Finance All Vocab
Downsides of bearer bonds
1. difficult to recover if lost or stolen 2. bondholders can't be notified of important events (company does not know who owns it) LESS COMMON THAN REGISTERED BONDS
Special circumstances where we can value a stock
1. dividend has a zero growth rate 2. dividend grows at a constant rate 3. dividend grows at a constant rate after some length of time
What causes interest rate risk to be greater?
1. longer time to maturity 2. lower coupon rate
Arrearage
A past due obligation such as interest, or dividends on a cumulative preferred stock.
Change in Net Working Capital
Ending NWC - Beginning NWC
True or False: portfolio risk is a weighted average of the individual standard deviations of the stocks
False
True or False: The cash flows from a bond change as time passes and interest rates change
False (only the value of the bond changes)
Junk bonds
High-risk, high-interest bonds
Proxy and Proxy Fight
Proxy: the authority to vote someone else's stock proxy fight: develops when a group solicits proxies in order to replace the existing board and thereby replace existing managers
DuPont Equation
ROE = Profit Margin x Total Assets Turnover x Equity Multiplier
Do risky securities or riskless securities have higher returns?
Risky securities
Mortgage securities
Securities by a mortgage on the real property of the borrower
Why should you diversify your portfolio and not just invest in the fastest growing stocks?
Slower growing stocks are steadier
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
Dirty price
The price of a bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.
Capital budgeting
The process of planning and managing a firm's long-term investments
What is the fundamental relationship between risk and return?
The reward-to-risk ratio must be the same for all the assets in the market
Capital structure
The specific mixture of long-term debt and equity the firm uses to finance its operations
Partnership Agreement
The way partnership gains and losses are divided
What is different about municipal bonds?
They are exempt from federal income taxes
What securities have risk-free return?
Treasury bills
True or False: There are more bond issues than stock issues
True
True or False: when we discuss portfolios of stocks, the standard deviation of the individual stocks is not the relevant measure of risk
True
true or false: Corporate bonds are usually callable
True
security market line (SML)
a positively sloped straight line displaying the relationship between expected return and beta
Straight Voting
a procedure in which a shareholder may cast all votes for each member of the board of directors
Cumulative Voting
a procedure in which a shareholder may cast all votes for one member of the board of directors
Unsystematic risk
a risk that affects at most a small number of assets. Also called unique or asset-specific risk
Systematic Risk
a risk that influences a large number of assets. Also called market risk
Mutually exclusive investment decisions
a situation in which taking one investment prevents the taking of another
Common-Base Year Statements
a standardized financial statement presenting all items relative to a certain base year amount
Dividend yield
a stock's expected cash dividend divided by its current price
normal distribution
a symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation
Consol
a type of perpetuity
Electric Communications Network (ECN)
a website that allows investors to trade directly with each other
Federal Corporate Tax Rate
about 21%
strong form efficient
all information of every kind is reflected in stock prices (no such thing as inside information)
If the market is efficient, what is one implication
all investments in that market are zero NPV investments
Put bond
allows the holder to force the issuer to buy back the bond at a stated price
Marginal Tax Rate
amount of tax payable on the next dollar earned
Sinking fund
an account managed by the bond trustee for early bond redemption
Broker
an agent who arranges security transactions among investors
Dealer
an agent who buys and sells securities from inventory
Call provision
an agreement giving the corporation the option to repurchase a bond at a specified price prior to maturity
Perpetuity
an annuity in which the cash flows continue forever
growing perpetuity
an asset with cash flows that grow at a constant rate forever
IRR rule
an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.
Average accounting return (AAR)
an investment's average net income divided by its average book value
NYSE member
an owner of a trading license in the NYSE
Debenture
an unsecured debt, usually with a maturity of 10 years or more
Note
an unsecured debt, usually with a maturity under 10 years
Annuity Due
annuity for which the cash flows occur at the beginning of the period
Free Cash Flow
another name for cash flow from assets
Modern trading is
automated and cheaper to do than ever
Price of Stock at time T (no dividends) =
benchmark PE ratio x Earnings Per Share at time T
Inflation-linked bonds
bond's whose coupon rate changes over time based on rate of inflation.
Structured notes
bonds that are based on stocks, bonds, commodities, or currencies
Catastrophe (Cat) Bonds
bonds with a return that depends on the incidence of natural catastrophes
Interest-only Loans
borrower pays interest each period and repays the entire principal at some point in the future
Discount
calculate the present value of some future amount
Ordinary Annuity
cash flows occur at the end of each period
Operating Cash Flow
cash generated from a firm's normal business activities
Income component of return
cash you receive from your return on investment
Requirements to be listed on NYSE
company is expected to have a market value for its publicly held shares of at least $100 million
What makes a market efficient?
competition among investors
Double Taxation
corporate profits are taxed first at the corporate level when they are earned and then again at the personal level when they are paid out (as dividends)
Variable costs
costs that vary with the quantity of output produced
floating-rate bonds (floaters)
coupon payments are adjustable
Net working capital
difference between a firm's current assets and it's current liabilities
Cash Flow
difference between number of dollars that came in and number of dollars that went out
Total dollar return =
dividend income + capital gain (or loss)
R =
dividend yield + capital gains yield
Cash Flow to Stockholders
dividends paid out by a firm - net new equity raised
EV/EBITDA Ratio
enterprise value/a measure of its cash created
Common stock
equity without priority for dividends or in bankruptcy
Announcement =
expected part + surprise
Total return =
expected return + unexpected return
Risk premium equation
expected return - risk-free rate
Noncash items
expenses charged against revenues that do not directly affect cash flow, such as depreciation
Diversification reduces ___
exposure to extreme outcomes, both good and bad
Balance Sheet
financial statement showing a firm's accounting value on a particular date
Income Statement
financial statement summarizing a firm's performance over a period of time
Pro forma financial statements
financial statements projecting future years' operations
To have a stock listed:
firms must meet certain minimum criteria concerning asset size, number of shareholders, etc.
Warrant
gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price
Stocks of small companies have higher or lower average returns than larger companies?
higher
More liquid stocks have ___ valuations but ___ returns than less liquid stocks
higher, lower
over-the-counter (OTC) market
securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories
Payday loans
short-term loans to consumers
Which type of investment did the best?
small-company stocks
principle of diversification
spreading an investment across a number of assets will eliminate some, but not all, of the risk
Restricted Stock Units (RSUs)
stock units offered to employees at bargain prices, but are only distributed when it vests
Preferred stock
stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights
semistrong form efficiency
suggests that security prices fully reflect all public information, such as firm announcements, economic news, or political news
Total risk =
systematic risk + unsystematic risk
Call premium
the amount by which the call price exceeds the par value of a bond
beta coefficient
the amount of systematic risk present in a particular risky asset relative to that in an average risky asset
Payback period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
Coupon rate
the annual coupon divided by the face value of a bond
Stand-alone principle
the assumption that evaluation of a project may be based on the project's incremental cash flows
Geometric average return
the average compound return earned per year over a multiyear period
Variance
the average squared difference between the actual return and the average return
Pure discount loan
the borrower receives money today and repays a single lump sum at some time in the future
Erosion
the cash flows of a new project that come at the expense of a firm's existing projects
Marginal cost
the change in costs that occurs when there is a small change in output. also called incremental cost
marginal revenue
the change in revenue that occurs when there is a small change in output. also called incremental revenue
Capital gain/loss on your investment
the change in the value of the asset you purchased
Interest rate risk premium
the compensation investors demand for bearing interest rate risk
weak form efficiency
the current price of a stock reflects the stock's own past prices
Operating leverage
the degree to which a firm or project relies on fixed costs
Scenario analysis
the determination of what happens to NPV estimates when we ask what-if questions
Incremental cash flows
the difference between a firm's future cash flows with a project and those without the project
Net present value (NPV)
the difference between an investment's market value and its cost
Bid-ask spread
the difference between the bid price and the asked price
The internal rate of return (IRR)
the discount rate that makes the NPV of an investment zero
Capital gains yield
the dividend growth rate, or the rate at which the value of an investment grows
Capital Asset Pricing Model (CAPM)
the equation of the SML showing the relationship between expected return and beta
Alpha
the excess return an asset earns based on the level of risk taken
Risk premium
the excess return required from an investment in a risky asset over that required from a risk-free investment
Systematic risk principle
the expected return on a risky asset depends only on that asset's systematic risk
Order flow
the flow of customer orders to buy and sell securities
Bearer form
the form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond
Registered form
the form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record
Inside quotes
the highest bid quotes and the lowest ask quotes for a security
Efficient markets hypothesis (EMH)
the hypothesis that actual capital markets, such as the NYSE, are efficient
Annual Percentage Rate (APR)
the interest rate charged per period multiplied by the number of periods per year
Effective Annual Rate (EAR)
the interest rate expressed as if it were compounded once per year
Stated Interest Rate
the interest rate expressed in terms of the interest payment made each period. Also known as the quoted interest rate
Main difference between public-issue and privately placed debt
the latter (privately placed debt) is directly placed with a lender and not offered to the public
Amortized Loan
the lender may require the borrower to repay parts of the loan amount over time (pay interest for a period + some fixed amount)
Discounted Payback Period
the length of time required for an investment's discounted cash flows to equal its initial cost
The higher the required rate of return...
the less valuable the firm
Primary market
the market in which new securities are originally sold to investors
secondary market
the market in which previously issued securities are traded among investors
slope of the SML is equal to
the market risk premium
cost of capital
the minimum required return on a new investment
The higher the growth rate...
the more valuable the firm
Opportunity cost
the most valuable alternative that is given up if a particular investment is undertaken
Primary Markets
the original sale of securities by governments and corporations
The real rate on an investment is ____
the percentage change in how much you can buy with your dollars - in other words, the percentage change in your buying power
degree of operating leverage
the percentage change in operating cash flow relative to the percentage change in quantity sold
The nominate rate on an investment is ___
the percentage change in the number of dollars you have
portfolio weight
the percentage of a portfolio's total value that is invested in a particular asset
Liquidity premium
the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
Default risk premium
the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default
Taxability premium
the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status
Inflation premium
the portion of a nominal interest rate that represents compensation for expected future inflation
Standard Deviation
the positive square root of the variance
Agency Problem
the possibility of conflict of interest between the stockholders and management of a firm
Forecasting Risk
the possibility that errors in projected cash flows will lead to incorrect decisions
multiple rates of return
the possibility that more than one discount rate will make the NPV of an investment zero
Equivalent Annual Cost (EAC)
the present value of a project's costs calculated on an annual basis
Bid price
the price a dealer is willing to pay for a security
asked price
the price a dealer is willing to take for a security
Clean price
the price of a bond net of accrued interest; this is the price that is typically quoted
Face/par value
the principal amount of a bond that is repaid at the end of the term
Compounding
the process of accumulating interest on an investment over time to earn more interest
Diversification
the process of spreading an investment across assets (and therefore forming a portfolio)
Discounted cash flow valuation
the process of valuing an investment by discounting its future cash flows
Yield to Maturity (YTM)
the rate required in the market on a bond
Term structure of interest rates
the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money
Fisher effect
the relationship between nominal returns, real returns, and inflation
Arithmetic average return
the return earned in an average year over a multiyear period
Expected return
the return on a risky asset expected in the future
Cost of equity
the return that equity investors require on their investment in the firm
Cost of debt
the return that lenders require on the firm's debt
Interest rate risk
the risk that arises for bond owners from fluctuating interest rates
Financial break-even
the sales level that results in a zero NPV
Cash break-even
the sales level that results in a zero operating cash flow
accounting break-even
the sales level that results in zero project net income
Capital rationing
the situation that exists if a firm has positive NPV projects but cannot find the necessary financing
Hard rationing
the situation that occurs when a business cannot raise financing for a project under any circumstances
Soft rationing
the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting
Market risk premium
the slope of the SML, which is the difference between the expected return on a market portfolio and the risk-free rate
Maturity
the specified date on which the principal amount of a bond is paid
Liquidity
the speed and ease with which an asset can be converted to cash
coupons
the stated interest payment made on a bond
Depreciation Tax Shield
the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate
Rule of 72
the time it takes to double your money is given approximately by (72/r%)
Cash flow from assets
the total of cash flow to creditors and cash flow to stockholders
Pure play approach
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
Financial Leverage
the use of debt in a firm's capital structure
The cost of capital depends primarily on...
the use of the funds, not the source
Weighted average cost of capital (WACC)
the weighted average of the cost of equity and the aftertax cost of debt
Indenture
the written agreement between the corporation and the lender detailing the terms of the debt issue
Average Tax Rate
total taxes paid divided by total taxable income
Which type of investment did the worst?
treasury bills
examples of systematic risk
uncertainties about general economic conditions (GDP, interest rates, inflation)
What is a bond
when a corporation or government wishes to borrow money from the public on a long-term basis, they issue or sell debt securities call bonds
Return on your investment
your gain (or loss) from an investment (ex: buying an asset)
Dealer Markets
secondary market: dealers buy and sell for themselves at their own risk --> over-the-counter markets
Quick Ratio
(Current Assets - Inventory/Current Liabilities) used to measure short-term liquidity of firm
Current Ratio
(Current Assets/Current Liabilities) --> used to measure short-term liquidity of firm
CPI
(consumer price index) a measure of the overall cost of the goods and services bought by a typical consumer
R (required rate of return) =
(dividend/stock price) + growth rate
What does capital market efficiency say about market efficiency?
1. prices appear to respond rapidly to new info 2. the future of market prices (particularly in the short run) is hard to predict based on publicly available info 3. if mispriced stocks exist, then there is no obvious means of identifying them
Why is it harder to value a share of common stock than a bond?
1. promised cash flows are not known in advance 2. life of investment is essentially forever 3. theres no way to easily observe the rate of return that the market requires
Rights of Shareholders
1. right to vote for directors 2. right to share proportionally in dividends paid 3. right to share proportionally in assets remaining after liabilities have been paid in a liquidation 4. the right to vote on stockholder matters of great importance, such as a merger
Two important points about diversification
1. some of the riskiness associated with individual assets can be eliminated by forming portfolios 2. there is a minimum level of risk that cannot be eliminated by diversifying
What does the bond indenture include
1. the basic terms of the bond 2. the total amount of bonds issued 3. a description of property used as security 4. the repayment arrangements 5. the call provisions 6. details of the protective covenants
Primary Disadvantages of Sole Proprietorships and Partnerships
1. unlimited liability for business debts on the part of the owners 2. limited life of the business 3. difficulty of transferring ownership
What is the beta of an average asset?
1.0
Average annual return percentage for large-company stocks, historically
12.1%
Limit of NYSE members
1366
average annual return for small company stocks
16.3%
Forward PE ratio
A PE ratio that is based on estimated future earnings
Reverse Convertible Bonds
A bond that can be converted to cash, debt or equity at the discretion of the issuer at a set date
Discount bond
A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate
Corporation
A business created as a distinct legal entity composed of one or more individuals or entities
Sole Proprietorship
A business owned by one person
Clawback
A corporation can take back a bonus for specific reasons, like fraud
Working capital
A firm's short-term assets and liabilities
Common-Size Statements
A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.
General Partnership
All partners share in gains or losses, all have unlimited liability for all partnership debts
Net present value rule
An investment should be accepted if the net present value is positive and rejected if it is negative.
Is the geometric average or arithmetic average higher?
Arithmetic
Another way to get geometric return
Arithmetic return - half the variance
Why do we want to diversify our portfolio?
Because by diversifying, unsystematic risk can essentially be eliminated. A portfolio with many stocks will see the effects of unsystematic risk cancelling each other out
convertible bonds
Bonds that can be converted into common stock at the bondholder's option
Cash Ratio
Cash / Current Liabilities
Cash Flow from assets =
Cash flow to creditors + cash flow to stockholders
Fixed costs
Costs that do not vary with the quantity of output produced in a certain period
Interval Measure
Current Assets/Average Daily Operating Costs
supplemental liquidity providers (SLPs)
Investment firms that are active participants in stocks assigned to them. Their job is to make a one-sided market (i.e., offering to either buy or sell). They trade purely for their own accounts.
Sukuk
Islamic bond which by Islamic law cannot charge interest
Designated market makers (DMMS)
NYSE members who act as dealers in particular stocks. Formerly known as "specialists"
Floor brokers
NYSE members who execute customer buy and sell orders
Return on Equity (ROE)
Net Income/Total Equity
Net working capital to total assets
Net Working Capital / Total Assets
Can systematic risk be diversified away?
No
Can we get answers from the dividend growth model formula if, indefinitely, the growth rate is more than or equal to the discount rate?
No
How are most bonds traded?
Over the counter (OTC)
Zero growth stock price formula
P = dividend/rate of return
Stakeholders
Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm
Preemptive Right
Stockholders' right to maintain their proportionate interest in a corporation with any additional shares issued.
Even though 2008 saw stock prices decrease, were there still positives for investors?
Yes, because as stocks fell, bonds soared
Standard Industrial Classification (SIC) code
a U.S. government code used to classify a firm by its type of business operation
Zero coupon bond
a bond that makes no coupon payments and is thus initially priced at a deep discount
Premium bond
a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate
Call-protected bond
a bond that, during a certain period, cannot be redeemed by the issuer
Current yield
a bond's annual coupon divided by its price
Deferred call provision
a call provision prohibiting the company from redeeming a bond prior to a certain date
Simulation analysis
a combination of scenario and sensitivity analysis
Sunk cost
a cost that has already been committed and cannot be recovered and therefore should not be considered in an investment decision
Accelerated cost recovery system (ACRS)
a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications
Statement of Cash Flows
a firm's financial statement that summarizes its sources and uses of cash over a specified period
Cash Flow to Creditors
a firm's interest payments to creditors - net new borrowing
DMMs Post
a fixed place on the exchange floor where the DMM operates
Proxy
a grant of authority by a shareholder allowing another individual to vote his or her shares
Net present value profile
a graphical representation of the relationship between an investment's NPVs and various discount rates
portfolio
a group of assets such as stocks and bonds held by an investor
Annuity
a level stream of cash flows for a fixed period of time
Efficient capital market
a market in which security prices reflect available information
Key Performance Indicators (KPIs)
a measurable value that shows how a company is progressing toward achieving a business goal
Dividend growth model
a model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate
Protective covenant
a part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest
Treasury yield rate
a plot of the yields on Treasury notes and bonds relative to maturity
Total cash if stock is sold =
initial investment + total return
Compound Interest
interest earned on both the principal amount and any interest already earned
Interest on Interest
interest earned on the reinvestment of previous interest payments
Simple Interest
interest earned only on the original principal amount invested
Real rates
interest rates or rates of return that have been adjusted for inflation
Nominal rates
interest rates or rates of return that have not been adjusted for inflation
Sensitivity Analysis
investigation of what happens to NPV when only one variable is changed
Municipal notes and bonds (munis)
issued by the state or local government
Examples of unsystematic risk
labor strikes, part shortages
Which 5 types of financial investments did Ibbotson and Sinquefield's studies deal with?
large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. treasury bills
Tobin's Q Ratio
market value of firm's assets / replacement cost of assets
Secondary Markets
markets where securities are bought and sold after the original sale
Goal of Financial Management
maximize the current value per share of the existing stock
Capital Spending
money spent on fixed assets - money received from the sale of fixed assets
Limited Partnership
one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business
Highly liquid asset
one that can be quickly sold without significant loss of value
Illiquid asset
one that cannot be quickly converted to cash without a substantial price reduction
Income bonds
pay no interest unless the issuing company is profitable
Dividends
payments by a corporation to shareholders, made in either cash or stock
Blanket Mortgage
pledges all the real property owned by the company
bond value =
present value of the coupons + present value of the face amount
Ask price
price at which dealer will sell security
Dividend growth model formula
price per share = (dividend * (1 + growth rate))/(rate of return - growth rate)
PE Ratio
price per share/earnings per share
Price-Sales Ratio
price per share/sales per share
Nominal rate =
real rate + inflation rate
Financial Ratios
relationships determined from a firm's financial information and used for comparison purposes
Auction Market
secondary market: brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold --> has a physical location (like Wall Street)