have the expertise on their own to raise money to finance the business.
There are some serious practical problems in using changes in the firm's stock to evaluate financial decisions
many things affect stock prices; We need not consider every stock price change to be a market interpretation of the worth of our decisions. -What we do focus on is the *effect that our decisions should have on the stock price if everything else were held constant.*
Measuring liquidity perspective 2
measurer a firm's ability to convert accounts receivable and inventory into cash -average collection period -inventory turnover
economic value added
measures a company's economic profits, as compared to its accounting profits, by including not only interest expense as a cost but also the shareholders' required rate of return on their investment
-within money markets there are different instruments that you have-
money market funds commercial paper treasury bills
Selling securities to the public
most corporations do not raise long term capital frequently
nominal interest rate approximately equals
nominal rate of interest = real rate of interest + anticipated rate of inflation + (real rate of interest)( anticipated rate of inflation) For example, if the real rate is 5% and the expected inflation rate is 4%, the nominal rate would then be 9.2%, computed as follows: nominal rate of interest = .05 + .04 + (.05)(.04) = .092 or 9.2%
operating return of assets
operating profit margin x total asset turnover
operating return on assets
operating profit/ sales x sales/total asset
Instead of net income we use operating profits
operating profits are the income generated from the firm's assets independent of how the firm is financed. While knowing the dollar amount of a firm's operating profits is important, we also want to know the amount of operating profit relative to the total assets employed. We want to know how much operating profit is generated per dollar of assets used; that is, we are interested in a firm's retune on its asset investment. We find this by calculating the operating return on assets
Organized Securities Exchanges
organized security exchanges are tangible entities whose activities are governed by a set of bylaws. security exchanges physically occupy space-such as a building or part of a building) and financial instruments are traded on its premises. -(NYSE/ "big board") is the most prominent exchange. In 2012, NYSE listed more than 4,000 U.S. and non-U.S. securities with total value of over $14 trillion. Firms listed on the exchanges must comply with the listing requirements of the exchange (such as for profitability, size, market value, and public ownership).
The time value concept/calculation used in amortizing a loan is
present value of an annuity
measuring cash flows
profits in the financial statements are calculated on "accrual basis" rather than "cash bases" -thus profits are not equal to cash
Risk free rate
rate of interest that we charge/demand based on delaying consumption for the future. If I die tomorrow, there is no interest rate compelling enough-even if you are trust worthy..I wont be able to use the money. How much we charge based on how risky the world is. -When there is a recession there is a greater change economic collapse/unexpected events occurring. Risk free rates go up or down based on the state of the economy. How likely it is that I will be around to use the money. -Risk free rate goes up with a recession. In a recession I'm more likely to use money. I'm delaying my own consumption. You charge risk free rate no matter what happens with the other party. RFR rate set by Federal Reserve.
Default risk premium
relates to how likely you are to pay me back.
real return
return earned above the rate of inflation
real risk-free interest rate=
risk-free rate-inflation premium The real risk-free interest rate a required rate of return on a fixed-income security that has no risk in an economic environment of zero inflation. Putting the term "real" in front of an interest rate means the rate has been adjusted for inflation.
fixed asset turnover
sales/net fixed assets
distribution methods
several methods are available to the corporation for placing new security offerings in the hands of investment bankers followed by financial investors. The investment banker's role is different in each of these (sometimes in fact it is possible to bypass the investment banker)
equity
shareholder's investments in the firm in the form of preferred stock and common stock.
treasury bills
short term bonds sold by the U.S government. 30/90 days. Then U.S give back money. Just like commercial paper for government debt. Considered safer CP markets much smaller because collapse of cp during recession. TB-do same thing but u.S gov instead of GE. Treasury can make it. we don't have money? we will print some gif you need money. Risk of U.S gov not giving back money is minimal. No risk that you wont get back money. I'm always willing to lend money to them. CP riskier-rates higher.
An investors rate of return
should equal a rate of return for delaying consumption plus an additional return for assuming risk. -If you have $5,000 to invest and are considering either buying stock in International Business Machines (IBM) or investing in a new bio-tech startup firm that has no past record of success, or *you would want the startup investment-to offer the prospect of a higher expected rate of return than the investment in an established company
treasury stock
stock that has been repurchased by the company
effective annual rate
the annual compound rate that produces the same return as the nominal, or quoted, rate when something is compounded on a nonannual basis. In effect, the EAR provides the true rate of return.
Clearly Home deport was doing better than Lowes's when it came to earning. higher return on its assets. But what?
the answer lies in two areas 1. how effectively the company's income state was being managed or what we will call operations management, which involves the day to day buying and selling of a firm's goods or services as reflected in the income statement and 2. how efficiently assets are being managed to generate sales, or asset management. That these two issues relate to the operating return on assets can be seen by using two other ratios-operating profit margin and total asset turnover.
Converting accounts receivable to cash
the conversion of accounts receivable into cash can be measured by computing how long it takes to collect the firm's receivables on average. We can answer this question by computing a firm's days in receivables (or average collection period) days in receivables= accounts receivable/daily credit sales
Cost of goods sold(COGS)
the cost of producing or acquiring the goods or services to be sold
The incremental cash flow to the company as a whole is
the difference between the cash flows the company will produce both with and without the investment its thinking about marketing -projected cash flows if the project is selected, versus what they will be, if the project is not selected.
1. Direct Transfer/investment
the firm seeking cash sells its securities directly to savers ( wealthy investors) who are willing to purchase them in hopes of earning a large return. -The new business/start up company may go directly to a wealthy investor called an angel investor or business angel for funds or it may go to a venture capitalist for early funding. Rich people with a lot of money want to invest in new start up businesses in hopes fo getting richer -investors send money directly to borrowers in exchange for a return. ex. venture capitalist
managing operations
the first component of the operating retune on assets (OROA) the operating profit margin, is an indicator of how well the company manages its operations-how well revenues are being generated and costs and express controlled. The operating profit margin measures how well a firm is managing its cost of operations, ini terms of bot the cost of goods sold and operating expenses (marketing expenses, general and administrative expenses and depreciation expenses) relative to the firm's revenues. All else being equal, the objective for managing operations is to keep costs and expenses low relative to sales. We use the operating profit margin to measure how well the firm is managing its income statement operating profit margin= operating profits/sales
financing costs
the interest paid to creditors
Money market vs capital market
the key distinguishing feature between the money and capital markets is the maturity period of the securities traded in them
who are shareholders
the legal owners of the firm
price/earnings ratio
the price the market places on $1 of a firm's earnings. For example, if a firm haas an earnings per share of $2 and a stock price of $30 per share, its price/earnings ratio is 15. $30/2
term structure of interest rates
the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money
managing assest
the second component in equation is the total asset turnover. This ratio tells us how efficiently a firm is using its assets to generate sales. To clarify, assume that Company A generates $3 in sales for every $1 invested in assets, whereas Company B generates the same $3 ini sales but has invested $2 in assets. in other words, Company a is using its assets more efficiently to generate sales, which leads to a higher return on the firm's investment in assets. The efficient is captured by the total asset turnover ratio shown as follows sales/total assets
future value factor
the value of (1+r)^n used as a multiple to calculate an amount's future value
present value factor
the value of 1/(1+r)^n used as a multiplier to calculate an amount's present value
The market price of the firm's stock reflects
the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk.
To answer this all-important question
think about the process of financing a company. In its simplest form, a form's shareholder's invest in a business. The company may also borrow additional money from other sources (bank). The purpose of making these investments is to create profits. the following ratios answer this question -operating return on assets -operating profit margin -total asset turnover -fixed assets turnover
commercial paper
this is short term debt which is issued by a company- Someone like GE would borrow money in January and repay it in February. Why would they do it? Commercial paper carries a low interest rate. cheaper than 5/10 year bonds. We borrowed a billion dollar now we have to pay a billion in a month there is not that much time to do anything. GE every month is in essence refinance their commercial paper. Its due in a month and you have to pay the January lender, the guys who gave you the Billion dollars. They want their money back in February. That okay we borrow billion dollars in February and repay the January guys and then we don't owe any money till march. Chain. What's the risk? what if we can't refinance. say you get a ten year mortgage. 10,000 every month for ten years. In ten years time you are supposed to may be 200,000. You wont have that in ten years Bullet mortgage assumption you will be able to re finance at then of ten years. You hare short term obligations but your cash flows come in long term and you cannot afford to pay them.
How is agency conflict reduced?
through *monitoring* (ex. annual reports), *compensation schemes* (ex. stock options), and *market mechanisms* (ex. takeovers)
All 5 principles of finance lead to the one singular purpose of finance-
to help investors or savers or people with money send money to borrowers,companies, people who need money. Investors send money to borrowers or user and in return they get a return on their investment in form of interest, stock appreciation, dividends. People who have money turn around and invest that with groups that need money. Point of finance is to facilitate money moving from party to another party in order to grow that money/generate returns. Higher risk of borrowers greater the return we expect. Move money to where it can make more money. - Purpose of finance is to lend money to companies and people that are attractive from a risk/reward standpoint
In the study of finance, we focus on the creation and measurement of value
to measure value, we use the concept of the time value of money to bring the future benefits and costs of a product, measured by its cash flows, back to the present. -If the benefits or cash inflows outweigh the costs, the project creates wealth and should be accepted -If the costs or cash outflows outweighs benefits or cash inflows, the project destroys wealth and should be rejected.
functions of an investment banker
underwriting, distributing, advising
When you think about what to charge for interest rate
what is the level of inflation? If inflation is higher, you need to charge a higher interest rate. Once you take out inflation, risk free rate, maturity risk premium and liquidity risk premium are the real rate. real+inflation=nominal
current ratio
when it comes to examining the relative size of current assets to current liabilities -the most commonly used measure of a firm's short term solvency we assume that the firm's accounts receivable will be collected and turned into cash on a timely basis and that its inventories can be sold without any extended delay.
If you decide to receive it a year from now,
you will have passed up the opportunity to earn a year's interest on the money. Economists would say that you suffering an "opportunity loss" or an "opportunity cost." The cost is the interest you could have earned on the $1,000 if you invested it for one year.
S type corporations benefits and limitations
• provides limited liability while allowing the business's owners to be taxed twice as is the case with dividends distributed by regular corporations. •Taxed as partnership (that is, distributions back to the owners are not taxed twice as is the case with dividends in the corporate form. no double taxation like corporations)
maturity-risk premium
•*Additional return required by investors* in long-term securities to compensate for greater risk of price fluctuations on those securities caused by interest rate changes
What Explains the Shape of the Term Structure? The Market Segmentation Theory
•*Legal restrictions* and *personal preferences* limit choices for investors to certain ranges of maturities. •Implies that the rate of interest for a particular maturity is determined by demand and supply for a given maturity. -we think about the yield curve as being a continuous curve but the reality is that its actually more like a serious of segments. short term, medium term and long term. Certain types of investors want to be in one of those segments. If I'm a pension fund buying bonds I have long term obligations-responsible for retirements of workers. I will solely look at long term. Different investors care about different terms. As long term investors get more nervous about the economy, that will cause the yield curve inversion.
Common-Sized Income Statement
•*restates the income statement items as a percentage of sales* -makes it easier to compare trends over time and across firms in the industry.
accrual basis accounting
•Accrual basis-principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid. -Thus, sales revenue recorded in the income statement includes both cash and credit sales. Inventory purchases may not be entirely paid for in cash as suppliers may extend credit for some of the purchases. •Treatment of long-term assets: Asset acquisitions (that will last more than one year, ie equipment) are not recorded as an expense but are written off every year as depreciation expense.
General partnership
•All partners are fully responsible for liabilities incurred by the partnership. Any partner's faulty conduct renders the remaining partners liable as well. The relationships among partners is dictated entirely by the partnership agreement, which may be an oral commitment or a formal document. -liable without limitation More expensive to organize than general partnership, as a written agreement is mandatory
Financial statements
•Balance Sheet, Income Statement, Cash Flow Statement •Comply with GAAP •Prepared quarterly by financial firms
Sole proprietorship
•Business owned by an individual •Owner maintains title to assets and profits-the owner absorbs any losses. •Unlimited liability-responsible without limitations for the liabilities incurred. -Initiated by the mere act of beginning the business operations. No legal requirement must be met in starting the operation particularly if the proprietor is conducting the business in his or her own name. -if a special name is used, an assumed-name certificate should be filed, requiring a small registration fee. -The sole proprietorship is for all practical purposes the absence of any formal legal business structure. •Termination occurs on owner's death or by the owner's choice minimum amount of legal structure. -inimal organizational costs Equity capital limited to the owner's personal investment
three sources of cash flows
•Cash flows from Operations(ex. Sales revenue, labor expenses) •Cash flows from Investments(ex. Purchase of new equipment) •Cash flows from Financing(ex. Borrowing funds, payment of dividends)
Risks/Challenges of Going Abroad
•Country risk (changes in government regulations, unstable government, economic changes in foreign country) •Currency risk (fluctuations in exchange rates) •Cultural risk (differences in language, traditions, ethical standards)
Standard Deviation —
•Dispersion or variability around the mean rate of return in the financial markets
Financial Markets: Transfer of Capital
•Financial markets play a critical role in capitalist economy. They help facilitate the transfer of funds from "saving surplus" units(those who spend less money than they take in(need money)) to "saving deficit"units(those who have a need for additional finding(have the money) -Examples of savings deficit units-Our federal government which is running a huge deficit takes much less in from taxes than it is spending. They would love to spend more money than they take in. This money will come from savings-surplus units in the economy-that is, from those who spend less than they take in. Examples of savings surplus units-individuals, companies and governments.
Long-term Rates of Return
•Higher returns are associated with higher risk. •investors demand compensation for inflation and other elements of risk (such as default).
Double taxation example: •Assume earnings before tax = $1,000 Federal Tax @ 25% = $250 After tax income available for distribution to shareholders = $750 - •Compute the taxes if the company chooses to distribute the entire after-tax profits to shareholders as dividends.
•If corporation distributes profits as dividends to shareholders, shareholders will be taxed again. •Assuming dividends are taxed @ 15% Dividend tax = 15% of $750 = $112.50 ==>Total tax = 250 + 112.5 = $362.5 or 36.25% -Before the 2003 tax changes, you paid your regular, personal income tax rate on your dividend income, which could be as high as 35 percent. With the new law, qualified dividends from domestic from domestic corporations and qualified foreign corporations are now taxed at a minimum rate of 15%. If your personal income puts you in the 10 percentage or 15 percent income rate bracket, your dividends will be taxed at only 5 percent and in 2008, this rate dropped to 0 percent. Unless Congress takes further action, this tax. break on dividends will end after 2012 and indivduals will once again be taxed at their regular personal tax
over the counter markets
•If firms do not meet the listing requirements of the exchange, and/or wish to avoid higher reporting requirements and fees of exchanges, they may choose to trade on OTC. •OTC (Over-the-Counter) market refers to all securities market except organized exchanges. There is no specific geographic location for OTC market. Most transactions are done through a network of security dealers who are known as broker-dealers and brokers. Their profit depends on the price at which they are willing to buy (bid price) and the price at which they are willing to sell (ask price). •Most prominent OTC market for stocks is NASDAQ. NASDAQ lists over 5,000 securities (including Google, Microsoft, Starbucks). Most corporate bond transactions are also conducted on OTC markets.
What Explains the Shape of the Term Structure? The Liquidity Preference Theory
•Investors require maturity-risk premiums to compensate them for buying securities that expose them to the risks of fluctuating interest rates. -if we think there is a recession coming I'm more likely to need my cash I prefer to invest in short term debt as opposed to long term debt. Which causes the yield curve to invert. We are saying how much do I think I will need cash in the future.
Opportunity cost
•It is the cost of making a choice in terms of next best alternative that must be foregone. It is the highest valued alternative that you had to give up when you made the choice. -Example: By lending money to your friend at zero percent interest, there is an opportunity cost of 1% that could potentially be earned by depositing the money in a savings account in a bank.
The Role of Finance in Business (cont.)
•Knowledge of financial tools is relevant for decision making in all areas of business (marketing, production etc.) and also in managing personal finances. While finance is primarily about the management of money, a key component of finance is the management and interpretation of information. •Decisions involve an *element of time and uncertainty* ... financial tools help adjust for time and risk. •*Decisions* taken in business should be *financially viable* ... financial tools help determine the financial viability of decisions.
The trade-offs Corporate form Benefits
•Limited liability, easy to transfer ownership, easier to raise capital, unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies).
Cash flow from investing in long-term assets
•Long-term assets include fixed assets and other long-term assets. A firm may be engaged in acquisition and sale of such assets leading to cash flows. •Home Depot's spent $1.126 billion on fixed assets (as observed by the change in gross fixed assets) and $159 million on other assets.
Interest rate determinants
•Nominal interest rate= Real risk-free rate + Inflation premium + Default-risk premium + Maturity-risk Premium + Liquidity-risk Premium •Thus the nominal rate or quoted rate for securities is driven by all of the above risk premium factors.
opportunity cost
•Rate of return on next best investment alternative to the investor
What Explains the Shape of the Term Structure? The Unbiased Expectations Theory
•Term structure is determined by an investor's expectations about future interest rates. -people look ahead and say oh shoot I think there is a recession coming and economic growth is going to be bad and inflation will be minimal so right now the economy is okay. If I expect that a recession is coming I will accept a lower interest rate in the future. I think there is going to be a recession and I want to see my money locked up which causes yield curve to invert. When we feel good about the economy we say that we can charge more in interst
The balance sheet
•The balance sheet provides a snapshot of a firm's financial position at a particular date. •It includes three main items: assets, liabilities, and owner-supplied capital (shareholders' equity). -Assets (A) are resources owned by the firm. -Liabilities (L) and owner's equity (E) indicate how those resources are financed: A= L+ E •The transactions in balance sheet are recorded at cost price, so the book value of a firm may be very different from its current market value.
Sarbanes-Oxley Act (SOX)
•This Act holds senior corporate advisors (such as accountants, lawyers, board of directors, officers) responsible for any instance of misconduct. •Attempts to protect the interest of investors by improving transparency and accuracy of corporate disclosures. -Mandates that senior executives take individual responsibility for the accuracy and completeness of the firm's financial reports -safeguards the interests of the shareholders by providing greater protection against accounting fraud and financial misconduct.
Why Do Companies Go Abroad?
•To increase revenues •To reduce expenses (land, labor, capital, raw material, taxes) •To lower governmental regulation standards (ex. environmental, labor) •To increase global exposure
Partnership
•Two or more persons come together as co-owners for the purpose of operating a business for profit. (l) Advantages - Minimal organizational requirements -Negligible government regulations (2) Disadvantages -All partners have unlimited liability -Difficult to raise large amounts of capital -Partnership dissolved by the death or withdrawal of general partner
Role of venture capitalist
•Venture capitalist are the prime source of funding for start-up companies and companies in "turnaround"situations. Funding for such ventures are very risky, but carry the potential for high returns. •The borrowing firm may not have the option of pursuing public offering due to: small size, no record of profits, and uncertain future growth prospects. -Vc say lets take angel investors and put them into a company that we called a venture capital company and then we will invest that money. We generate a return for the investor-goal.
Three basic issues addressed by the study of finance:
•What long-term investments should the firm undertake? (This area of finance is generally referred to as capital budgeting decision) •How should the firm raise money to fund these investments? (the firm's funding choices are referred to as capital structure decision) •How to manage cash flows arising from day-to-day operations? (referred to as working capital decision)
The income statement
•known as Profit/Loss Statement •Measures the results of firm's operation over a specific period. -Indicates the amount of profits generated by a firm over a given time period such as 1 year •The bottom line of the income statement shows the firm's profit or loss for a period. •Sales - Expenses = Profits The income statement begins with sales or revenue from which we subtract the cost of goods sold(the cost of producing or acquiring the product or service to be sold) to yield gross profits. Next, operating expenses are dedicated to determine operating income(also called operating profits o earning before enters and taxes of EBIT)
