fin 320f final
Accruals
A "note-to-self" about how much you owe
Cost of Goods Sold
All money made from things sold in the inventory
Net Working Capital
Measures firms ability to pay the bills
The Fed is charged with controlling the money supply in order to
(1) limit inflation and (2) promote economic growth. The problem is, these two goals conflict with one another. Since inflation and GDP move together, lowering one also lowers the other.
stop order
(also called a stop loss order) is an order to sell when the price drops to (or below) a particular price. Again, the particular price must be specified in the order.
over-the-counter (OTC) stock market
(market? yes; exchange? no) requires dealers to negotiate directly with one another to trade stocks. The stocks traded in OTC markets, such as The Pink Sheets and the OTC Bulletin Board, are either penny stocks or stocks of companies that have poor credit ratings.
When a budget deficit exists
(we spent more than we earned), the government has to borrow money to make up the difference. This creates debt.
Advantages of common stock (over debt) for the issuer
1. Common stock doesn't require the company to make fixed payments. 2. Common stock never matures and never has to be repaid. 3. Using common stock improves the company's debt ratio.
Disadvantages of common stock (over debt) for the issuer
1. The company may have to give up some voting control. (a. Founders' shares generally have sole voting rights (but zero dividends) for several years to limit this disadvantage. b. Shares issued to the public (non-founders) could be given a classification (eg. Class B) that would limit voting rights but allow for dividend payments.) 2. If the company chooses to pay a dividend to owners, it uses up cash. 3. The cost to issue common stock is higher than the cost to issue debt. Investment bankers charge higher fees for issuing stock (versus debt) because of the greater risk that the stock issue will fail. 4. Common stock dividend payments are not a tax-deductible expense (but interest expense is).
order of risk (lowest to highest)
1. short term T-bills 2. treasury bonds 3. corporate bonds (mortgage - lower, debenture - higher) 4. preferred stock 5. common stock
Currently, the reserve requirement is
10%
Operating Cash Flow
= EBIT + Depreciation Expense - Taxes
You are more likely to pay bills on time
A high Net Working Capital means what?
20%
A maximum of what percentage is charged on long-term dividend and capital?
Corporation
A separate and distinct entity chartered (given permission to exist) by the state. Most complicated form of business but the easiest to gain revenue
Limited Partnership (LP)
A type of partnership where one partner has limited liability but no control over form's operations and there is a general partner who has all control and unlimited liability. Popular for risky businesses (oil, drilling, mining)
Trend analysis
A way to measure financial performance when firm ratios are compared over time
Bench marking
A way to measure financial performance when firms ratios are compared to those of other firms (competitors, average of the industry, etc.)
Personal Exemption
Amount deducted or each child you provide for and.or you/spouse
Sales/Revenue
Amount earned from selling good/services
Tax Credit
An amount deducted from the amount of taxes you need to pay (deducted from tax amount after it has been calculated)
Tax Deduction
An amount deducted from you gross income along with other deductions
inverted curve
An economic death knell. Long-term rates are actually lower than short-term rates. We are in or expecting to be in a slowdown in the economy.
Trade Accounts Payable Payable
Another name for Accounts Payable?
Receivables
Another name for Accounts Receivable?
Statement of Financial Position
Another name for Balance Sheet?
Direct costs COS (Cost of Sales)
Another name for COGS?
Gross Working Capital
Another name for Current Assets?
Liabilities
Another name for Debts?
COGS
Another name for Direct Costs?
Operating Income
Another name for EBIT?
Operating Income
Another name for Earnings Before Interest & Taxes?
EBT Income Before Tax Pre-Tax Earnings
Another name for Earnings before Tax?
Operating Income
Another name for Earnings from Operations?
Net Worth Shareholders' Equity Stockholders' Equity
Another name for Equity?
Gross Profit
Another name for Gross Earnings?
Gross Property Plant and Equipment
Another name for Gross Fixed Assets?
Gross Profit
Another name for Gross Margin Dollars?
Gross Earnings Gross Margin Dollars
Another name for Gross Profit?
Earnings Before Tax
Another name for Income Before tax?
Statement of Earnings Statement of Profit & Loss
Another name for Income Statement?
Provision for Income Taxes
Another name for Income Tax Expense?
Operating Expense
Another name for Indirect Costs?
Debts
Another name for Liabilities?
Net Income
Another name for Net Earnings?
Net Property, Plant & Equipment Property and Equipment Net of Accumulated Depreciation
Another name for Net Fixed Assets?
Net Profit Net Earnings The bottom line
Another name for Net Income?
Net Income
Another name for Net Profit?
Equity
Another name for Net Worth?
Operating Income
Another name for Operating Earnings?
Opex Indirect Costs (Opex includes depreciation and SG&A)
Another name for Operating Expenses?
EBIT Operating Profit Operating Earnings Earnings From Operations Earnings Before Interest & Taxes
Another name for Operating Income?
Operating Income
Another name for Operating Profit?
Operating Expense
Another name for Opex?
Accounts Payable
Another name for Payables?
Earnings Before Tax
Another name for Pre-Tax Earnings?
Income Tax Expense
Another name for Provision for Income Taxes?
Accounts Receivables
Another name for Receivables?
Revenue Turnover Net Sales Net Revenue
Another name for Sales?
Equity
Another name for Shareholders' Equity?
Income Statement
Another name for Statement of Earnings?
Balance Sheet
Another name for Statement of Financial Position?
Income Statement
Another name for Statement of Profits & Loss (P&L)?
Equity
Another name for Stockholders' Equity?
Net Income
Another name for The Bottom Line?
Accounts Payable
Another name for Trade Accounts Payable?
DSI (Inventory Conversion Period)
Asks How many days does the inventory sit around the shelves = Inventory/Daily COGS (Annual COGS/360)
Cash Conversion
Asks How quickly so you generate liquidity? Number of days from receipt of inventory until receipt of customer payment + DSI + DSO -DPO
Inventory Turnover
Asks how many time per year you buy inventory, sell it, then re-buy it? (Number of times during the year inventory is sold and replenished) = COGS/Inventory
Acid Test (Quick Ratio)
Asks if a company can still pay bills with current assets (excluding all inventory) = (current assets-inventory)/current liabilities
Standard Deduction
Automatically "taken out" of the income to spend on anything (medical bills, etc.)
Partnership
Business shared by two or more owners. Goals are determined by multiple owners (no one can tell you why you are in business)
Net Profit Margin
Can either be kept (retained earnings) or shared (passed out as dividends) Equation: Net Income / Sales
Reduce litigation and judgement costs, Maintain a positive corporate image, Build shareholder confidence, and Gain the loyalty of all shareholder
Corporate Ethics Programs seek what four things?
Profit Margins
Explains how much of each sales dollar remains after deducting expenses
Increases, decreases Debt magnifies positives and negatives (acts as a leverage)
Debt (increases/decreases) ROE when profitable, but (increases/decreases) ROE when not profitable
Smaller which means it will be turned to cash sooner
Do you want the Cash Conversion value to be bigger or smaller? Why or why not?
Larger because you want to have more cash on hand. If it is too big, however, it may cut ties with the supplier (you are not paying them quickly enough).
Do you want the DPO value to be larger or smaller? Why or why not?
flat curve
Either we are transitioning from normal to inverted, or this is just a pause between normal and normal. Watch closely.
Financial Leverage
Equity Multiplier/Debt Ratio is also as what?
financial intermediary
Financial intermediaries facilitate the transfer of funds between those who have money and those who need money
Get people to pay for something they think will be beneficial for the country
Give a reason why the IRS would initiate a tax credit?
Gross Profit Margin
Gross Profit/Sales
Spread the wear and teat cost over the lifetime
How is the Depreciation Expense determined?
30 days
How long do accounts receivables usually appear in the account?
1 year
How quickly do current assets usually disappear?
Everything in Debt box/Everything in Assets box
How to calculate Debt Ratio?
Tax Expense/Taxable Income
How to calculate the Average/Effective Tax Rate
You can't get a tax refund if your business fails. If you have a tax loss one year and are profitable the next year, combine both numbers to not pay any taxes (both numbers should balance out)
How was Donald Trump able to avoid paying taxes?
Sources of Cash
Includes borrowing money, selling stocks, selling inventory, collecting receivables, etc. (anything that generates cash) High Liability, High Equity, low assets
Uses of Cash
Includes paying off loans, paying dividends, buying inventory or fixed assets, etc. (anything that consumes cash) Low liability, low equity, and high assets
"going public" or participating in an initial public offering (IPO)
If a company is offering shares of stock to the public for the first time in its history, the public gets the stock and the company gets the money.
you are not making enough long-term assets and investing in them. It is too liquid. Company is not growing
If the Acid Test value is too big, what does this mean?
Unrealized gains and losses
If you haven't sold your investment yet, and are just checking its market price in the newspaper, then the gain (or loss) that you calculate is unrealized, not reported on your tax return
The government must pay interest on their debt
In 2015, we paid a net $223 billion in interest on the federal debt. Thus, we spent about 6% of every tax dollar on net interest expense. To compare, we spent 22% on defense, 24% on Medicare and Medicaid, 24% on Social Security, and 24% on everything else. "Everything else" includes all discretionary spending by the departments of agriculture, commerce, education, energy, health & human services, housing & urban development, interior, justice, labor, state & international assistance, transportation, treasury, Corps of Engineers, Environmental Protection Agency, NASA, the National Science Foundation, and so on.
The other partner must give up their assets to cover the cost
In a partnership, if an individual wants to sue one of the partners and that partner does not have enough in assets, what will happen?
_ Borrowing the 50% will bring more financial leverage (ROE) because to find ROE, you divide net income by the amount you have put in yourself. Even though net income is smaller with the 50% debt option, you are dividing it by a smaller number. - Equity Only option
In an instance where you had two options 1) to use all your money or 2) to borrow 50% to start up a business, which instance would provide more financial leverage (higher ROE)? Why? - Net income is higher with which option?
direct transfer
In this case, the money goes directly to the company that issues the security and the security goes directly to the investor. A private placement of equity and a loan from a bank are both examples of direct transfer.
Sub Charter S Corporation (S-Corporation)
Income is passed to owner for tax purpose in order to avoid double taxation. Owners pay taxes themselves. These may have no more than 100 stockholders and each must be a US citizens/resident alien and must be an actual human being
investment banker
Investment bankers are not bankers in the traditional sense. They don't accept deposits or make loans. Instead, investment bankers help companies raise money by helping those companies issue new securities to the public
Smaller number
Is a larger or smaller number favored for the Receivables Collections Period?
Yes; Cash is being consumed (spent)
Is there a such thing as negative cash flow? If so, what does it mean?
Limited Liability Corporation (LLC)
Just like an S-Corporation except stockholders can be any foreign investor, corporation, etc. These are pass-through entities
Return on Assets (ROA)
Level of net income generated on assets of the company (How much profit you got using assets) = Net Income / Total Assets
no-load funds
Many funds charge no sales commissions at all. If a fund calls itself a no-load fund, then its 12b-1 fee is limited to 0.25% of NAV (otherwise, they might try to simply hide the load inside the 12b-1 fee).
The Income statement changes while the balance sheet stays the same
Missing Forecast: When the actual sales are different than the predicted sales, which statement changes? The balance sheet or the income statement - Which option will have the higher ROE with sales lower than predicted?
3 ratings agencies
Moody's, Standard & Poor's, and Fitch, rate corporate debt on a scale from AAA to D. The higher the rating (AAA is the highest), the less risky it is, therefore the less costly it is to issue.
Sole Proprietorship
Most common form of a business. Owned by one person. Goals are determined by one person (no one can tell you why you are in business)
ROA
Net Profit Margin + Total Asset Turnover =
Effectiveness
Net Profit Margin is also known as the Effectiveness or Efficiency?
DSO (Days of Sales Outstanding/Average Collection Period)
Number of Days to collect forms of payment = Receivables / Daily TOTAL Sales
DPO (Average Payables Period/Days of Payables Outstanding)
Number of days until payables are paid (paid to suppliers) = Accounts Payable / Daily Purchases
Receivables Collection Period
Number of days until receivables is collected = Receivables/Daily Credit Sales
Current Ratio
Number of times current assets can pay for current liabilities. = current assets/current liabilities.
Free Cash Flow
Operating Cash Flow - Long-term Assets - Net Working Capital. Asks how much excess cash is available to invest in new activities or pay dividends
Operating Profit Margin
Operating Income/Sales
Equity Multiplier
Percentage of assets financed with Equity = Total Assets / Total Equity
Debt Ratio
Percentage of assets financed with debt = Total Debt / Total Assets
Return on Equity (ROE)
Return generated on shareholder's capital invested in the company = Net Income / Total Equity
Operating Expense
SG&A + Depreciation Expense = ?
capital markets
Securities with maturities of more than a year (stocks and medium- to long-term debt instruments) are traded in
The feds tools
Setting bank reserve requirements, Setting the discount rate, Conducting open market operations
1 year or less
Short term capital is considered to be less than how many days?
60 days or less
Short term securities are considered less than how many days?
Progressive Tax System
Tax percentage increase as you increase in income
Net Profit Margin Total Asset Turnover Equity Multiplier/Debt Ratio
The DuPont chart says that increasing what three things will increase the ROE?
Conducting open market operations
The Fed can buy or sell Treasury securities to change the money supply.
Dollar return = Income + Capital gain
The amount of dollars that you earn from an investment is the sum of the income from the investment, plus the change in the market value of the investment.
Annualized return = Yield × (360 ÷ T), where T = the number of days in the holding period
The annualized return takes the holding period return for holding periods of less than a year, and makes it look like a one-year return. It is used when comparing returns on assets that have been held for unequal periods of a year or less.
Average Annual Return = [(1 + r1) × (1 + r2) × ... × (1 + rn)]1/n - 1
The average annual return takes several yearly returns and averages them. It is a geometric, rather than a simple average, because it reflects the impact of compounding.
New York Stock Exchange (NYSE)
The biggest stock market in the US, It is an organized physical exchange; that is, a real, physical place, located on Wall Street in New York City.
Goodwill
The bland value of money that is the total amount worth for the company-physical assets. (the amount for the idea of a company)
Regressive Tax System
The lower income you receive, the more percentage of tax you pay. Tax percentage decreases as you increase in income
higher
The lower the firm's risk, the _____ its market value
Limited Partner
The partner in a LLC that has limited liability. If the company were to get sues, this partner cannot exceed to pay up more than they have invested
General partner
The partner in an LLC that has unlimited liability and all control
normal curve
This is gently upward sloping. The spread between a 90-day and a 30-year Treasury is about 3 percentage points. Treasury investors believe the economy is behaving "normally" and they expect it to continue that way.
steep curve
This is just a bit steeper than a normal curve—the spread between 90-day and 30-year Treasuries is equal to or greater than 4 percentage points. An expansion is expected by Treasury investors.
Setting bank reserve requirements
This is the percentage of deposits that banks must hold in reserve to ensure there is cash available for those who want to make withdrawals. Once banks have met the reserve requirement, they can lend out the rest of their deposits. If the Fed decreases the reserve requirement, banks can lend more money, so the money supply increases.
Setting the discount rate
This is the rate at which the Fed lends money to banks. If the Fed decreases the discount rate, banks borrow more money from the Fed, which means the banks can lend more, so the money supply increases. (See how the banks just created money?) The Fed's discount rate is currently 1.00%. Don't confuse the Fed's discount rate with the Federal Funds Rate. The latter is the rate at which banks lend money to one another. The Fed sets target for the Federal Funds Rate (currently the target is between 0.25% and 0.50%)
What does "most investors are risk-averse" mean?
This means that most investors expect a higher level of return in exchange for taking on a higher level of risk. As a result, as the risk of various financial instruments rises, so to do their expected returns. Thus is born the risk return trade-off.
rRF = r* + IP
This says that the interest rate earned on a 30-day or 90-day T-bill (that is, the discount rate) equals the real risk-free rate plus inflation. If we rearrange the formula, we find that the real risk-free rate, r*, equals the interest rate earned on a 30-day or 90-day T-bill minus inflation. r* = rRF - IP.
Assets, Debts, Equity
Three categories the balance sheet includes
Where do interest rates come from?
To figure out where market rates come from, start with the real, risk-free rate, r*. This is the rate that would be paid on financial instruments that have absolutely no risk whatsoever. We assume that the rate on 30-day or 90-day Treasury bills, minus inflation, equals r*. This rate is determined by: a. The Federal Reserve's monetary policy (see details above). b. The US government's foreign trade surplus/(deficit): The foreign trade balance is the sum of all of the goods and services the US exports to other nations, minus the sum of all the goods and services the US imports from other nations, (exports minus imports).
Efficiency
Total Asset Turnover is also known as the Effectiveness of Efficiency?
Accounts Payable Accruals Notes Payable Other Current Liabilities Long-term debt Other non-current liabilities
What is the order of Debt in a Balance Sheet?
True
True/False: A Balance Sheet reports Assets, Liabilities and Debt while an Income Statement reports Income and Expense
True Assets = Debt + Equity Debt = Assets - Equity Equity = Assets - Debt
True/False: A balance sheet must always balance
False. It eventually will
True/False: Accumulated Depreciation will never equal cost of income (amount received)
True
True/False: Assets are listed in order of liquidity (which can turn to cash easiest and quickest)?
False. Reports balance at one point in time
True/False: Balance Sheet reports balance over a period of time?
True: the financial leverage concept proves borrowing to be more effective in raising the ROE (and therefore the stock price) which is only effective if the company is profitable. simply borrowing the money and not having the means to pay it back will not increase the ROE
True/False: Financial Leverage concept is only assuming profitability for the company
True
True/False: High Debt=High Financial (Default) Risk
False
True/False: It is harder to transfer ownership in a corporation than a sole proprietorship
False
True/False: Profit = Cash Flow
False. Amount after deductions
True/False: Taxable Income is the total amount you have received in income
True; To ensure that the last row in the table (corporations that make 18,333,333+) has an average and marginal tac rate of 35%
True/False: The corporation tax table goes from Progressive > Regressive > Progressive > Regressive? If true, why? If false, why not?
False:
True/False: To find the variance amount, you can simply subtract the actual number minus the forecasted number and if the difference in negative, it is unfavorable
True
True/False: Usually ROE will tell if the stock price will increase
True
True/False: You must apply and add all the amounts from each tax bracket until you get to yours
Trend Analysis and Bench Marking
Two ways to analyze financial performance with ratio
federal debt includes
US Treasury bills, notes and bonds. These are considered to be default-free instruments. Since the federal government can simply borrow new money to pay its debts, it has never defaulted on its debt. As a result, we assume the federal government will never default. Thus, the Default Risk Premium (DRP) on a Treasury instrument is always 0%.
about 15.3%
What is the average taxable income rare for an individual in the US?
To maximize long-term shareholder wealth/value but not to maximize gain for managers of the corporation
What is the goal of a Corporation?
Money is transferred from those who have money to those who need money through one of three primary methods
Via a direct transfer, Through an investment banker, Through a financial intermediary
1. How liquid is the firm? 2. Is Management generating adequate operating profits on the firm's assets? 3. How is the firm financing its assets 4. Is management generating and adequate return on the capital provided by the owner? 5. Is management creating shareholder value?
What 5 questions does ratio analysis need to answer?
Less/(Plus): Interest & Other Earnings Before Tax (EBT)
What are considered Financial Activities in an Income Statement?
Sales Revenue Less: COGS Gross Profit Less: Depreciation Expense Less: SG&A Expense Operating Income (EBIT)
What are considered Operating Activities in an Income Statement?
Cash Marketable Securities Accounts Receivables Inventory Prepaid expenses Other Current Assets
What are considered current assets?
Accounts Payable Accruals Notes Payable Other Current Liabilities
What are considered current liabilities?
Pros: easy to create, all income and expenses are divided by the owners (partners), few regulations, taxed like an individual Cons: unlimited personal liability for partners, difficult to obtain capital, hard to transfer ownership (illiquid), business does with partners
What are pros and cons of a Partnership?
Pros: Easy to create, few regulations (only those from the industry), and taxed like and individual (company is not a separate entity and if the something goes wrong, the proprietor is sued) Cons: Unlimited personal liability, difficult to obtain capital (business grows slowly), hard to transfer ownership, illiquid, business dies with the proprietor
What are pros and cons of a Sole Proprietorship?
Balance Sheet (Financial Position), Income Statement (Statement of Profit & Loss), Statement of Changes in Retained Earnings, Statement of Changes in Cash (Sources and Uses)
What are the 4 basic financial statements published when a company goes public?
Pros: Unlimited life (does not die when owners die), ownership is easily transferable (selling stocks - very liquid), owners have limited liability, easy to raise large sums of capital Cons: Starting a corporation can be complex, earnings are subject to double taxation,
What are the pros and cons of a Corporation?
Sole Proprietorship Partnership Corporation
What are the three basic forms of business?
1. ROE is based on Accounting (historical data) which compares use to predict future finances 2. ROE measures only the return while financial decision should incorporate both risk and return 3. ROE measures return on book value of equity - owners demand return on market value of equity
What are the three limitations for ROE predicting share value?
1. Determine Gross Income 2. Subtract Deductions/Exemptions 3. Remaining amount is taxable income which you compare to the tax bracket chart
What are the three steps to figure out amount of tax paid?
1. Operating Cash Flow 2. Free Cash Flow
What are the two useful measures of cash?
Selling, General & Administrative Expenses
What doe SG&A stand for?
Cost of Goods Sold
What does COGS stand for?
Cost of Sales COGS
What does COS stand for? What is another name for it?
Default Risk Tells you what percentage of the company assets were bought with debt
What does Debt Ratio measure?What does it tell you?
Earnings Before Interests and Taxes
What does EBIT stand for?
Earnings Before Tax
What does EBT stand for?
that its more liquid and has Shorter amount of time on shelf
What does a small value for DSI mean?
Gross Working Capital - Total Current Liabilites
What equation is used to calculate Net Working Capital?
You must write a check to the IRS and pay the rest of the amount
What happens if you employer takes out too little money than what you need to pay in taxes?
Get a tax refund. IRS will give the money back
What happens if your employer takes out more money than you you needed to pay in taxes?
Current Assets
What is Gross Working Capital?
Conflict of interest with managers of a corporation, in appropriate use of company assets and inappropriate personal conduct
What is the Agency Problem?
Preferred Stock Common Stock + APIC Retained Earnings Other Equity
What is the order of Equity in a Balance Sheet?
Cash Marketable Securities Accounts Receivables Inventory Prepaid expenses Other Current Assets gross Property, Plant, and Equipment accumulated depreciation net PPE Goodwill Other non-current Assets
What is the order of the Assets in a Balance Sheet?
Sales Revenue Less: COGS Gross Profit Less: Depreciation Expense Less: SG&A Expense Operating Income (EBIT) Less/(Plus): Interest & Other Earnings Before Tax (EBT) Less: Income Tax Expense Net Income
What is the order of the Income Statement?
Stock Price Maximization (Income in the public owners)
What is the ultimate goal of existence for corporations?
Current Ratio: Times Quick Ratio: Times Inventory Turnover: Times DSI: Days RCP: Days DSO: Days DPO: Days Cash Conversion: Days ROA: % Debt Ratio: % Equity Multiplier: Times ROE: % EPS: $ P/E Ratio: Times Market-to-Book Ratio: Times Enterprise Value: $
What is the unit of: Current Ratio? Quick Ratio? Inventory Turnover? DSI? Receivables Collection Period? DSO? DPO? Cash Conversion? ROA? Debt Ratio? Equity Multiplier ROE? EPS? P/E Ratio? Market-to-Book Ratio? Enterprise Value?
They may buy T-bills (or other securities) to keep their money safe. It is like putting the money in a savings accounts except a savings account only secures up to $250,000
What might a company do to keep their money safe? Why do they do this?
15-20%
What percentage of businesses are operated as Corporations?
8-10%
What percentage of businesses are operated as Partnerships?
70-75%
What percentage of businesses are operated as Sole Proprietorships?
83%
What percentage of income do Corporations make of all businesses?
15-20%
What percentage of income do Partnerships make of all businesses?
3-4%
What percentage of income do Sole Proprietorships make of all businesses?
SG&A and Depreciation Expense
What two amounts does Operating Expense combine?
Deductions
What you subtract from you income before the rest of your gross income is tax
chapter 7 bankruptcy
When a companies (or individuals) file for chapter 7 bankruptcy, they are declaring themselves insolvent. The assets get liquidated (turned into cash) and the proceeds are consumed paying customers, employees, government, and maybe the lenders. There will not be anything left for the owners.
chapter 11 bankruptcy
When a company files for chapter 11 bankruptcy, the company is said to be restructuring its debts. That means the company is negotiating new payment terms with its lenders. Often, the lenders agree to forgive some of the debts in exchange for ownership of the company. In that case, the former equity holders end up with nothing.
Tax Credit
Which usually yields more money: A Tax Credit or a Tax Deduction
yield curve
a line graph showing the relationship between the interest rates and terms to maturity on Treasury instruments. A new yield curve is created each day
The most widely known derivative is
a stock option. Its value is based on the values of the stocks mentioned in the option grant.
Pension funds (including Social Security)
accept contributions from employers (and sometimes employees). They invest these contributions, then pay out pensions for the employees when the employees retire. Only 29% of US companies have pension funds. Most of those pension funds are offered only to current employees. Most new employees will not have pensions.
Insurance companies
accept premiums from the insured, invest the proceeds, and hopefully earn enough money to pay out payments for claims of loss.
Subordinated debt gets paid _____ superior debt
after
Commercial banks, Credit unions, Savings & Loan institutions (S&Ls) and Thrifts
all accept deposits from savers. They reserve some of the deposits (as mandated by the Fed, see below) to ensure that there is enough cash available for people who want to make withdrawals. Then they lend the rest of the money to businesses and individuals. When someone simply says "bank," they are probably referring to a commercial bank. When the bank lends money, it is creating liquidity in the economy. In this sense, it is creating money.
call provision
allows the bond issuer to call (pay in full) the bond before the maturity date. Companies would be motivated to do this if interest rates have fallen, because they would prefer to issue new debt at the new, lower rate.
index
an imaginary collection of consumer goods, stocks or bonds, used to gauge the performance of assets that are comparable to your own
market order
an instruction to buy or sell a stock as soon as your order reaches the market. This is the most common kind of trade. It assumes that you are taking a long position, that is, you expect the price of the stock to rise.
limit order
an order to buy at a particular price (or lower) or sell at a particular price (or higher). The particular price must be specified in the order.
NASDAQ
an organized virtual exchange. It is a collection of dealers and brokers who are connected electronically, via telephones and computers.
portfolio return provides
an overall weighted average of all of the different assets in your portfolio i. Portfolio return = [(Value of security1 ÷ Value of portfolio) × Return1] + [(Value of security2 ÷ Value of portfolio) × Return2] + ... + [(Value of securityn ÷ Value of portfolio) × Returnn] ii. Portfolio Return = w1r1 + w2r2 + ...+ wnrn
Derivatives
are financial instruments whose value is based on the value of some other underlying financial asset.
Mutual funds
are investment companies that pool the resources of many investors in order to buy stocks and/or bonds of other companies. A mutual fund issues shares of itself to its investors based on the fund's Net Asset Value (NAV) per share. As of 2011, although 54% of US households invested in the stock market, 80% of that 54% invested in stocks via mutual funds. Mutual funds have gained in popularity during the last thirty years. Back in 1980, fewer than 6% of US households owned a mutual fund.
private or closely held
before the company goes public
junk bonds
bonds issued by companies with low debt ratings (a C, for example)
Many mutual funds invest in
bonds. Funds are typically distinguished by the types of bonds they invest in (ie. corporate versus municipal) and the maturities of those bonds (short-, intermediate- or long-term). Bond funds focus on earning current income while preserving the invested capital. They are commonly used as a means of diversifying an otherwise all-stock portfolio.
debt
borrowed money that must be repaid
Trading in securities is facilitated by
brokers and dealers
Dealers
buy inventory and then resell it. They make their money on the spread, that is, the difference between the purchase price and the sale price. (Think car dealers.)
forms of bankruptcy
chapter 7, chapter 11, chapter 9 and 13
Corporate debt includes
commercial paper, term loans, junk bonds and investment grade bonds
equity instruments
common and preferred stock
Securities and Exchange Commission (SEC)
created in response to the Great Depression by Franklin Delano Roosevelt (Teddy's nephew-in-law) to regulate the issuance and trading of financial securities. a. All public companies must disclose their financial information to the investing public. You can look up all public financial information on the SEC's database, called EDGAR. b. Corporate insiders cannot profit at the expense of other stockholders. That is, if you have inside information that the public doesn't know about, you cannot buy or sell the company's stock based on that information. c. It is illegal to artificially manipulate stock prices. An example of such manipulation: posting phony press releases on the internet in the hopes that it will make a company's stock price rise or fall.
who has priority in liquidation?
debt holders have priority over equity holders. Employees and customers are paid first, followed by the government, debt holders (aka creditors/lenders/debt investors), and equity holders (aka owners/equity investors/stock holders).
Bonds, loans, commercial paper, US Treasuries, and other debt instruments are traded in
debt markets
3 types of financial instruments
debts (like loans and bonds), equities (as in stock) and derivatives (like stock options)
debt holders
do not have voting rights, but can exert some influence through bond indentures or loan contracts
During periods of economic contraction (recessions or busts), there is less demand for money, putting _______ pressure on interest rates
downward
interest payment with bonds (INT)
equals the par value of the bond, M, times the annual coupon rate, C, then divided by the number of payments per year, m. INT = (M × C) ÷ m. Almost all US corporate bonds pay coupon interest payments semi-annually; so in our class, m (for bonds) will always be 2. Almost all US corporate bonds have a face value of $1,000; so in our class, M will always be $1,000.
Stocks are traded in
equity markets, also called stock markets
If GDP is rising, we say the country's economy is _______; if GDP is falling, the economy is ________
expanding; contracting
As the prices fall, the index ________
falls
sinking fund
fund requires the bond issuer to pay off the debt over the course of time, rather than paying off the entire amount on the maturity date
the longer the term to maturity, the _______ the maturity risk, and the ________ the MRP
greater; higher
seasoned offering
had both its initial public and secondary public offering long ago
debenture bond
has no collateral backing it up
The higher the default risk, the ______ the DRP.
higher
APIC
how much a company received in stock the day it went public
Standard & Poor's 500, or S&P 500
imaginary collection of stocks from the 500 largest, most reputable US firms. The firms cover a range of industries and are traded on every major stock exchange. The S&P declined 37% during 2008, and rose 1% during 2015. When people say "the stock market rose X%," they usually mean the S&P 500 rose X%.
MSCI Emerging Markets
indexes that track emerging markets stocks
MSCI EAFE, DJ World
indexes that track international stocks
discount rate and risk-free rate (Rrf)
interest rate on T-bills
coupon rate
interest rate on bonds
maturity risk
interest rate risk
Income funds
invest in bonds that pay interest and stocks that pay high dividends in order to ensure that current income stays ahead of inflation. Since growth is largely ignored, these funds don't earn significant capital appreciation. These are for investors who need current income, not for those who are aiming for long-term increases in wealth.
International funds
invest in firms outside the US. They are useful for diversifying beyond the US stock market, and can mitigate losses from US economic downturns.
Sector funds
invest in firms that are all within a particular industry. These funds are those who feel comfortable with lots of their eggs in one basket.
Growth funds
invest in firms that are growing faster than their industries in order to earn above-average capital gains (especially during bull markets). They are more focused on earning capital gains than on earning dividend income. They tend to perform poorly during bear markets.
Emerging markets funds
invest in firms that are in rapidly growing developing economies (like the BRICs). In terms of performance and risk, they are similar to US-based aggressive growth funds (that is, small caps).
Value funds
invest in firms that they considered to be undervalued, in the hope of earning above-average returns. To determine the "true" value of a firm, the fund's analysts evaluate each firm's financial statements, management team, product offerings, labor practices, and so on. In addition, the analysts look at the firm's industry and competitors, as well as the total economic picture. If the analysts determine that the "true" value of the firm's stock is more than the current market price, they consider the firm to be undervalued by the market, and they add it to their fund. Once the market recognizes the true value of the firm, the funds reasons, the market will drive the price up and the fund will reap the reward. Value funds attempt to achieve above-average, long-term capital appreciation, as well as dividend income. They decline during bear markets, but less precipitously than growth funds.
Growth-and-income funds
invest in steadily growing blue chip companies that pay dividends. They attempt to earn long-term capital appreciation, with higher current income (from the dividends) than growth funds earn. These funds, like everything else, decline during bear markets, but like value funds, they don't fall as hard as growth funds do.
If the Fed sells its stash of Treasuries
investors take their money out of their bank accounts and give it to the Fed. As a result, the money supply decreases, enabling banks to increase their interest rates (and causing both inflation and GDP to fall).
Buying on the margin
involves borrowing money from your broker in order to buy stock
Selling a stock short
involves borrowing stock from an investor and selling it in the hope that the price will fall
financial instrument
is a particular type of debt or equity that a company issues in order to raise money
maturity risk premium, MRP
is added to the risk-free rate to compensate the investor for investing in long-term instruments and potentially losing the opportunity to invest at higher rates. Maturity risk is also called duration risk and interest rate risk. Long-term Treasury securities (both notes and bonds) like all other long-term debt instruments include an MRP.
liquidity premium, LP
is the amount added to the risk-free rate to compensate the investor for assuming some liquidity risk, the chance that you won't be able to get your invested capital back when you need it. Investments in real estate and small, private companies are considered to have higher liquidity risk (thus, higher LPs) than investments in publicly traded stocks and bonds. The US Treasury market is the world's most liquid market, so Treasury instruments are assumed to have no liquidity risk at all (LP equals 0%).
bond indenture
is the contract between the buyer and seller (lender and borrower). The indenture specifies restrictive covenants that constrain the actions of the borrower, such as call provisions and sinking fund requirements.
inflation premium, IP
is the expected average annual rate of inflation over the term of the investment.
Inflation
is the tendency of prices to rise over time. This means that it takes more money to buy things today than it took yesterday. In other words, inflation decreases your buying power.
A sinking fund provision generally decreases the cost of the debt, because
it decreases the perceived risk.
efficient markets
it would be impossible to earn abnormal returns, challenged in the Great Recession
Investors in mutual funds are subject to paying two types of fees
loads, expense ratios
interest rate on mortgage bonds are ____ than the cost of debenture bonds
lower
The longer it takes to get your money back, and the _______ the chance of getting ALL your money back, the _________ the liquidity risk.
lower; higher
market interest rate, rD
market interest rate is also called the nominal rate, the actual rate, or just "the rate," rD = rRF + DRP + MRP + LP
Stock traders can enter many types of orders
market order, limit order, stop order, etc.
Brokers
match up buyers and sellers, and earn commissions on the resulting transactions. (Think ebay.)
Gross National Product (GNP)
measures all the goods and services produced by a country, regardless of where the production takes place
Gross Domestic Product (GDP)
measures all the goods and services produced within the country's borders
Nasdaq Composite index
measures the performance of all of the stocks listed on the Nasdaq exchange. It fell 41% in 2008, and rose 6% in 2015.
subordinated debt is _______ risky than superior debt
more
up-front sales load
most common load, the load percentage is deducted from the investor's deposit. There are also back-end loads, but they less common
rRF
nominal risk-free rate
four basic types of yield curve results
normal curve, steep curve, inverted curve, flat curve
During the recent great recession, the Fed was granted a new bag of tricks
not only did it expand its lending to investment banks, commercial banks, insurance companies and automobile manufacturers; it accepted "toxic" assets and equity as collateral. That's how the US government ended up owning General Motors
expense ratio
officially called the annual fund operating expense percentage. The expense ratio () is in addition to any load that the fund might charge. Unlike the load, the expense ratio is charged to the investor annually. The message is this: unless you have a compelling reason to do otherwise, you should buy a no-load fund with a low expense ratio.
general obligation bonds are repaid with
property tax dollars
Common stock
represents ownership. If you own a share of stock, you own a piece of the company. Common stock never matures, and may or may not pay dividends. Stockholders usually have voting rights, but get paid last in the event that the company is liquidated.
Revenue-generating bonds are repaid with
revenue generated by the project that the bond financed
state and local government debt includes
revenue-generating municipal bonds and general obligation municipal bonds (both are referred to as "munis").
As the prices of the goods, stocks or bonds rise, the index _________
rises
loads
sales commissions
Financial markets are where
savers/lenders/investors give up their money in exchange for the securities (that is, the financial instruments) of spenders/borrowers/companies
mortgage bond
secured by some form of collateral
money markets
securities that mature in a year or less (short-term debt instruments) are traded in
To turn your dollar return into a percentage figure, called yield, or rate of return (denoted with our friend "r")
simply divide by the beginning value i. % return = Yield = r = Dollar return ÷ Beginning Value ii. % return = Yield = (Income + Capital gain) ÷ Beginning Value iii. % return = Yield = [Income + (End value - Beg value)] ÷ Beginning value
Preferred stock
sort of a cross between common stock and bonds. Preferred stock pays a dividend, and preferred stockholders cannot force a company into bankruptcy (which makes it feel like common stock), but preferred stockholders have priority over common stockholders in the event of liquidation, and the preferred stock dividends are of a fixed amount (which makes it feel like bonds).
The majority of mutual funds invest in
stocks
Balanced funds invest in
stocks and bonds to simplify the process of diversification for investors
Index funds can own either
stocks or bonds. Index funds attempt to mirror a particular stock or bond market index, thereby earning average returns (that is, the same returns as their index). Note that index funds are considered to be passively managed, whereas all of the other funds discussed above are actively managed. If we look at average annual returns before considering expenses, index funds have historically outperformed actively managed funds. Index funds typically have very low expense ratios (that is, low annual operating expenses) making their net returns after expenses all the more attractive.
The biggest risk faced by bonds and bond funds is
that their values can fall as interest rates rise. The longer the term to maturity, the greater the interest rate risk (also called maturity risk).
The biggest lender to the US government is
the US public (both individual and institutional investors), who own 40% of the debt. 28% of federal debt is owned by US government agencies (primarily the Social Security Administration). The remaining 32% of US Treasuries are owned by foreign governments, companies and individuals (China and Japan each hold 7%).
default risk premium, DRP
the amount added to the risk-free rate to compensate the investor/lender for taking on default risk, the chance that a borrower won't pay back the lender. To find the default risk premium on a corporate bond, compare its rate to the rate on a Treasury bond of the same maturity. We assume that the DRP on any Treasury instrument equals 0%.
principal
the amount that must be repaid by the end of the term. The principal is also called the maturity value, par value, and/or face value.
interest rate
the borrower's cost of the debt
The Federal Reserve System (the Fed)
the central bank of the US. It is responsible for regulating banks, S&Ls, and other depository institutions, clearing all of the paper checks and electronic payments in the US so that the monies get where they're supposed to go, holding the US Treasury's checking account, and, most importantly, conducting monetary policy. Conducting monetary policy means controlling the US money supply.
The federal budget balance is
the difference between the monies that the government receives in a single fiscal year (mainly in the form of taxes), and the amount the government spends in that same year. That is, receipts less outlays.
capital gain (or loss) equals
the ending value of the investment minus the beginning value of the investment
the transactions take place in the secondary markets when
the initial buyers of stocks or bonds decide to sell their investments to other members of the investing public. The initial investors give up their stocks or bonds in exchange for cash, and the secondary investors give up their cash in exchange for the stocks or bonds. None of the money goes to the company that originally issued the stock or bond. Nearly all stock market transactions are secondary market transactions.
If the Fed buys Treasuries from investors
the investors receive the proceeds and put the money in their bank accounts. The money supply increases, so banks reduce their interest rates (and inflation and GDP both rise).
Income
the money that is received from interest payments (from bonds), dividend payments (from stocks), or rents (from buildings). This income is taxable during the period in which it is earned.
Dow Jones Industrial Average (aka the Dow, the DJIA)
the oldest index. It tracks the cost to purchase stocks of the largest 30 US companies. The DJIA fell 34% during 2008 and fell about 2% in 2015.
The first time an issue of stocks or bonds is offered to the public, it is offered in
the primary market. The stocks or bonds end up in the hands of the public, and the cash ends up in the hands of the issuing company.
low debt rating means
the risk of default is high; thus, junk bonds pay higher-than-average coupon rates.
Call provisions generally increase the cost of the debt, because
they add to investors' risk.
When companies take out loans (a private placement of debt)
they need only work with one or two banks to get the money. It's a relatively fast and flexible process.
When companies issue bonds (a public issue of debt)
they need to work through an investment banker and borrow funds from potentially thousands of investors. The process is much more expensive and time consuming—but also makes it possible to borrow a lot more.
Investors would prefer not to buy T-bills unless
they pay enough to cover the cost of inflation. Right now, however, T-bills are paying less than inflation.
To subordinate a debt means
to make it less important than other debts
Russell 2000
tracks the performance of 2000 small US public firms. It fell 34% in 2008, and fell 4% in 2015
During periods of economic expansion (booms), there is greater demand for money, putting ________ pressure on interest rates
upward
Federal budget deficits put ________ pressure on interest rates.
upward
Foreign trade deficits put _______ pressure on interest rates.
upward
chapter 13 bankruptcy
used when individuals attempt to restructure their debts
chapter 9 bankruptcy
used when municipalities (like the city of Detroit) restructure their debts
maturity date
when principal must be repaid
capital gain (or loss) is realized when
you sell the investment for more (or less) than you paid for it. Realized gains and losses must be reported on your tax return. Capital gains are taxed when realized