FIN 305: Exam 1

'true' means:

-the cash flows and risk that investors would expect of they had all of the information that existed about a company

corporations:

advantages: -unlimited life -easy transfer of ownership -limited liability -ease of raising capital disadvantages: -double taxation -cost of setup and report filing

note that sales occur over the entire year, where the inventory figure is for one point in time:

-for this reason, it may be better to use an average inventory measure

most rapidly growing companies have negative:

-free cash flows -the fixed assets and working capital needed to support a firm's rapid growth generally exceed cash flows from its existing operations

finance, as we know it:

-grew out of both economics and accounting

taxable income is defined as:

-gross income less a set of exemptions and deductions -tax law eliminated most itemized deductions except deductions for charitable contributions, retirement savings, and student loan interest

firms with relatively high debt ratios typically:

-have higher expected returns when the economy is normal, but experience lower returns and possibly face bankruptcy if the economy goes into a recession -therefore, decisions about the use of debt require firms to balance higher expected returns against increased risk

many high-tech companies such as Microsoft and Google:

-have remained on NASDAQ even though they meet the listing requirements of the NYSE

companies benefit by:

-having good reputations -they are penalized by having bad ones (same goes with individuals)

effective governance requires:

-holding managers accountable for poor performance and understanding the important role that executive compensation plays in encouraging managers to focus on the proper objectives -having stock and stock options as a part of pay instead of a bonus related solely to earnings - structures managers to think more like stockholders

what is the relationship between EVA and MVA?

-if EVA is positive, then AT operating income > cost of capital needed to produce that income -positive EVA on annual basis helps to ensure MVA is positive -MVA is applicable to entire firm, while EVA can be calculated on a divisional basis as well

consolidated corporate tax returns:

-if a corporation owns 80% or more of another corporation's stock, it can aggregate income and file one consolidated tax return

the 2002 Sarbanes-Oxley Act:

-if the firm is publicly owned, the CEO and CFO must both certify to the SEC that reports released to stockholders, especially the annual report, are accurate

the capital allocation process:

-in a well functioning economy, capital flows efficiently from those who supply capital to those who demand it suppliers of capital: individuals and institutions with 'excess funds' - these groups are saving money and looking for a rate of return on their investment demanders of capital: 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

stock prices and intrinsic value:

-in equilibrium, a stock's price should equal its 'true' or intrinsic value -intrinsic value is a long-run concept -to the extent that investor perceptions are incorrect, a stock's price in the short run may deviate from its intrinsic value -ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run

the united stated is an important economy, and without its participation it will be difficult to truly have global accounting standards:

-in the meantime, it is important for companies and analysts that evaluate businesses in different countries to have a full understanding of the key differences between the various global accounting standards

a dealer market:

-includes all facilities that are needed to conduct security transactions, but the transactions are not made on the physical location exchanges

bondholders attempt to protect themselves by:

-including covenants in the bond agreements that limit the firms' use of additional debt and constrain managers' actions in other ways

security prices are volatile:

-investors expect to make money, which they generally do over time - but losses can be large in any given year

benchmarking:

-involves comparison to a subset of top competitors in a specific industry

profit margin or net profit margin:

-is calculated by dividing net income by sales -if a company's profit margin is 4.9% and the industry average is 6%, this could be because of; high operating costs as well as a heavy use of debt -while high return on sales is good, we must also be concerned with turnover; if a firm sets a very high price on its products, it may earn a high return on each sale but fail to make many sales; a high profit margin with low sales makes for a low net income

the operating marginL

-is calculated by dividing operating income (EBIT) by sales, and gives the operating profit per dollar of sales -if a company's operating margin is 9.3%, which is below the industry average of 10%, this indicates that the company's operating costs are too high; this is consistent with the low inventory turnover and high days sales outstanding ratios

basic earning power (BEP) ratio:

-is calculated by dividing operating income (EBIT) by total assets -this ratio shows the raw earning power of the firm's assets before the influence of taxes and debt, and it is useful when comparing firms with different debt and tax situations -low turnover ratios and poor profit margins on sales can lead to a low BEP ratio

operating income:

-is derived from the firm's regular core business -it is calculated before deducting interest expenses and taxes, which are considered to be non-operating costs -operating income is also called EBIT or earnings before interest and taxes -operating income or EBIT = sales revenues - operating costs

times-interest-earned (TIE) ratio:

-is determined by dividing earnings before interest and taxes (EBIT) by the interest charges -the TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs

limited liability partnership (LLP):

-is similar to an LLC, but is used for professional fields of accounting, law, and architecture, while LLC's are used for other businesses

the bid-ask spread:

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

the annual report:

-is the most important report that corporations issue to stockholders, and it contains two types of information: 1. a verbal section, often presented as a letter from the chairperson, which describes the firm's operating results during the past year and discusses new developments 2. the report provides four basic financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders' equity

if you want to compare two companies' operating performances:

-it is best to focus on their operating income

possible reasons markets may not be efficient:

-it is costly and or risky for traders to take advantage of mispriced assets -cognitive biases cause investors to make systematic mistakes that lead to inefficiencies; behavioral finance borrows insights from psychology to better understand how irrational behavior can be sustained over time - some examples include: -evaluating risks differently in up and down markets -overconfidence leads to self-attribution bias and hindsight bias

trend analysis:

-it is important to analyze trends in ratios as well as their absolute levels, for trends give clues as to whether a firm's financial condition is likely to improve or deteriorate -to do a trend analysis: plot a ratio over time

because intrinsic value cannot be observed:

-it is impossible to know whether is is really being maximized

a project's ROE must be combined with:

-its size and risk to determine shareholder value

the claims against assets are of two basic types:

-liabilities, or money the company owes to others -stockholders' equity

five major categories of ratios and the questions they answer:

-liquidity: can we make required payments? -asset management: right amount of assets vs sales? -debt management: right mix of debt and equity? -profitability: do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? -market value: do investors like what they see as reflected in P/E and M/B ratios?

short term capital gains or losses are taxed at the same rate as ordinary income:

-long term capital gains are taxed differently, usually at only 15%

enterprise value/EBITDA ratio:

-looks at the relative market value of all of the company's key financial claims (unlike the P/E and market/book ratios which focus on the relative market value of the company's equity) -one benefit to this approach is it is not heavily influenced by the company's debt and tax situations

using financial ratios to assess performance:

-management should look at industry averages and compare itself to specific companies or 'benchmarks' and analyze the trends in each ratio

stockholder-manager conflicts:

-managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders) the following factors affect managerial behavior: -managerial compensation packages -direct intervention by shareholders -the threat of firing -the threat of takeover

managers recognize that being socially responsible is not inconsistent with:

-maximizing shareholder value

total debt to total capital also known as debt ratio:

-measures the percentage of the firm's capital provided by debtholders -total debt includes all short term and long term interest bearing debt, but it does not include operating items such as accounts payable and accruals -creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of liquidation -stockholders, on the other hand, may want more leverage because it can modify expected earnings -if a company's debt ratio is 47.8%, this means its creditors have supplied roughly half of its total funds -with a high debt ratio, creditors will be reluctant to lend the firm more money, and management would probably be subjecting the firm to a high risk of bankruptcy if it sought to borrow a substantial amount of additional funds

return on invested capital:

-measures the total return that the company has provided for its investors -ROIC differs from ROA in two ways: 1. its return is based on total invested capital rather than total assets 2. in the numerator it uses after-tax operating income (NOPAT) rather than net income -the key difference is that net income subtracts the company's after-tax interest expense and therefore represents the total amount of income available to shareholders, while NOPAT is the amount of funds available to pay both stockholders and debtholders

the total asset turnover rario:

-measures the turnover of all the firm's assets, and is calculated by dividing sales by total assets -the industry average is 1.8, if a company received a 1.5 which is somewhat below the industry average, this indicates that it is not generating enough sales given its total assets; therefore, inventories should be reduced and receivables collected faster, which would improve operations

return on total assets:

-net income divided by total assets -if a company has a 7.3% return and the industry average is 10.8% - this is not good; it is better to have a higher return on assets than lower -a low ROA can result from a conscious decision to use a great deal of debt. in which high interest expenses will cause net income to be relatively low

NOWC is calculated as follows:

-net operating working capital (NOWC) = operating current assets - operating current liabilities -operating current assets = (current assets - excess cash) -operating current liabilities = (current liabilities - notes payable)

the total of accounts payable, accruals, and notes payable represent current liabilities on the balance sheet; if we subtract current liabilities from current assets, the difference is called:

-net working capital -net working capital = current assets - current liabilities

what happens if fixed assets are depreciated over 7 years as opposed to 10 years?

-no effect on physical assets -fixed assets on the balance sheet would decline -net income would decline -tax payments would decline -cash position would improve

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 information by purchasing the stock?

-no; if the market is efficient, this information will already have been incorporated into the company's stock price. so, it's probably too late to capitalize on the information

maximizing the intrinsic value will maximize the average price over the long run, but:

-not necessarily the current price at each point in time

both corporate and personal taxes used to have a progressive tax structure:

-now corporations have a flat-tax rate

the exchange members with sell orders:

-offer the shares for sale, and they are bid for by the members with buy orders -therefore, the exchanged operate as auction markets

a liquid asset is:

-one that trades in an active market and thus can be quickly converted to cash at the going market price

line-by-line explanation of the statement of cash flows:

-operating activities: items that occur as part of normal ongoing operations -net income: the source of all cash -depreciation and amortization: when calculating net income depreciation and amortization are subtracted, they are noncash charges and therefore must be added back to net income when cash flow is determined -increase in inventories: to make or buy inventory items, the firm must use cash -increase in accounts receivable: if one chooses to sell on credit when it makes a sale, they do not immediately get the cash that they would have received had they not extended credit -increase in accounts payable: accounts payable represent a loan from suppliers, when one buys goods on credit payables increase -increase in accrued wages and taxes: same logic applies to accruals as accounts payable, if accruals increase by $10 million that means one borrowed an additional $10 million from workers and taxing authorities -net cash provided by operating activities: all the previous items are part of normal operations; when we sum them we obtain the net cash flow from operations -investing activities: all activities involving long term assets are apart of investing activities; this includes the purchase and sale of shoer term investments, and lending and collecting on notes receivable -additions to property, plant, and equipment: outflows are shown in parentheses, if you sell fixed assets it is a cash inflow -increase in notes payable: when borrowing funds, you have a cash inflow; when the loan is repayed, it is an outflow -increase in bonds (long-term debt): when borrowing from long-term investors, bonds are issued in exchange for cash - this is an inflow, when bonds are repaid by the firm years later, it is an outflow -payments of dividends to stockholders: dividends are paid in cash, when paid it is a negative amount -summary: this section summarizes the change in cash equivalents

dividends paid:

-paid out of after-tax income

economies with well-developed markets perform better than economies with:

-poorly functioning markets

primary markets vs. secondary markets:

-primary markets are the markets in which corporations raise new capital -secondary markets are markets in which existing, already outstanding securities are traded among investors

where can you find a stock quote?

-print sources (wall street journal) -local newspaper -online sources (cnn money)

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?

-probably not, the long-run track record of hot IPOs is not 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

tax rates are:

-progressive; the higher one's income, the larger the percentage paid in taxes

forms of business organization:

-proprietorships -partnerships -corporations -limited liability companies (LLCs)

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

behavioral finance:

-rather than assuming investors are rational, behavioral finance theorists borrow insights from psychology to better understand how irrational behavior can be sustained over time -two major criticisms of EMH or efficient market hypothesis: 1. it is often difficult or risky for traders to take advantage of mispriced assets; for example 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, and 2. why mispricings can occur in the first place; for example, individuals view potential losses or gains differently as well as people's willingness to take a gamble may depend on recent performance (gamblers ahead may take more risk, whereas those behind tend to become more conservative)

why are ratios useful?

-ratios standardize numbers and facilitate comparisons -ratios are used to highlight weaknesses and strengths -ratio comparisons should be made through time and with competitors (industry analysis, benchmark analysis, trend analysis)

the income statement is tied to the balance sheet through the:

-retained earnings account on the balance sheet -net income as reported on the income statement less dividends paid = the retained earnings for the year, those retained earnings are added to the cumulative retained earnings from prior years to obtain the year-end 2019 balance for retained earnings -retained earnings for the year are also reported in the statement of stockholders' equity; all four of the statements provided for the annual report are interrelated

currently, corporations' capital gains are taxed at the:

-same flat corporate tax rate as their operating income

ratio analysis:

-satisfactory liquidity ratios are necessary if the firm is to continue operating -good asset management ratios are necessary for the firm to keep its costs low and thus its net income high -debt management ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders -profitability ratios combine the asset and debt management categories and show their effects on ROW -market value ratios tell us what investors think about the company and its prospects

what is meant by stock market efficiency?

-securities are normally in equilibrium and are 'fairly priced' -investors cannot 'beat the market' except through good luck or better information -efficiency continuum

the primary financial goal of management is:

-shareholder wealth maximization, which translates to maximizing stock price -value of any asset is present value of cash flow stream to owners -most significant decisions are evaluated in terms of their financial consequences -stock prices change over time as conditions change as as investors obtain new information about a company's prospects

short term vs. intermediate vs. long term

-short term: less than one year -intermediate: one to ten years -long term: more than ten years

compensation packages:

-should be sufficient to attract and retain managers, but should not go beyond what is needed -need to be consistent over time -should be structured so 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

stock market indexes are designed to:

-show the performance of the stock market -however, there are many stock indexes, and it is difficult to find which index best reflects market actions; some are designed to represent the entire stock market and some track the returns of certain industry sectors, etc.

price/earnings (P/E) ratio:

-shows how much investors are willing to pay per dollar of reported profits -calculated by price per share divided by earnings per share -P/E ratios are relatively high for firms with strong growth prospects and little risk; but low for slowly growing and risky firms -P/E ratios vary considerably over time and across firms

apple computer decides to issue additional stock with the assistance of its investment banker, an investor purchases some of the newly issued shares; is this a primary market transaction or a secondary market transaction?

-since new shares of stock are being issued, this is a primary market transaction

what if instead an investor buys existing shares of apple stock in the open market; is this a primary or secondary market transaction?

-since no new shares are created, this is a secondary market transaction

markets are more efficient for individual stocks rather than for entire companies:

-so for investors with enough capital,. it does make sense to seek out badly managed companies that can be acquired and improved

privately owned or closely 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

the liquidity, asset management, and debt ratios covered so far show:

-something about the firm's policies and operations

economic value added or EVA:

-sometimes called 'economic profit' -companies create value (and realize positive EVA) if the benefits of their investments exceed the cost of raising the necessary capital

spot markets vs. futures markets:

-spot markets are markets in which assets are bought or sold for 'on the spot' delivery (within a few days) -futures markets are markets in which participants agree today to buy or sell an asset at some future date - such a transaction can reduce, or hedge, the risks faced by both the buyer and seller (such as a farmer and a food processor)

ethics is defined by:

-standards of conduct or moral behavior -business ethics can be seen as a company's attitude and conduct toward it's employees, customers, community, and stockholders

stockholder-debtholder conflicts:

-stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds -bondholders receive fixed payments and are more interested in limiting risk -bondholders are particularly concerned about the use of additional debt -bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers' actions

assets purchases years ago at pre-inflation prices are carried at their original costs even though inflation might have caused their actual values to rise substantially:

-successful companies' values rise above their historical costs, whereas unsuccessful ones have low M/B ratios

interest paid:

-tax deductible for corporations (with limitations), but usually not for individuals

one tool to determine how ROE is determined is:

-the DuPont Equation -ROE = profit margin x total assets turnover x equity multiplier -if a firm's ROE is below the industry average and that of the benchmark companies, a DuPont analysis can help identify problem areas that should be strengthened

tying the ratios together:

-the DuPont Equation -can be used to help identify ways to improve performance

free cash flow (FCF):

-the amount of cash that could be withdrawn without harming a firm's ability to operate and produce future cash flows

total invested capital represents:

-the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock)

stockholders' equity:

-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 -stockholders' equity = paid-in capital + retained earnings or -stockholders' equity = total assets - total liabilities

earnings per share (EPS) is often called:

-the bottom line

ordinary corporate operating losses can be carried forward indefinitely:

-the carryforward deduction is limited to the lessor of the total available net operating loss (NOL) or 80% of the taxable income for the year to which the carryforward will be applied

management's goal is to maximize the firm's intrinsic value, and the value of any asset, including share of stock, is based on:

-the cash flows the asset is expected to produce -therefore, managers strive to maximize cash flows available to investors

market price is:

-the current price of stock -market price can vary from $27.90 to $29.33 in the same day as buy and sell orders come in

the primary liquidity ratio is:

-the current ratio -which is calculated by dividing current assets by current liabilities -the industry average is a 4.2, if a company's average is a 3.2 its liquidity position is somewhat weak, but by no means desperate -a deviation from the industry average should signal the analyst or management to check further -a high current ratio generally indicates a very strong, safe liquid position; but it could also indicate that the firm has too much cash, receivables, and inventory relative to its sales, in which case these assets are not being managed efficiently

market value added or MVA:

-the difference between the market value of a firm's equity and the book value as shown on the balance sheet, with market value found by multiplying the stock price by the number of shares outstanding

the use of debt will increase, or 'leverage up' a firm's ROE if:

-the firm earns more on its assets than the interest rate it pays on debt

the markets for some companies' stocks being highly efficient and the market for other stocks being highly inefficient:

-the key factor is the size of the company -the larger the firm, the more analysts tend to follow it and thus the faster new information is likely to be reflected in the stock's price -also, the better the communications, the more efficient the market for the stock

the balance sheet of an average american household:

-the largest asset is the primary residence -the average household does not have a large amount of savings in place for retirement -average household debt levels have not increased dramatically in recent years -average household net worth increased slightly from 2004 to 2007, but declined sharply from 2007 to 2009; this decline was due to the sharp decline in the housing market reducing the value of the average home and the sharp decline in the stock market reduced the value of the average amount of retirement savings

assets on the balance sheet are listed by:

-the length of time before they will be converted to cash (inventories or accounts receivable) or used by the firm (fixed assets)

in a global context, economic development is highly correlated with:

-the level and efficiency of financial markets and institutions -it is difficult, if not impossible, for an economy to reach its full potential if it doesn't have access to a well-functioning financial system

the larger the depreciation:

-the lower the taxable income, the lower the tax bill, and thus the higher the operating cash flow

the corporate tax structure is simple:

-the new tax law lowered the corporate rate to one single flat rate of 21%.; but because of state and local tax rates we will use a rate of 25%

even if markets are efficient and all stocks and companies are fairly priced, an investor should still be careful when selecting stocks for his or her portfolio:

-the portfolio should be diversified with a mix of stocks from various industries along with some bonds and other fixed-income securities

intrinsic value is:

-the price at which the stock would sell if all investors had knowable information about a stock; based on expected future cash flows and risk -market price tends to fluctuate around the intrinsic value, and the intrinsic value changes over time as the company succeeds or fails with new projects, competitors enter or exit the market, and so forth -we can guess or estimate intrinsic value, but different analysts will reach somewhat different conclusions

equilibrium price is:

-the price that balances buy and sell orders at any given time; when a stock is in equilibrium, the price remains relatively stable until new information becomes available and causes the price to change

market/book ratio:

-the ratio of a stock's market price to its book value gives another indication of how investors regard the company -companies that are well regarded by investors - which means low risk and high growth - have high M/B ratios -first you find the book value per share; then to find the M/B ratio you take the market price per share and divide it by the book value per share

most analysts regard free cash flow as being:

-the single most important number that can de developed from accounting statements, even more important than net income -FCF shows how much cash the firm can distribute to its investors

market ratios relate:

-the stock price to earnings and book value price -if the liquidity, asset management, debt management, and profitability ratios all look good and if investors think these ratios will continue to look good in the future - the market value ratios will be high; the stock price will be as high as can be expected; and management will be judged as having done a good job

marginal tax rate is defined as:

-the tax rate on the last dollar of income -marginal rates begin at 10% and rise to 37%

companies do not just pile up cash in a bank account:

-therefore, retained earnings as reported on the balance sheet do not represent cash and are not "available" for dividends or anything else

different firms have different amounts of debt, different tax carryforwards, and different amounts of non-operating assets such as marketable securities:

-these differences can cause two companies with identical operations to report significantly different net incomes

even though depreciation and amortization are reported as costs on the income statement:

-they are not cash expenses -therefore, those concerned with the amount of cash a company is generating often calculate EBITDA or earnings before interest, tax, depreciation, and amortization

accounting statements are inefficient for evaluating managers' performance because:

-they do not reflect market values

these four statements are related to one another, and taken together:

-they provide an accounting picture of the firm's operations and financial position

the measure of enterprise value subtracts out the company's cash holdings:

-this adjustment makes it easier to compare companies with very different levels of excess cash; if we didn't make this assumption, a company with large cash holdings but inefficient operations would mistakenly appear to be outperforming a peer that is much more efficient but has less cash on hand -a low EV/EBITDA ratio indicates that the firm's operations are not run as efficiently as they could be

experiments have suggested that investors and managers behave differently in down markets than they do in up markets:

-this might explain why those who made money early in the stock market bubble continued to invest their money in the market even as priced went ever higher

roth IRAs are more attractive for:

-those individuals who believe that their tax rates will increase over time - either because they think their income will increase as they age and/or because they think congress will raise overall tax rates in the future

investing in socially responsible funds:

-today there are a large number of mutual funds that only invest in companies with specified social goals -typically consider a company's environmental record, its commitment to societal causes, and its employee relations

two main types of individual retirement accounts (IRAs):

-traditional IRAs and roth IRAs -qualified contributions to a traditional IRA are tax deductible, and the income and capital gains on the investments within the account are not taxed until the money is withdrawn after age 59.5 -contributions to a roth IRA are not tax deductible (they come out of after-tax dollars), but from that point forward, neither the future income nor the capital gains from the investments are taxed

the alternative minimum tax (AMT):

-was created in 1969 because congress learned that 155 millionaires with high incomes paid no taxes because they had so many tax shelters from items such as depreciation -under AMT law, people must calculate their tax under the regular system and then under the AMT system, where many deductions are added back to income and then taxed at a special AMT rate

the firm's financial statements report:

-what has actually happened to its assets, earnings, and dividends over the past few years, whereas management's verbal statements attempt to explain why things turned out the way they did and what might happen in the future

4. the statement of stockholders' equity:

-which shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year

1. the balance sheet:

-which shows what assets the company owns and who has claims on those assets as of a given date - for example, december 31, 2019

if a firm's stock is undervalued, corporate raiders:

-will see it as a bargain and will attempt to capture the firm in a hostile takeover -if the raid is successful, the target's executives will most certainly be fired -this situation gives managers a strong incentive to maximize their stock price

before judging the performance of a company:

-you must look at a number of ratios, see what each suggests, and look at the overall situation

potential misuses of ROE:

1. ROE does not consider risk 2. ROE does not consider the amount of invested capital 3. a focus on ROE can cause managers to turn down profitable projects

good analysis requires that certain qualitative factors also be considered, here they are outlines by the American Association of Individual Investors (AAII):

1. are the company's revenues tied to one key customer? 2. to what extent are the company's revenues tied to the key product? 3. to what extent does the company rely on a single supplier? 4. what percentage of the company's business is generated overseas? 5. how much competition does the firm face? 6. is it necessary for the company to continually invest in research and development? 7. are changes in laws and regulations likely to have important implications for the firm?

several additional points about the balance sheet should be noted:

1. 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. the non-cash assets should generate cash over time, but they do not represent cash in hand; and the cash they would bring in of they were sold today could be higher or lower than the values reported on the balance sheet 2. working capital: current assets are often called working capital because assets 'turn over' that is, they are used and then replaced throughout the year 3. total debt vs. total liabilities: a company's total debt includes both its short-term and long-term interest-bearing liabilities; total liabilities equal total debt plus the company's 'free' (non-interest bearing) liabilities 4. other sources of funds: most companies finance their assets with a combination of short term debt, long term debt, and common equity; some companies also use 'hybrid' securities such as preferred stock, convertible bonds, and long-term leases. preferred stock is a hybrid between common stock and debt, while convertible bonds are debt securities that give the bondholder an option to exchange their bonds for shares of common stock; in the event of bankruptcy, debt is paid off first, and then preferred stock; common stock is last, receiving a payment only when something remains after the debt and preferred stock are paid off 5. depreciation: most companies prepare two sets of financial statements, one is based on the IRS rules and is used to calculate taxes; the other is based on GAAP and is used for reporting to investors. firms often use straight-line depreciation for stockholder reporting because the financial statements will report higher earnings to stockholders than it would with accelerated depreciation methods 6. market values vs. book values: companies generally use GAAP to determine the values reported on their balance sheets; in most cases, these accounting numbers (or book values) are different from what the assets would sell for if they were offered for sale (or market values) 7. time dimension: the balance sheet is a snapshot of the firm's financial position at a point in time; the balance sheet changes every day as inventories rise and fall, as bank loans are increased or decreased, and so forth

ratios can be divided into 5 categories:

1. liquidity ratios: which give an idea of the firm's ability to pay off debts that are maturing within a year 2. asset management ratios: which give an idea of how efficiently the firm is using its assets 3. debt management ratios: which give an idea of how the firm has financed its assets as well as the firm's ability to repay its long term debt 4. profitability ratios: which give an idea of how profitable the firm is operating and utilizing its assets 5. market value ratios: which give an idea of what investors think about the firm and its future prospects

ratio analysis is used by 3 main groups:

1. managers: who use ratios to help analyze, control, and thus improve their firm's operations 2. credit analysts: including bank loan officers and bond rating analysts, who analyze ratios to help judge a company's ability to repay its debts 3. stock analysts: who are interested in a company's efficiency, risk, and growth prospects

limitations of ratio analysis:

1. many firms have divisions that operate in different industries making it difficult to develop a meaningful set of industry averages 2. most firms want to be better than average, so merely getting average performance is nor necessarily good 3. inflation has distorted many firms' balance sheets 4. seasonal factors can distort a ratio analysis 5. firms can employ window dressing techniques to improve their financial statements; such as hedge funds borrowing and investing money to increase their apparent size 6. different accounting practices can distort comparisons 7. it is difficult to generalize about whether a particular ratio is good or bad 8. firms often have some ratios that look 'good' and others that look 'bad', making it difficult to tell whether the company is, on balance, strong, or weak

we can classify stock market transactions into three distinct categories:

1. outstanding shares of established publicly owned companies that are traded: the secondary market; allied food products has 75 million shares of stock outstanding, of the owner sells 100 shares of his or her stock, the trade is said to have occurred in the secondary market. the company receives no new money when sales occur in this market 2. additional shares sold by established publicly owned companies: the primary market; if allied foods decides to sell (or issue) an additional 1 million shares to raise new equity capital, this transaction is said to occur 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 market 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

stocks are traded using a variety of market procedures, but there are two basic types:

1. physical location exchanges: which include the NYSE and several regional stock exchanges 2. electronic dealer-based markets: which include the NASDAQ, the less formal over-the-counter market, and the recently developed electronic communications networks (ECNs)

two procedures that analysts use to examine the firm's debt:

1. they check the balance sheet to determine the proportion of total funds represented by debt 2. they review the income statement to see the extent to which interest is covered by operating profits

proprietorships and partnerships:

advantages: -ease of formation -subject to few regulations -no corporate income taxes disadvantages: -difficult to raise capital -unlimited liability -limited life often set up through LLCs/LLPs

tax cuts and jobs act of 2017:

changes to the individual tax code: -lowered the maximum tax rate from 39.6% to 37% -eliminated the personal exemption for taxpayers and their dependents -raised the standard deduction for all individuals and married couples -limited mortgage interest deductions -limited deductions for state and local taxes -individual alternative minimum tax (AMT) was kept -eliminated misc. itemized deductions -doubles the estate tax exclusion amount to $10 million changes to the corporate tax code: -established a flat 21% corporate tax rate -permits an immediate 100% expensing of certain new and used business assets -repealed the corporate alternative minimum tax (AMT) -eliminated the net operating loss (NOL) carryback provision and changed the carryforward provision so that NOLs can be carried forward indefinitely -limits the corporate interest deduction on debt to 30% of income -provides a one-time repatriation tax holiday for firms with money parked overseas -changed the corporate dividend exlusion

individual taxes begin at:

-10% and rise to 37% for high income individuals and couples -may be subject to state tax

approximately ________% of u.s. stocks are owned by long-term investors, while only ________% are held by short-term investors

-75% -25%

where MVS applies for the entire firm,

-EVA can be determined for divisions as well as for the company as a whole, so it can be useful as a guide to 'reasonable' compensation for divisional as well as top corporate managers

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 trading practices -the computerized network used by FINRA is known as NASDAQ

financial analysts often make an important distinction between net working capital (NWC) and net operating working capital (NOWC)

-NOWC differs from NWC in two important ways: 1. NOWC makes a distinction between cash that is used for operating purposes and 'excess' cash that is being held for other purposes; thus when calculating NOWC, analysts make an estimate of excess cash and subtract this from the company's current assets to get the company's operating current assets 2. when looking at a company's current liabilities, analysts distinguish between its 'free' liabilities (accruals and accounts payable) and its interest bearing notes payable; these interest bearing liabilities are typically treated as a financing cost, rather than an operating cost, which explains why they are not included as part of the company's operating current liabilities

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

-ROE does not consider risk -ROE does not consider the amount of capital invested -given these problems, reliance on ROE may encourage managers to make investments that do not benefit shareholders -as a result, analysts have looked to develop other performance measures, such as EVA

EVA is an estimate of:

-a businesses's true economic profit for a given year, and it often differs sharply from accounting net income (EVA takes into account the total dollar cost of all capital, which includes both the cost of debt and equity capital_ -if EVA is positive, then after-tax operating income exceeds the cost of the capital needed to produce that income, and management's actions are adding value for stockholders -positive EVA on an annual basis will help ensure that MVA is also positive

retained earnings represents:

-a claim against assets -stockholders allow management to retain earnings and reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, etc.

negative after-tax operating income and decline in cash position shows:

-a company is spending more on its operations than it is taking in

what are derivatives? how can they be used to reduce or increase risk?

-a derivative security's value is derived from the price of another security (e.g. options and futures) -can be used to 'hedge' or reduce 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)

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 that they are getting good prices

what is a market?

-a market is a venue where goods and services are exchanged -a financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds

the balancer sheet *continued*:

-a snapshot of the firm's financial position at a specific point in time

claims are listed in the order in which they must be paid:

-accounts payable must generally be paid within a few days, accruals must also be paid promptly, notes payable to banks must be paid within one year, and so forth, down to the stockholders' equity accounts, which represent ownership and do not need to be 'paid off'

although ratio analysis is useful, it must be applied with care and good judgement:

-actions taken to improve one ratio can have negative effects on other ratios

actively managed funds vs. indexed funds

-actively managed funds try to outperform the overall markets -indexed funds are designed to simply replicate the performance of a specific market index

interest income received by individuals from corporate securities is:

-added to other income and thus is taxed at federal rates going up to 37% plus state taxes

financial management:

-also called corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value -the same principles apply to both for-profit and not-for-profit organizations

investors need to be cautious when `they review financial statements:

-although companies are required to follow GAAP, managers still have a lot of discretion in deciding how and when to report certain transactions

amortization:

-amounts to the same thing as depreciation except that it represents the decline in value of intangible assets such as patents, copyrights, trademarks, and goodwill

depreciation:

-an annual charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were depleted in the production process

stock-based compensation does not always work as planned:

-an executive could exercise the option on a specific set date, receive stock, instantly sell it, and earn a profit -therefore, some managers may be looking to maximize at their own specific date rather than over the long-run -some managers may deliberately overstate profits, temporarily boosting stock prices so they can benefit

what is an IPO?

-an initial public offering occurs when a company issues stock in the public market for the first time -'going public' enables a company's owners to raise capital from a wide variety of outside investors - once issued, the stock trades in the secondary market -public companies are subject to additional regulations and reporting requirements

by financing expansion with external capital:

-and issuing long-term debt, financial strength and flexibility will be reduced

ROE reflects the effects of all of the other ratios:

-and it is the single best accounting measure of performance -investors like a high ROE, and high ROEs are correlated with high stock prices -but, other things come into play: financial leverage generally increases the ROE but also increases a firm's risk - so if a high ROE is achieved by using a great deal of debt, the stock price might end up lower than if the firm had been using less debt and had a lower ROE

common stock is riskier than bonds:

-any mistake management makes has a big impact on the stockholders

in an inefficient market, it might be possible to purchase the company's stock at a low price and then be able to turn around and sell it at a higher price making a profit, this is called:

-arbitrage

3. financial services corporations:

-are large conglomerates that combine many different financial institutions within a single corporation -most have started in one area, but have now diversified to cover most of the financial spectrum -for example, citigroup owns citibank (a commercial bank), an investment bank, a securities brokerage organization, insurance companies, and leasing companies

retained earnings:

-are not just the earnings retained in the latest year - they are the cumulative total of all of the earnings the company has earned and retained during its life

5. pension funds:

-are retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies -pension funds invest primarily in bonds, stocks, mortgages, and real estate

consider qualitative factors when evaluating a company's future financial performance:

-are the firm's revenues tied to one key customer, product, or supplier? -what percentage of the firm's business is generated overseas? -firm's competitive environment -future prospects -legal and regulatory environment

there can be and generally are large differences between expected and realized prices and returns:

-as logic would suggest, a stock's expected return as estimated by investors at the margin is always positive; otherwise, investors would not buy the stock -but in reality in some years, actual returns are negative

capital gains and losses are treated differently:

-assets such as stocks, bonds, and real estate are defined as capital assets -when you buy a capital asset and later sell it for more than you paid, you earn a profit that is called a capital gain -when you suffer a loss, it is called a capital loss -if you held the asset for a year or less it would be a short term capital gain or loss, if you held it for more than a year you would have a long term capital gain or loss

if the stock market is efficient, it is a waste. of time for most people to seek bargains by analyzing published data on stocks:

-because if stock prices already reflect all publicly available information, they will be fairly priced, and a person can beat the market only with luck or inside information

ROE is always important:

-but a high ROE depends on maintaining liquidity, on efficient asset management, and on the proper use of debt -managers are of course vitally concerned with the stock price, but managers have little direct control over the stock market's performance; they do, however, have control over their firm's ROE - so ROE tends to be the main focal point

actual stock price tends to move up and down with the estimated intrinsic value:

-but investor optimism and pessimism, along with imperfect knowledge about the true intrinsic value, led to deviations between the actual prices and intrinsic values

changes in interest rates and inflation affect the market value of the company's assets and liabilities:

-but often have no effect on the corresponding book values shown in the financial statements

a typical stockholder focuses on the reported earnings per share:

-but professional security analysts and managers differentiate between operating and non-operating inovome

corporations earn most of their income from operations:

-but they may also own securities, stocks and bonds, and receive interest and dividend income -interest income received by a corporation is taxed as ordinary income at the lower corporate flat rate; however, dividends are taxed more favorably: 50% of dividends received is excluded from taxable income and the other 50% is taxed at the flat corporate tax rate

return on common equity:

-calculated by net income divided by common equity -stockholders expect a return on their money, and this ratio stats how well they are doing in an accounting sense

the information contained in the annual report:

-can be used to help forecast future earnings and dividends -therefore, investors are very interested in this report

in a well-functioning economy:

-capital flows efficiently from those with surplus capital to those who need it -this transfer can take place in: direct transfers, primary market transactions, and through financial intermediaries

the main financial goal:

-creating value for investors

accounts receivable are evaluated by the:

-days sales outstanding (DSO) ratio -also called the average collection period -it is calculated by dividing accounts receivable by the average daily sales to find how many days' sales are tied up in receivables; therefore the DSO represents the average length of time the firm must wait after making a sale before receiving cash -DSO can be evaluated by comparing it with the company's credit terms; high average DSO can mean quite a number of extremely late payers, late-paying customers often default, so their receivables may end up as bad debts that can never be collected

stockholder-debtholder conflicts:

-debtholders, which include the company's bankers and bondholders, generally receive fixed payments regardless of how well the company does; while stockholders do better when the company does better -therefore, stockholders are typically more willing to take on risky projects -additional debt: the more debt a firm uses to finance a given amount of assets, the riskier the firm becomes

turnover ratios (asset management ratios):

-divide sales by some asset: sales/various assets -as the name implies, these ratios show how many times the particular asset is 'turned over' during the year

initial buzz surrounding IPOs:

-does not always translate into long-lasting success -there is not always a strong correlation between the market's initial reaction to an IPO and the stock's long run performance

asset management ratios answer:

-does the amount of each type of asset seem reasonable, too high, or too low in view of current and projected sales? -these ratios are important because when companies acquire assets, they must obtain capital from banks or other sources and capital is expensive; therefore, if a company has too many assets, its cost of capital will be too high, which will depress its profits - on the other hand, if assets are too low, profitable sales will be lost

because corporations pay dividends out of earnings that have already been taxed, there is:

-double taxation of corporate income -income is first taxed at the corporate rate; then, when what is left is paid out as dividends, it is taxed again -this double taxation motivated congress to tax dividends at a lower rate than on ordinary income

three leading stock market indexes:

-dow jones industrial average: includes 30 companies that are leading companies in their industries and widely held by individual and institutional investors -s&p 500 index: widely regarded as the standard for measuring large-cap u.s. stock market performance; it is one of the most commonly used benchmarks for the u.s. stock market -nasdaq composite index: measures the performance of all stocks listed on nasdaq; currently includes approximately 2,700 companies - this index is generally regarded as an economic indicator of the high-tech industry

well functioning markets promote:

-economic growth

when a stock's actual market price is equal to its intrinsic value, this stock is in:

-equilibrium -when equilibrium exists, there is no pressure for a change in the stock's price

effects of debt on ROA and ROE holding assets constant, if debt increases:

-equity declines -interest expense increases: which leads to a reduction in net income -ROA declines (due to the reduction in net income) -ROE may increase or decrease (since both net income and equity decline)

corporate tax code changes (major provisions):

-established a 21% corporate tax rate -permits an immediate 100% expensing of certain new and used business assets -limits the corporate interest deduction on debt to 30% of income -provides a one-time repatriation tax holiday

NASDAQ has invested in the London Stock Exchange and other market makers, while the NYSE merged with:

-euronext -and was purchased by the intercontinental exchange - further adding to the competition

ratios help us:

-evaluate financial statements

over the counter (OTC) market:

-exchanges operate as auction markets; buy and sell orders come in more or less simultaneously, and exchange members match these orders -when a stock is traded infrequently, perhaps the firm is new or small, 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 tp buy -at one time, the inventory of securities were kept in a safe, and the stocks, when bought or sold, were literally passed over the counter -today, these markets are often referred to as dealer markets

what is finance?

-finance is defined as 'the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities'

securitization has dramatically transformed the banking industry:

-financial engineers came up with the idea of securitizing loans: this is a process whereby an agent (such as an investment bank) creates an entity that buys a large number of loans from a wide range of banks and then issues securities that are backed by the loan payments -this is a tremendous innovation; banks no longer have to hold mortgages so they can quickly convert loans to cash; it also allows for investors to invest in diversified portfolios as well as trade in the open market where securities are easily bought and sold as circumstances and views of the mortgage market change over time

finance is generally divided into three areas:

-financial management -capital markets -investments

people and organizations wanting to borrow money are brought together with those who have surplus funds in the:

-financial markets -markets is plural as we have many different financial markets

profitability ratios reflect the net result of all of the firm's:

-financing policies and operating decisions

the two leaders in the stock market:

-NYSE -NASDAQ

the efficient markets hypothesis (EMH):

-a cornerstone of modern finance theory -it implies that, on average, asset prices are about equal to their intrinsic values -if the 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 -if prices are 'too high', rational traders will sell the stock, pushing the price down to its equilibrium level

managers must:

-communicate effectively with stockholders (without divulging information that would aid their competitors) to keep the actual price close to the intrinsic value

accounting statements are designed primarily for use by:

-creditors and tax collectors, not for managers and stock analysts

household debt burdens have _________________________ in recent years:

-declined

investors like:

-higher expected cash flows

dividends received:

-most investors pay 15% -dividends are paid out of net income which has already been taxed at the corporate level (this is a form of double taxation)

corporate governance:

-putting in place a set of rules and practices to ensure that managers act in shareholders' interests while also balancing the needs of other key areas such as customers, employees, and affected citizens -having a strong, independent board of directors is viewed as an important concept of strong governance

potential uses of freed up cash:

-repurchase stock -expand business -reduce debt (all these actions would likely improve the stock price)

the number of new initial public offerings (IPOs):

-rises and falls with the stock market -when the market is strong many companies go public to bring in new capital and to give their founders an opportunity to cash out some of their shares -not all IPOs are well received; such as facebook which went public at $38 and reached a price below $17.55

investors dislike:

-risk

the inventory turnover ratio:

-sales / inventories -the industry average is 10.9; an inventory turnover ratio of 4.9 suggests that the company is holding too much inventory -excess inventory represents an investment with a low or zero rate of return; with such a low turnover, the firm may be holding obsolete goods that are not worth their stored value

the second liquidity ratio is:

-the quick, or acid test ratio -which is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities -inventories are typically the least liquid of a firm's current assets and if sales slow down, they might not be converted to cash as quickly as expected -therefore, the quick ratio measures the firm's ability to pay off short-term obligations without relying on the sale of inventories -the industry average is a 2.2, if a company's average is 1.2 it is relatively low; still, if the accounts receivable can be collected, the company can pay off its current liabilities even if it has trouble disposing of its inventories

the dealer's risk increases when:

-the stock is more volatile or when the stock trades infrequently

interest earned:

-usually fully taxable (an exception being interest from a 'muni')

securitization has accelerated over the past few decades, one way is through collateralized debt obligations (CDOs):

-where an entity issues several classes of securities backed by a portfolio of loans -CDOs backed by pools of higher risk (subprime) mortgages played a major role in the 2007-2008 financial crisis; when the housing market collapsed, the value of these securities plummeted, destroying the balance sheets of many financial institutions

the fixed assets turnover ratio:

-which is the ratio of sales to net fixed assets, measures how effectively the firm uses its plant and equipment -the industry average is 2.8, if a company has a ratio slightly above at 3.0, this indicates that they are using their fixed assets at least as intensively as other firms in the industry -potential problems may arise when interpreting the fixed assets turnover ratio: comparing an old firm whose fixed assets have been depreciated with a new company with similar operations that acquired its fixed assets only recently, the old firm will probably have the higher fixed assets turnover ratio; however this is more reflective of the age of the assets than of the inefficiency on the part of the new firm

3. the statement of cash flows:

-which shows how much cash the firm began the year with, how much cash it ended up with, and what it did to increase or decrease its cash

2. the income statement:

-which shows the firm's sales and costs (and thus profits) during some past period - for example, 2019

market value ratios are used in three primary ways:

1. by investors when they are deciding to buy or sell a stock 2. by investment bankers when they are setting the share price for a new stock issue (an IPO) 3. by firms when they are deciding how much to offer for another firm in a potential merger

various ratios:

1. liquidity ratios -current ratio -quick, or acid test ratio 2. asset management ratios -inventory turnover ratio -days sales outstanding -fixed assets turnover ratio -total assets turnover ratio 3. debt management ratios: -total debt to total capital -times-interest-earned ratio 4. profitability ratios -operating margin -profit margin -return on total assets -return on common equity -return on invested capital -basic earning power (BEP) ratio 5. market value ratios -price/earnings ratio -market/book ratio -enterprise value/EBITDA ratio

what if a company's sales manager decides to offer 60-day credit terms to customers, rather than 30-day terms?

if competitors match terms, and sales remain constant: -A/R would increase -cash would decrease if competitors don't match, and sales double: -short-run: inventory and fixed assets increase to meet increases sales, A/R increases and cash decreases; company may have to seek additional financing -long-run: collections increase and the company's cash position would improve

the importance of financial markets:

well functioning financial markets facilitate the flow of capital from investors to the users of capital: -markets provide savers with returns on their money saved/invested, which provide them money in the future -markets provide users of capital with the necessary funds to finance their investment projects

another important long-standing trend over the past few decades has been the increased use of derivatives:

-a derivative is an security whose value is derived from the price of some other 'underlying' asset -an option to buy ibm stock is a derivative, as is a contract to buy japanese yen 6 months from now. the value of the ibm option depends on the price of ibm's stock and the value of the japanese yen "future" depends on the exchange rate between yen to dollars

limited liability company (LLC):

-a hybrid between a partnership and a corporation -provide limited liability protection, but they are taxed as partnerships -unlike limited partnerships, the investors in an LLC or LLP have votes in proportion to their ownership interest

corporation:

-a legal entity created by a state, it is separate and distinct from it's owners and managers -this separation limits stockholders' losses to the amount that they invested in the firm - the corporation can lose all it's money, but its owners can lose only the funds that they have invested in the company -they have unlimited lives, and it is easier to transfer shares of stock in a corporation than one's interest in an unincorporated business -it is therefore easier for corporations to raise the capital necessary to operate large businesses -major drawback to corporations: taxes -most corporations earnings are subject to double taxation - the corporation's earnings are taxed, and then when its after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders -as an aid to small businesses, congress created s corporations: which are taxed as if they were proprietorships or partnerships, and thus exempt from the corporate income tax -to qualify for s corporations: a firm can have no more than 100 stockholders, which limits their use to relatively small, privately owned firms -larger corporations are known as c corporations -the vast majority of small corporations elect s corporation status and retain that status until they decide to sell stock to the public - then they become c corporations

business ethics:

-actions begun by the new york attorney general to sue companies for improper acts; the passing of the sarbanes-oxley act of 2002 to impose sanctions on executives who sign financial statements later found to be false; congress's passing of the dodd-frank act to implement an aggressive overhaul of the u.s. financial regulatory system aimed at preventing reckless actions that could cause another financial crisis; and business schools trying to inform students about proper vs. improper business actions

management's goal should be to:

-take actions designed to maximize the firm's intrinsic value, not its current market price

6. life insurance companies:

-take savings in the form of annual premiums; invest these in stocks, bonds, real estate, and mortgages; and make payments to beneficiaries of the insured parties

financial markets have experienced many changes in recent years:

-technological advancements in computers and telecommunications, along with the globalization fo banking and commerce, have led to deregulation, which has increased competition throughout the world -as a result, there are more efficient, internationally linked markets, which are far more complex than what existed a few years ago

market price:

-the actual market price based on perceived but possibly incorrect information as seen by the marginal investor -not all investors agree, so it is the 'marginal' investor who determines the actual price

a firm's commitment to business ethics can be measured by:

-the tendency of it's employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and selling practices, the use of confidential information for personal gain, community involvement, and the use of illegal payments to obtain business

although we separate these three areas of finance:

-they are closely interconnected -banking is studied under capital markets, but a bank lending officer evaluating a business' loan request must understand corporate finance to make a sound decision. similarly, a corporate treasurer negotiating with a banker must understand banking if the treasurer is to borrow on 'reasonable' terms. moreover, a security analyst trying to determine a stock's true value must understand corporate finance and capital markets to do his or her job. -financial decisions of all types depend on the level of interest rates; so all people in corporate finance, investments, and banking must know something about interest rates and the way they are determined

if firms are successful at maximizing the stock's value:

-they will also be contributing to social welfare and citizens' well-being

1. investment banks:

-traditionally help companies raise capital, they: 1. help corporations design securities with features that are currently attractive to investors 2. buy these securities from the corporation 3. resell them to savers -investment bankers are also called underwriters, as the IB generally guaranteed that the firm will raise the needed capital -the credit crisis has had a dramatic effect on the investment banking industry, the two 'surviving' major investment banks are morgan stanley and goldman sachs; they received federal reserve approval to become commercial bank holding companies

financial intermediary:

-transfers can also be made through a financial intermediary such as a bank, insurance company, or a mutual fund; here the intermediary obtains funds from savers in exchange for its securities. the intermediary uses this money to buy and hold businesses' securities, and the savers hold the intermediary's securities. for 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 a mortgage loan. thus, intermediaries literally create new forms of capital - in this case, certificates of deposit, which are safer and more liquid than mortgages and thus better for most savers to hold. the existence of intermediaries greatly increases the efficiency of money and capital markets

9. hedge funds:

-are also similar to mutual funds because they accept money from savers and use the funds to buy various securities, but there are important differences: hedge funds are largely unregulated (as they typically have large minimum investments often exceeding $1 million) and they are marketed primarily towards institutions and individuals with high net worths -hedge funds received their name because they traditionally were used when an individual was trying to hedge risk -some hedge funds do take on risks that are considerably higher than that of an average individual stock or mutual fund -hedge funds have grown tremendously in the past two decades, the road has been bumpy; hedge fund assets under management fell sharply after the financial crisis, and it wasn't until 2013 when they were back to their pre-crisis levels

4. credit unions:

-are cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm -members' savings are loaned only to other members; generally for auto purchases, home improvement loans, and home mortgages -credit loans often have the cheapest source of funds available to individual borrowers

7. mutual funds:

-are corporations that accept money from savers and then use these to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units -these organizations pool funds and therefore reduce risks by diversification; they also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities -different funds are designed to meet the objectives of different types of savers - hence there are bond funds for those who prefer safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns, and money market funds that are used as interest bearing checking accounts

8. exchange traded funds (ETFs):

-are similar to regular mutual funds and are often operated by mutual fund companies -ETFs buy a portfolio of stocks of a certain type - and then sell their own shares to the public -ETF shares are generally traded in public markets, so an investor who wants to invest in the chinese market, for example, can buy shares in an ETF that holds stocks in that particular market

physical location exchanges:

-are tangible entities; each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body -most of the larger investment banks operate brokerage departments - they purchases seats on the exchanges and designate one or more of their officers as memebers

we should maximixe:

-average price over the long run, which will be maximized if management focuses on the stock's intrinsic value

ethical lapses can lead to:

-bankruptcies -misleading accounting behavior and overstating profits attributes to this -damaging blows to reputation

most businesses have an organization chart similar to the one above:

-board of directors is the top governing body -the chairperson of the board is generally the highest ranking individual -the CEO comes next, but note that the chairperson of the board often also serves as the CEO -below the CEO comes the chief operating officer (COO), who is often designated as the firm's president -the COO directs the firm's operations, which include the marketing, manufacturing, sales, and other operating departments -the chief financial officer (CFO), who is generally a senior vice-president and the third ranking officer, is in charge of accounting, finance, credit policy, decisions regarding asset acquisitions, and investor relations, which involves communications with stockholders and the press

credit default swaps"

-credit default swaps are contracts that offer protection against the default of a particular security -suppose a bank wants to protect itself against the default of one of its borrowers; the bank could enter into a credit default swap where it agrees to make regular payments to another financial institution. in return, that financial institution agrees to insure the bank against losses that would occur if the borrower defaulted

to maximize value, firms must:

-develop products that consumers want, produce the products efficiently, sell them at competitive prices, and observe laws relating to corporate behavior

a healthy economy is dependent on:

-efficient funds transfers from people who are net savers to firms and individuals who need capital -it is essential that financial markets function efficiently - not only quickly, but also inexpensively

intrinsic values are:

-estimates -different analysts with different data and different views about the future form different estimates of a stock's intrinsic value

lower fees motivate:

-investors to move toward index funds such as ETFs -a passive fund generally costs less because you do not have to pay a group of often expensive fund managers to try and beat the market - instead, the fund is simply replicating the given market using technology

partnership:

-is a legal arrangement between two or more people who decide to do business together; partnerships are similar to proprietorships in that they can be established relatively easily and inexpensively -the firm's income is allocated on a pro rata basis to the partners and is taxed on an individual basis; this allows the firm to avoid the corporate income tax -all partners are generally subject to unlimited personal liability - if a partnerships goes bankrupt or a partner is unable to meet his or her share, the remaining partners are held responsible -unlimited liability makes it difficult for partnerships to raise large amounts of capital

intrinsic value:

-is an estimate of the stock's 'true' value as calculated by a competent analyst who has the best available data and a market price

proprietorship:

-is an unincorporated business owned by one individual three important advantages: -they are easy and inexpensive to form -they are subject to few government regulations -they are subject to lower income taxes than corporations three important limitations: -proprietors have unlimited personal liability for the buiness' debts -the life of the business is limited to the life of the individual who created it -because of the first two points, proprietorships have difficulty obtaining large sums of capital; hence, proprietorships are used primarily for small businesses -however, businesses are frequently started as proprietorships and then converted to corporations when their growth results in the disadvantages outweighing the advantages

for the following reasons, the value of any business other than a relatively small one will probably be maximized if it is organized as a corporation:

-limited liability reduced the risks borne by investors, and other things held constant, the lower the firm's risk, the higher it's value -a firm is dependent on it's growth opportunities, which are dependent on it's ability to attract capital. because corporations can attract capital more easily than other types of businesses, they are better able to take advantage of growth opportunities -the value of an asset also depends on it's 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 investors are more willing to invest in stocks, a corporate investment is relatively liquid

direct stockholder intervention:

-majority of stock today is owned by institutional investors such as insurance companies, pension funds, hedge funds, and mutual funds -can act as lobbyists for the body of stockholders; when large stockholders speak, companies listen

we should not maximize shareholder value at 'all costs':

-managers have an obligation to behave ethically, and they must follow the laws and other society-imposed constraints -if we are unresponsive to both employees and customers: society will impose a large range of costs such as it may be hard to attract top-notch employees, products may be boycotted, it may face additional lawsuits and regulations, and there could be bad publicity -these costs can ultimately lead to a reduction in shareholder value

stockholder-manager conflicts:

-managers may be more interested in maximizing their own wealth than stockholders' wealth -effective compensation plans motivate managers to act in stockholder interest, some useful motivation tools are: 1. reasonable compensation packages 2. firing of managers that do not perform well 3. the threat of hostile takeovers

money markets vs. capital markets:

-money markets are the markets for short term, highly liquid debt securities; the new york, london, and tokyo money markets are among the world's largest -capital markets are the markets for the intermediate or long term debt and corporate stocks; the new york stock exchange, where the stocks of the largest u.s. corporations are traded, is a prime example of a capital market

direct transfers:

-of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution; the business delivers its securities to savers, who, in return, give the firm the money it needs; this procedure is mainly by small firms and relatively little capital is raised by direct transfers

private equity companies:

-organizations that operate much like hedge funds, but rather than purchasing some stock of a firm, private equity players buy and then manage entire firms -most of the money used to buy the target companies is borrowed; over the past decade a number of high-profile companies have been acquired by private equity firms

the capital allocation process:

-people and organizations with surplus funds are saving today in order to accumulate funds for some future use (members of a household might save to pay for their children's education) -those with surplus funds expect to earn a return on their investments, while people and organizations that need capital understand that they must pay interest to those who provide the capital

physical asset markets vs. financial asset markets:

-physical asset markets also called 'tangible' are for products such as wheat, autos, real estate, computers, and machinery -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' while an option to buy ford shares is a derivative security whose value depends on the price of ford stock

private markets vs. public markets:

-private markets are where transactions are negotiated directly between two or more parties (such as bank loans and private debt placements with insurance companies) -public markets are where standardized contracts are traded on organized exchanges (such as common stock and corporate bonds), they are held by a large number of individuals -broad ownership and standardization result in publicly traded securities being more liquid than tailor-made, uniquely negotiated securities

derivatives can be used to:

-reduce risk or speculate -hedging is done by reducing risk by purchasing derivatives (wheat processor purchasing wheat futures) -speculation is done in the hopes of high returns, but it raises risk exposure

investments:

-relate to decisions concerning stocks and bonds and include a number of activities: -security analysis: deals with finding the proper values of individual securities (i.e. stocks and bonds) -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 -market analysis: deals with the issue of whether stock and bond markets at any given time are 'too high' 'too low' or 'about right' -included in market analysis is behavioral finance, where investor psychology is examined in an effort to determine whether stock prices have been bid up to unreasonable heights in a speculative bubble or driven down to unreasonable lows in a fit of irrational pessimism

capital markets:

-relate to markets where interest rates, along with stock and bond prices, are determined -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 -governmental organizations such as the Federal Reserve System, which regulates banks and controls the supply of money, and the Securities and Exchange Commission (SEC), which regulates the trading of stocks and bonds in public markets, are also studied as part of capital markets

the most active secondary market, and the most important one to financial managers, is the:

-stock market, where the prices of firms' stocks are established

2. commercial banks:

-such as bank of america, are the traditional 'department stores of finance' as they serve a variety of savers and borrowers - historically, commercial banks were the major institutions that handled checking accounts through which the federal reserve system expanded or contracted the money supply (today, several other institutions are also involved)

primary market transaction:

-transfers ma also go through an investment bank (IB) such as morgan stanley, which underwrites the issue; an underwriter facilitated the issuance of securities. the company sells its stocks or bonds to the IB, which then sells these same securities to savers. the businesses' securities and the savers' money merely pass through the investment bank. however, because the IB buys and holds the securities for a period of time, it is taking risk - it may not be able to resell the securities to savers for as much as it paid

consequences of having a short-run focus:

-wells fargo example, where they implemented incentives to reward employees for signing up customers to new accounts; employees then created fake accounts to obtain bonuses - this led to a loss of millions of dollars in fines for wells fargo as well as the firing of thousands of employees

'perceived' means:

-what investors expect, given the limited information they have

a dealer market system consists of:

1. 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 together with investors 3. the computers, terminals, and electronic networks that provide a communication link between dealers and brokers

globalization has exposed the need for greater cooperation among regulators at the international level, factors that complicate coordination include:

1. the different structures in nations' banking and securities industries 2. the trend toward financial services conglomerates, which obscures developments in various market segments 3. the reluctance of individual countries to give up control over their national monetary policies

the primary tasks of the CFO:

1. to make sure the accounting system provides 'good' numbers for internal decision making and for investors 2. to ensure that the firm is financed in the proper manner 3. to evaluate the operating units to make sure they are performing in an optimal manner 4. to evaluate all proposed capital expenditures to make sure they will increase the firm's value