FIN 331 terms and concepts

If a firm is financed entirely by bonds (Debt) rather than stocks, its taxable income (EBIT) is ____ If a firm is financed entirely by stock and has no debt, then its taxable income is... (assume its EBIT is 1,500,000)

0 (interest is completely deducted) 1,500,000(0.4 tax rate)= 600,000 in taxes So investors would receive only 0.9 million

ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance What 2 problems?

1. ROE does not consider risk 2. ROE does not consider the amount of capital invested Reliance on ROE may encourage mangers to make investments that don't benefit shareholders. As a result, analysts have looked to develop other performance measures such as EVA

What qualitative factors should be considered when evaluating a company's future financial performance?

Arethefirm'srevenuestiedtoonekeycustomer, product, or supplier? • Whatpercentageofthefirm'sbusinessisgenerated overseas? • Firm'scompetitiveenvironment • Futureprospects • Legalandregulatoryenvironment

Higher Equity multiplier means more of the company's asset financing is being done through

DEBT EM is a variation of the debt ratio

Stockholder's equity?

Can be thought of in two ways: 1. First, it is the amount that stockholders paid to the company when they bought shares the company sold to raise capital, in addition to all of the earnings the company has retained over the years 2. Can also be thought of as a residual Equity= Assets- Liabilities

potential problems and limitations of financial ratio analysis

Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions. Different operating and accounting practices can distort comparisons. Sometimes it is hard to tell if a ratio is "good" or "bad." Difficult to tell whether a company is, on balance, in a strong or weak position. "average" performance not necessarily good, perhaps firm should aim higher seasonal factors can distort ratios (higher sales in certain months) "window dressing" techniques can make statements and ratios look better than they are Inflation has distorted many firms' balance sheets so analyses must be interpreted with judgment

Main financial goal of any public corporation?

Creating value for investors

****Holding assets constant, if debt increases****

Equity declines Interest expense increases- leading to a reduction in net income ROA declines (b/c of reduction in net income) ROE may increase or decrease (since both net income and equity decline)

T or F: firms financed entirely from equity (capital comes from equity) have interest expenses T or F: in this case, the firm's taxable income and its operating income are the same (EBIT=taxable income)

FALSE no borrowed money, so no interest expenses TRUE

What does total debt to total capital ratio tell you?

How much of the firm's capital is financed by debt (borrowed) rather than by equity; measures the percentage of firm's capital provided by debtholders

In what case would a firm with a high debt ratio (lots of its capital comes from debt rather than equity) have high returns?

In a normal economy Lower returns and possible bankruptcy if the economy goes into a recession

Who generally estimates the intrinsic value of stock?

Managers/analysts within the corporation

True or false: Managers should avoid actions that reduce intrinsic value even if those decisions increase stock price in the short run

TRUE intrinsic value is a long-run concept

ROE= net income/shareholder's equity Net income factors in preferred shares paid in dividends; shareholders equity does not

The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested

What exactly takes place in the stock market?

The prices of firms' stocks are established

what is a market?

a venue where goods and services are exchanged

Profit margin tells what?

how much the firm earns on its sales (ratio depends primarily on costs and sale prices)

If operating margin of a firm is below industry average

indicates that its operating costs are too high

Higher debt charges lead to higher ___ charges and ____ net income

interest decreased

TIE ratio (times interest earned)

measures extent to which operating income (EBIT) can decline before the firm is unable to meet its annual interest costs

Finance

the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities

debtholders How does the amount debtholders get from the company differ from the amount stockholders get?

company's bankers and bondholders who generally receive fixed payments from the company *debtholders generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two groups, to the extent that stockholders are typically more willing to take on risky projects* Also, stockholders receive whatever is left over after bondholders have been paid

Progressive structure

corporate and individual taxes both have progressive structure-that is, the higher the income, the higher the marginal tax rate

Retained earnings

cumulative total of all earnings kept by the company during its life

S corportation

Congress created S corporations that are taxed as if they are proprietorships or partnerships, thus they are exempt from corporate income tax To qualify for S corporation status, a firm can have no more than 100 stockholders Vast majority of small corporations elect S status and retain it until they decide to sell stock to the public, at which time they become C corporations

Current assets Long-term (fixed) assets

Current assets= cash and cash equivalents, A/R, inventory Long-term assets= plant and equipment, intellectual property (patents and copyrights) *Plant and equipment is reported NET of accumulated depreciation

Current vs long term liabilities

Current- claims that are paid off within a year -A/P -Accruals -N/P (to banks and short term lenders) Long term -Bonds that mature in more than a year (B/P)

NASDAQ

DEALER; global electronic marketplace for buying and selling securities-- brokers and dealers who participate in the OTC market are members of a self-regulatory body known as the Financial industry regulatory authority (FINRA), which licenses brokers and oversees)

Total debt vs total liabilities

DEBT=INTEREST BEARING LIABILITIES Company's total debt includes both its short term interest bearing liabilities (N/P) and long term interest bearing liabilities (Bonds) Total debt= N/P + bonds Total liabilities= total debt + company's "free" (non-interest bearing) liabilities Total liabilities= (N/P+bonds)+(A/P+Accruals)

Capital

Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based, i.e. retail, corporate, investment banking, etc

Dutch auction

Google conducted a Dutch auction during its IPO, where individual investors placed bids for shares directly. In a Dutch auction, the actual transaction price is set at the highest price (the clearing price) that causes all of the offered shares to be sold. Investors who set their bids at or above the clearing price received all of the shares they subscribed to at the offer price, which turned out to be $85

If I am the holder of a bond, that means that... If a company issues bonds, that means....

I have loaned a company some amount of money When companies need to raise money, issuing bonds is one way to do it. A bond functions like a loan between an investor and a corporation. The investor agrees to give the corporation a specific amount of money for a specific period of time in exchange for periodic interest payments at designated intervals. When the loan reaches its maturity date, the investor's loan is repaid

Ratio comparisons should be made through time and with competitors:

Industry analysis (industry average compared to firm's average in a particular aspect) Benchmark (peer) analysis Trend analysis (comparing same firm's ratios over time)

Why would companies often issue bonds to raise capital rather than borrowing from a bank?

Interest on investors' bonds is often less than interest on a bank loan

Tax treatment of various uses and sources of funds: Interest paid Interest earned Dividends paid

Interest paid= tax-deductible for corporations (paid out of pre-tax income) and then what's left is your taxable income, but usually not for individuals (interest on home loans being the exception) Interest earned: usually fully taxable (an exception being interest from a "muni") Dividends paid: paid out of after-tax income (cannot be deducted) Dividends earned: 70% dividends received is excluded from taxable income, while remaining 30% is taxed at ordinary tax rate

Why is it difficult for a small investor to purchase shares in a company's IPO?

These deals are often "oversubscribed", which means that the demand for shares at the offering price exceeds the number of shares issued. In such instances, investment bankers favor large institutional investors (who are their best customers); and small investors find it hard, if not impossible, to get in on the ground floor. They can buy the stock in the after-market; but evidence suggests that when an investor does not get in on the ground floor, over the long run IPOs often under-perform the overall market

OTC markets

a large collection of brokers and dealers, connected electronically by phones and computers, that provides for trading in unlisted securities ***used when stock is traded infrequently, perhaps because the firm is new or small, and few buy and sell orders come in and matching them within a reasonable amount of time is difficult. To avoid this problem, some brokerage firms maintain an inventory of such stocks and stand prepared to make a market for them. These "dealers" buy when individual investors want to sell, and they sell part of their inventory when investors want to buy

The corporate tax system favors ___ financing over ___ financing

debt > equity because interest is a deductible expense on the way businesses are financed

bid-ask spread

difference between bid and ask prices, represents dealer's markup or profit

Private equity company?

organizations that operate much like hedge funds, but rather than purchasing some of the stock of a firm, they buy and then mange entire firms

Inventory turnover ratio If firm's inventory turnover ratio is much lower than industry average, what does this imply?

sales/inventories these ratios show how many times the particular asset is "turned over" during the year If it equals 4.9, that means that each item of Allied's inventory is sold and restocked, or "turned over" 4.9 times per year It suggests that it is holding too much inventory

Balance sheet Income statement Statement of cash flows Statement of stockholder's equity

shows what assets the company owns and who has claims on those assets as of a GIVEN DATE (ex. Dec. 31st, 2014) summarizes firm's revenues and expenses over given period of time (ex. 2014) shows how much cash the firm began the year with, how much it ended up with, and what it did to increase or decrease its cash shows amount of equity (RETAINED EARNINGS) the stockholders had at start of the year, the items that increased or decreased equity, and equity at end of the year; shows how much of the firm's earnings were retained rather than paid out as dividends

Tax loss carry-back and carry-forward

since corporate incomes can fluctuate widely, the tax code allows firms to carry losses back to offset taxable income in previous years or forward to offset taxable income in the future

direct transfers of money and securities is a procedure used mainly by ____ and relatively ____ capital is raised

small firms little capital

In what case would derivatives increase risk?

speculators can use derivatives to bet on the direction of future stock prices, interest rates, exchange rates, and commodity prices. In many cases, these transactions produce high returns if you guess right, but large losses if you guess wrong. Here, derivatives can increase risk.

Market price > intrinsic value Market price < intrinsic value Market price = intrinsic value

stock is overvalued stock is undervalued equilibrium

Derivatives can be used to _____ risk Example?

"hedge" (reduce) Suppose a wheat processor's costs rise and its net income falls when the price of wheat rises. The processor could reduce its risk by purchasing derivatives—wheat futures—whose value increases when the price of wheat rises. This is a hedging operation, and its purpose is to reduce risk exposure

2 ways companies can raise capital****

1. Borrowing money; debt= BONDS 2. Selling shares of itself (allowing people to become partial owners of it); equity= STOCKS "Security" in equity world= stock; in debt world= bond

3 ways capital is transferred between savers and borrowers?

1. Direct transfers of money and securities- occur when a business sells it stocks or bonds directly to savers without going through any type of financial institution 2. Investment bank- underwriter "underwrites" the issue; the underwriter facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers; the businesses' securities and savers' money merely "passes through" the investment banks -corporationr eceives the sale proceeds -this is called a *primary market transaction* 3. Financial intermediary (bank, insurance company, mutual fund)- intermediary obtains funds from savers in exchange for its securities. The intermediary uses this money to buy and hold businesses' securities, while the savers hold the intermediary's securities

Finance is divided into what 3 areas?

1. Financial management (= corporate finance): decisions that focus on how much and what types of assets to acquire, how to raise the capital needed to purchase those assets, and how to run a firm so as to maximize its value 2. Capital markets: markets where interest rates, along with stock and bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together "savers", who have money to invest, and businesses, individuals, and other entities that need capital for various purposes; Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions. Capital markets help channelize surplus funds from savers to institutions which then invest them into productive use 3. Investments: Investments relate to decisions concerning stocks and bonds and include a number of activities: a. Security analysis b. Portfolio theory c. Market analysis

Why will the value of any business other than a relatively small one be maximized if it is organized as a corporation?

1. Limited liability reduces the risk born by investors; Limited liability is where a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a company or partnership. If a company with limited liability is sued, then the plaintiffs are suing the company, not its owners or investors 2. A firm's value is dependent on its growth opportunities which are dependent on its ability to attract capital. Corporations attract capital more easily. 3. The value of an asset also depends on its liquidity, which means the time and effort it takes to sell the asset for cash at a fair market value. Because the stock of a corporation is easier to transfer to a potential buyer than is an interest in a proprietorship or partnership, and because more investors are willing to invest in stocks than in partnerships (with their potential unlimited liability), a corporate investment is relatively liquid

What factors affect managerial behavior? (i.e. what influences whether managers act in their own best interests which may deviate from interests of stockholders, vs. just in the interests of stockholders)

1. Managerial compensation: good compensation package is one that is sufficient to attract and retain good managers, but doesn't go beyond what is needed. It should be structured so that managers are rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date 2. Direct intervention by shareholders 3. Threat of firing 4. Threat of takeover: hostile takeover is when "corporate raiders" attempt to capture a firm when its stock is undervalued because the raiders see it as a bargain; this provides an incentive to managers-- if you want to keep your job, never let your stock become a bargain

Types of financial markets: 1. Physical assets vs. financial assets

1. Physical asset markets vs. financial asset markets: physical "tangible" asset markets are for prodcts such as wheat, autos, real estate, computers, machinery, etc. Financial asset markets deal with stocks, bonds, notes, and mortgages. Financial markets also deal with *derivative securities* whose values are derived from changes in the prices of other assets -A share of Ford stock is a "pure financial asset" whikle an option to buy Ford shares is a derivative security whose value depends on the price of Ford stock

4 types of business organizations

1. Proprietorships 2. Partnerships 3. Corporations 4. Limited liability companies and limited liability partnerships

How do investment banks help companies raise capital?

1. help corportions design securiteis with geatyres that are attractive to investors 2. buy these securities from the corporation 3. resell them to savers

3 categories of stock market transactions

1. outstanding shares of established publicly owned companies that are traded= secondary market ("used shares") -company receives no new money when sales occur in this market -if a company has 50 million shares outstanding and the owner of 100 shares sells his stock, the trade is said to have occurred in the 2ndary market 2. Additional shares sold by established publicly owned companies= the primary market -If a company decides to issue/sell an ADDITIONAL 1 million shares to raise new equity capital, this transaction occurs in the primary market 3. Initial public offerings made by privately held firms= *the IPO market* -Whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market.

Individual's tax rates begin at ___ and rise to ____ for single individuals with incomes over 400,000 and married couples filing jointly with incomes over 450,000

10%---------39.6%

Dividends received: Most investors pay ____% on dividends they receive Investors in the 10% or 15% tax bracket (low level of income) pay _____ on qualified dividends Single individuals with incomes over 400,000 and married couples filing jointly with incomes over 450,000 pay ___% on dividends received **HOW ARE DIVIDENDS TAXATION A FORM OF DOUBLE TAXATION OF CORPORATE INCOME?**

15 0 20 Dividends are paid out of corporation's net income which has already been taxed at corporate level, and then those dividends received by investors are taxed again

Corporations: Marginal rates begin at ___ and rise to ____ for corporations with income over 10 million, although corporations with income between 15 and 18.33 million pay a marginal tax rate of ___ Also may be subject to _____

15%, rise to 35% 38% state tax, around 5%

Operating income

=EBIT

Working capital

=current assets Current assets are often called working capital because these assets "turn over"; that is, they are used and then replaced throughout the year. When Allied buys inventory items on credit, its suppliers, in effect, lend it the money used to finance the inventory items. Allied could have borrowed from its bank or sold stock to obtain the money, but it received the funds from its suppliers. These loans are shown as accounts payable, and they typically are "free" in the sense that they do not bear interest. Similarly, Allied pays its workers every two weeks and pays taxes quarterly; so Allied's labor force and tax authorities provide it with loans equal to its accrued wages and taxes. In addition to these "free" sources of short-term credit, Allied borrows from its bank on a short-term basis. These bank loans are shown as notes payable. While accounts payable and accruals do not bear interest, Allied pays interest on funds obtained from the bank.

Derivatives?

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. EXAMPLES: 1. Options= a privilege sold by one party to another offering the holder the right, but not the obligation, to buy or sell a security at the strike price at a certain time 2. Futures= a financial contract that obligates the buyer to purchase (or in the case of a seller, to sell and deliver) the assets underlying the contract at a certain future date; For example, suppose that on July 31, 2014 Diana owned ten thousand shares of Wal-Mart (WMT) stock, which were then valued at $73.58 per share. Fearing that the value of her shares would decline, Diana decided that she wanted to arrange a futures contract to protect the value of her stock. Jerry, a speculator predicting a rise in the value of Wal-Mart stock, agrees to a futures contract with Diana, dictating that in one year's time Jerry will buy Diana's ten thousand Wal-Mart shares at their current value of $73.58

Financial intermediary system example

A saver deposits dollars in a bank, receiving a certificate of deposit; then the bank lends the money to a business in the form of mortgage loan- in this case, certificates of deposit, which are saver and more liquid than mortgages and thus better for most savers to hold.

Cash vs other assets

Although assets are reported in dollar terms, only the cash and equivalents account represents actual spendable money. Accounts receivable represent credit sales that have not yet been collected. Inventories show the cost of raw materials, work in process, and finished goods. Net fixed assets represent the cost of the buildings and equipment used in operations minus the depreciation that has been taken on these assets. At the end of 2014, Allied has $10 million of cash; hence, it could write checks totaling that amount

1. Stock market efficiency? 2. You hear in the news that a medical research company received FDA approval for one of its products. If the market is highly efficient, can you expect to take advantage of this info by purchasing the stock? 3. A small investor has been reading about a "hot" IPO that is scheduled to go public later this week. She wants to buy as many shares as she can get her hands on, and is planning on buying a lot of shares the first day once the stock begins trading. Would you advise her to do this?

An efficient market is a market in which prices are close to intrinsic values and stocks seem to be in equilibrium; when markets are efficient, investors can buy and sell stocks and be confident they are getting good prices *In an efficient market, investors cannot "beat the market" except through good luck of insider trading* 2. NO. If the market is efficient, this information will already have been incorporated into the company's stock price (market value= intrinsic value). So, it's probably too late to "capitalize" on this information. 3. Probably not. The long-run track record of hot IPOs is not that great, unless you are able to get in on the ground floor and receive an allocation of shares before the stock begins trading. It is usually hard for small investors to receive shares of hot IPOs before the stock begins trading

In what order are assets and liabilities listed on the balance sheet?

Assets listed in order of the length of time before they will be converted to cash or used by the firm Liabiities listed in th eorder in which they must be paid 1. A/P (paid off within a few days) 2. Accruals (also paid off promptly) 3. then N/P (b/c paid within one year)

EVA vs MVA

Economic value added= focuses on management effectiveness in a given year; companies create value if the benefits of their investments exceed the cost of raising the necessary capital Market value added= excess of market value over book value MVA is applicable to entire firm, while EVA can be calculated on a divisional basis as well

Reasons market may be inefficient

It is costly and/or risky for traders to take advantage of mispriced assets--- For example, even if you know that a stock's price is too low because investors have overreacted to recent bad news, a trader with limited capital may be reluctant to purchase the stock for fear that the same forces that pushed the price down may work to keep it artificially low for a long time (when they would normally want to purchase the stock then and there b/c they're getting a deal). Similarly, during the recent stock market bubble, many traders who believed (correctly) that stock prices were too high lost a great deal of money selling stocks short in the early stages of the bubble, because prices went even higher before they eventually collapsed. Thus, mispricings may persist. Cognitive biases cause investors to make systematic mistakes that lead to inefficiencies. This is an area of research known as "behavioral finance"

LLC LLP

Limited liability COMPANY: hybrid between a partnership and corporation; provides limited liability protection (like a corporation), but taxed as a partnerhsip LLP= similar to LLC but used for professional firms in the fields of accounting, law, and architecture. It provides personal asset protection from business debts and liabilities (like a corporation) but is taxed as a partnership Unlike limited partnerships, where the general partner has full control of the business, investors in LLC or LLP have votes in proportion to their ownerhsip interest

Market analysis

Market analysis deals with the issue of whether stock and bond markets at any given time are "too high," "too low," or "about right."

What types of liabilities bear interest?

N/P (accounts payable and accruals do not)

Example of capital market?

NY stock exchange- stocks from largest US corporations are traded (ex. Apple)

What type of transaction is occurring? Apple decides to issue additional stock with the assistance of its investment banker. An investor purchases some of the newly issued shares. Investor buys existing shares of Apple stock in the open market (i.e. a shareholder sells some of his/her shares to the public and an investor buys them)

PRIMARY market transaction SECONDARY market transaction

Types of financial markets: 4. Primary markets vs secondary markets

PRIMARY= markets in which corporations raise new capital. If GE were to sell a NEW issue of common stock to raise capital, a primary market transaction would take place. The corporation selling the newly created stock, GE, receives the proceeds from the sale in a primary market transaction. SECONDARY= markets in which existing, already outstanding securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market because it deals in outstanding, as opposed to newly issued, stocks and bonds

Portfolio theory

Portfolio theory deals with the best way to structure portfolios, or "baskets," of stocks and bonds. Rational investors want to hold diversified portfolios in order to limit risks, so choosing a properly balanced portfolio is an important issue for any investor

Types of financial markets: 5. Private markets vs public markets

Private= transactions are negotiated directly between two parties -Bank loans and private debt placements with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner to which the two parties agree. Public= standardized contracts are traded on organized exchanges. -Securities that are traded in public markets (for example, common stock and corporate bonds) are held by a large number of individuals. These securities must have fairly standardized contractual features because public investors do not generally have the time and expertise to negotiate unique, nonstandardized contracts. Broad ownership and standardization result in publicly traded securities being more liquid than tailor-made, uniquely negotiated securities

Why are ratios useful? What are the 5 types?

Ratios standardize numbers & facilitate comparisons; they are used to highlight weaknesses and strengths 1. Liquidity= can we make required payments (due within a year)? -Current ratio -Quick ratio 2. Asset management= how efficiently is a firm using its assets? Right amount of assets vs. sales? 3. Debt management= right mix of debt and equity? 4. Profitability= do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? 5. Market value= do investors like what they see as reflected in P/E and M/B ratios?

How are depreciation and amortization reported on the income statement?

Reported as an operating cost *but they are NOT expenses because they represent depreciation/amortization of assets that are already paid for

OUTSTANDING, previously issued securities are traded in _____ markets The most important type is the ___ market

SECONDARY; STOCK

Security analysis

Security analysis deals with finding the proper values of individual securities (i.e., stocks and bonds)

closely held vs publicly held corporations

Some companies are so small that their common stocks are not actively traded; they are owned by relatively few people, usually the companies' managers. These firms are said to be privately owned, or closely held, corporations; and their stock is called closely held stock. In contrast, the stocks of most large companies are owned by thousands of investors, most of whom are not active in management. These companies are called publicly owned corporations, and their stock is called publicly held stock.

Types of financial markets: 2. Spot vs. future markets

Spot= assets are bought or sold for "on the spot" delivery Future= participants agree today to buy or sell an asset at some future date. For example, a farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of soybeans for 6 months from now at a price of 13.75 a bushel. A food processor that needs soybeans in the future may enter into a futures contract in which it agrees to buy soybeans 6 months from now

Stock exchange? Physical location stock-exchanges vs Electronic dealer-based markets

Stock exchange= a market in which securities are bought and sold; security exchanges facilitate communication between buyers and sellers; for example, Goldman Sachs brokers might receive an order from a customer who wants to buy shares of GE stock. Simultaneously, Morgan Stanley brokers might receive an order from a customer wanting to sell shares of GE. Each broker communicates electronically with the firm's representative on the NYSE (GE representative). Other brokers throughout the country are also communicating with their own exchange members. The exchange members with sell orders offer the shares for sale, and they are bid for by the members with buy orders. Thus, the exchanges operate as *auction markets* 1. Physical location exchanges= NYSE and several regional stock exchanges -tangible entities -occupies its own building and allows a number of people to trade on its floor -members meet in large room equipped with phones that enable each member to communicate with his or her firm's offices throughout the country 2. Electronic *dealer*-based markets= include the NASDAQ and the less formal OTC market, and recently developed electronic communications networks (ECNs) -ECNs bring buyers and sellers together -OTC market

Who are the suppliers of capital? Who are the demanders/users of capital?

Suppliers: individuals and institutions with "excess finds". These groups are saving money and looking for a rate of return on their investment. Demanders or users: individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.

EBITDA

amount of cash a company is actually generating

Liquid asset= Liquidity ratios show what? Current ratio? Quick/acid test ratio?

an asset that can be converted to cash quickly without having to reduce the asset's price very much ratios that show the relationship of a firm's cash and other current assets to its current liabilities current ratio indicates the extent to which liabilities are covered by those assets expected to be converted to cash in the near future quick ratio: subtracts inventories from current assets since they are typically the least liquid and will most likely not be converted to cash as quickly as expected; also inventories are the asses on which losses are most likely to occur *Measures firm's ability to pay off short-term obligations without relying on sale of inventories*

Marginal investor

an investor whose views determine the actual stock price (market price)

Proprietorship=? Advantages and disadvantages?

an unincorporated business owned by one individual Advantages: 1. They are easy and inexpensive to form 2. They are subject to few government regulations 3. They are subject to lower income taxes than are corporations Disadvantages: 1. Proprietors have unlimited personal liability for the business' debts, so they can lose more than the amount of money they invested into the company. You may invest 10,000 to start a business but be sued for $1 million if one of your employees runs over someone with a car 2. The life of the business is limited to the life of the individual who created it; and to bring in new equity, investors require a change in the structure of the business 3. Proprietorships have trouble obtaining large sums of capital; hence, they are used mostly for small businesses

Behavioral finance

area of research that attempts to better understand how irrational behavior can be sustained over time. Some examples include: 1. Evaluating risks differently in up and down markets-- suggest that investors and managers behave differently in down markets than they do in up markets, which might explain why those who made money early in the stock market bubble continued to invest their money in the market even as prices went ever higher 2. Overconfidence leads to self-attribution bias and hindsight bias

Auction market vs dealer markets

auction market (NYSE): exchanges operate as auction markets- buy and sell orders come in simultaneously, and exchange members match these orders Dealer market: A dealer market includes all facilities that are needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of (1) the relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities (2) the thousands of brokers who act as agents in bringing the dealers (sellers) together with investors; and (3) the computers, terminals, and electronic networks that provide a communication link between dealers and brokers.

Efficient market hypothesis

efficient markets hypothesis (EMH) remains one of the cornerstones of modern finance theory. It implies that, on average, asset prices are about equal to their intrinsic values. The logic behind the EMH is straightforward. If a stock's price is "too low," rational traders will quickly take advantage of this opportunity and buy the stock, pushing prices up to the proper level. Likewise, if prices are "too high," rational traders will sell the stock, pushing the price down to its equilibrium level. Proponents of the EMH argue that these forces keep prices from being systematically wrong

What advantage does "going public" have for a closely-held corporation? IPO

enables a company's owners to raise capital from a wide variety of outside investors; *once issued, the stock trades in the secondary market*

Importance of well functioning financial markets?

facilitate the flow of capital from investors to the users of the capital -Markets provide savers with returns on their money invested -Markets provide users of capital with necessary funds to finance their investment projects *Well functioning markets provide economic growth

Double taxation

first the corporation's earnings are taxed, then when its after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders

Types of financial institutions

investment banks commercial abnks credit unions pension funds life insurance companies mutual funds exchange traded funds hedge funds private equity companies financial services corps.

Partnership

legal arrangmeent between two or more people who decide to do business together Advantages: 1. Can be established easily and inexpensively 2. Firm's income is allocated on a pro rata basis to the partners and is taxed on an individual basis (no corporate income tax) Disadvantages: 1. Partners subject to unlimited personal liability, which means if a partnership goes bankrupt and any partner is unable to meet his or her pro rata share of the firm's liabilities, the remaining partners will be responsible for making good on the unsatisfied claims 2. Makes it difficult for partnerships to raise large amounts of capital

Corporation Advantages and disadvantages?

legal entity created by a state, and it is separate and distinct from its owners and managers Advantages: 1. Unlimited life 2. LIMITED liability 3. Easy transfer of ownership 4. Ease of raising capital Disadvantages: 1. Double taxation 2. Cost of setup and report filing

How do bondholders protect themselves?

limit risk by including covenants in bond agreements that limit the use of additional debt and constrain managers' actions

Balancing shareholder interests and society interests?

management's primary goal is shareholder wealth maximization. At the same time, the managers know that this does not mean maximize shareholder value "at all costs." Managers have an obligation to behave ethically, and they must follow the laws and other society-imposed constraints that we discussed in the opening vignette to this chapter

Financial markets

markets that bring people and organizations wanting to borrow money together with those who have surplus finds

Fixed assets turnover ratio Total assets turnover ratio

measures how effectively the firm is using its plant and equipment TAT= how efficiently are total assets being used? If TAT for a firm is below industry average, then it is not generating enough sales given its total assets If FAT is at industry average or higher, then its fixed assets are being used at least as intensively as other firms, which is good. So, if TAT is bad relative to the industry, then the problem is not with the fixed assets, but rather, the current assets, inventories, and A/R (whose ratios were below industry standards)

Types of financial markets: 3. Money markets vs. capital markets

money markets= markets for short-term, highly liquid debt securities capital markets= markets for intermediate of long-term debt and corporate stocks -Ex. NY stock exchange is where the stocks of largest US corporations are traded

Management's goal should be to what?

take actions designed to maximize the firm's intrinsic value, not its current price this measn that it will maximize the AVERAGE price over the long run, but not necessarily the current price and each point in time; for example, management might make an investment that lowers profts for the current year but raises expected future profits

Days sales outstanding tells what?

tells the average length of time the firm must wait after making a sale before it receives cash (A/R)/average daily sales Allied DSO= 46 days Industry average= 36 days Allied's credit policy calls for payment within 30 days, so the fact that their DSO is 46 means their customers aren't paying their bills on time

Annual report

the report issued annually by a corporation to its stockholders. It contains basic financial statements as well as management's analysis of the firm's past operations and future prospects includes 4 financial statements: 1. Balance sheet 2. Income statement 3. Statement of cash flows 4. Statement of stockholder's equity

Marginal tax rate

the tax rate on the last dollar of income percentage of tax taken from your next dollar of taxable income above a pre-defined income threshold Ex. 33% marginal tax rate for people with incomes of $171,551- 372,950 35% tax rate for people with income 372,951+

equity

the value of shares issued by a company

The dealers who make the market in a particular stock do what?

they quote the price at which they will pay for the stock (bid price) and price at which they will sell shares (ask price); this info is displayed electonically throughout the world

Why would managers not want to make it so that the stock is undervalued?

threat of hostile takeover they want to maximize the average price over the long run, which will be maximized if management focuses on the stock's intrinsic value-- they want to keep the actual price close to the intrinsice balue

limited vs unlimited liability

unlimited= proprietorships and partnerships: Proprietorship= Legally, the business and the owner are one and the same, so the debts of the business are automatically those of the owner. General partnerships are also unlimited liability companies. Each partner is personally liable for all the debts of the business -- even those taken on by other partners. A "limited partnership" has two kinds of partners: general and limited. The general partners have unlimited liability; they're also the ones who run the company. The limited partners are shielded from personal liability for business debts, but they usually don't get a say in running the company. limited= LLC, LLP, corporations The shareholders of a corporation can lose the money that they have invested in the company -- the price they paid for their shares, essentially -- but that's it. Any debts belong to the corporation, not them. Their liability is therefore limited to whatever they put into the company.

What types of things do individuals pay taxes on? Taxable income is defined as...

wages and salaries, profits of proprietorships and partnerships, and investment income (dividends received, interest received, and profits from sales of securities) Taxable income= gross income less exemptions and deductions

accruals

wages and taxes

Capital gains=? Most tax payers pay ___ on taxes on long-term capital gains; but single individuals with incomes over 400,000 and married couples with joint incomes over 450,000 pay ____

when you buy capital asset (stock, bond, real estate) and sell it for more than you paid for it, you get a capital gain for a certain amount. If you held the asset for a year or less, you'll have a short-term capital gain; if you held it for over a year, you'll have a long-term capital gain -short-term capital gains are taxed at the same rate as ordinary income 15% 20%