Finance Exam 1

Thus, firms with relatively high debt ratios typically have higher expected returns when the economy is normal, but lower returns and possibly 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. For now, we simply look at 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 _____. (2) They review the income statement to see the extent to which interest is covered by operating profits.

debt

Even though depreciation and amortization are reported as costs on the income statements, they are not cash expenses—cash was spent in the past, when the assets being written off were acquired, but no cash is paid out to cover depreciation and amortization. Therefore, managers, security analysts, and bank loan officers who are concerned with the amount of cash a company is generating often calculate EBITDA, an acronym for earnings before interest, taxes, depreciation, and amortization. Allied has no amortization charges, so Allied's depreciation and amortization expense consists entirely of ___. In 2016, Allied's EBITDA was $383.8 million.

depreciation

The fixed assets turnover ratio, which is the ratio of sales to net fixed assets, measures how effectively the firm uses its plant and ___: Allied's ratio of 3.0 times is slightly above the 2.8 industry average, indicating that it is using its fixed assets at least as intensively as other firms in the industry. Therefore, Allied seems to have about the right amount of fixed assets relative to its sales.

equipment

Finance is defined by Webster's Dictionary as "the system that includes the circulation of money, the granting of credit, the making of investments, and the _____ of banking facilities."

provision

Although the balance sheet represents a snapshot in time, the income statement reports on operations over a period of time. For example, during 2016, Allied had sales of $3 billion and its net income was $117.5 million. Income statements are prepared monthly, quarterly, and annually. The quarterly and annual statements are reported to investors, while the monthly statements are used internally by managers for __ and control purposes.

planning

If a manager is to maximize stockholder wealth, he or she must know how that wealth is determined. Throughout this book, we shall see that the value of any asset is the _______ value of the stream of cash flows that the asset provides to its owners over time. We discuss stock valuation in depth in Chapter 9, where we see that stock prices are based on cash flows expected in future years, not just in the current year. Thus, stock price maximization requires us to take a long-run view of operations. At the same time, managerial actions that affect a company's value may not immediately be reflected in the company's stock price.

present

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. However, other things come into play. For example, financial leverage generally increases the ROE but also increases the firm's ___; 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. We use the final set of ratios—the market value ratios, which relate the stock price to earnings and book value price—to help address this situation. 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.

risk

Actual stock prices are easy to determine—they can be found on the Internet and are published in newspapers every day. However, intrinsic values are ____; and different analysts with different data and different views about the future form different estimates of a stock's intrinsic value. Indeed, estimating intrinsic values is what security analysis is all about and is what distinguishes successful from unsuccessful investors.

estimates

Allied's earnings dropped from $121.8 million in 2015 to $117.5 million in 2016. Management reported that the drop resulted from losses associated with a drought as well as increased costs due to a three-month strike. However, management then went on to describe a more optimistic picture for the future, stating that full operations had been resumed, that several unprofitable businesses had been eliminated, and that 2017 profits were expected to rise sharply. Of course, an increase in profitability may not occur; and analysts should compare management's past statements with subsequent results. In any event, the information contained in the annual report can be used to help __ future earnings and dividends. Therefore, investors are very interested in this report.

forecast

Spot markets versus futures markets. Spot markets are markets in which assets are bought or sold for "on-the-spot" delivery (literally, within a few days). Futures markets are markets in which participants agree today to buy or sell an asset at some __ date. For example, a farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of soybeans 6 months from now at a price of $9.75 a bushel. To continue that example, a food processor that needs soybeans in the future may enter into a futures contract in which it agrees to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the risks faced by both the farmer and the food processor.

future

Limited liability reduces the risks borne by investors; and other things held constant, the lower the firm's risk, the ________ its value.

higher

In addition to these "free" sources of short-term credit, Allied borrows from its bank on a short-term basis. These bank loans are shown as notes __. Although accounts payable and accruals do not bear interest, Allied pays interest on funds obtained from the bank. The total of accounts payable, accruals, and notes payable represent current liabilities on its balance sheet. If we subtract current liabilities from current assets, the difference is called net working capital:

payable

With a partnership, all of the partners are generally subject to _______ personal liability, which means that if a partnership goes bankrupt and any partner is unable to meet his or her pro rata share of the firm's liabilities, the remaining partners will be responsible for making good on the unsatisfied claims. Thus, the actions of a Texas partner can bring ruin to a millionaire New York partner who had nothing to do with the actions that led to the downfall of the company. Unlimited liability makes it difficult for partnerships to raise large amounts of capital

unlimited

The DSO can be compared with the industry average, but it is also evaluated by comparing it with Allied's credit terms. Allied's credit policy calls for payment within 30 days. So the fact that 46 days' sales are outstanding, not 30 days', indicates that Allied's customers, on average, are not paying their bills on time. This deprives the company of funds that could be used to reduce bank loans or some other type of costly capital. Moreover, the high average DSO indicates that if some customers are paying on time, quite a few must be paying very late. Late-paying customers often default, so their receivables may end up as ___ debts that can never be collected. Note too that the trend in the DSO over the past few years has been rising, but the credit policy has not been changed. This reinforces our belief that Allied's credit manager should take steps to collect receivables faster.

bad

Companies create value (and realize positive EVA) if the benefits of their investments exceed the cost of raising the necessary capital. Total invested __ represents the amount of money that the company has raised from debt, equity, and any other sources of capital (such as preferred stock). The annual dollar cost of capital is total invested capital multiplied by the after-tax percentage cost of this capital. So, for example, if the company has raised $1 million in capital, and the current cost of capital is 10%, the annual dollar cost of capital would be $100,000. The funds raised from this capital are invested in a variety of net fixed assets and net operating working capital. In any given year, NOPAT is the amount of money that these investments have generated for the company's investors after paying for operating costs and taxes—in this regard it represents the benefits of capital investments.

capital

Note too that interest income received by individuals from corporate securities is added to other income and thus is taxed at federal rates going up to 39.6%, plus state taxes.Footnote Capital gains and losses, on the other hand, are treated differently. Assets such as stocks, bonds, and real estate are defined as __ 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.

capital

A short-term capital gain is taxed at the same rate as ordinary income. However, long-term capital gains are taxed ___. For most taxpayers, the rate on long-term capital gains is only 15%. Thus, if in 2015, you were in the 35% tax bracket, any short-term capital gains you earned would be taxed just like ordinary income; but your long-term capital gains would only be taxed at 15%. However, the tax rate on long-term capital gains is 20% for taxpayers in the 39.6% tax bracket. In addition, high-income taxpayers may incur a 3.8% unearned income Medicare contribution tax applied to their capital gains and other net investment income. So, the highest tax rate that could apply on short-term capital gains that are taxed at ordinary rates is 43.4% compared to 23.8% on long-term capital gains. Even for individuals at these top tax brackets, the tax rate on long-term capital gains still remains considerably lower than the tax rate on ordinary income.

differently

Individuals with money to invest understand the tax advantages associated with making equity investments in newly formed companies versus buying bonds, so new ventures have an easier time attracting capital under the tax system. All in all, lower capital gains and ___ tax rates stimulate capital formation and investment.

dividend

Corporations earn most of their income from operations, but they may also own securities—bonds and stocks—and receive interest and dividend income. Interest income received by a corporation is taxed as ordinary income at regular corporate tax rates. However, dividends are taxed more favorably: 70% of dividends received is excluded from taxable income, whereas the remaining 30% is taxed at the ordinary tax rate. Footnote Thus, a corporation earning more than $18,333,333 and paying a 40% marginal federal plus state tax rate would normally pay only of its dividend income as taxes. If this firm had $10,000 in pretax dividend income, its after-tax dividend income would be $8,800: The rationale behind this exclusion is that when a corporation receives dividends and then pays out its own after-tax income as dividends to its stockholders, the dividends received are subjected to triple taxation: (1) The original corporation is taxed. (2) The second corporation is taxed on the dividends it receives. (3) The individuals who receive the final ___ are taxed again. This explains the 70% intercorporate dividend exclusion.

dividends

Note that "retained earnings" represents a claim against assets, not assets per se. Stockholders allow management to retain earnings and reinvest them in the business, use retained earnings for additions to plant and equipment, add to inventories, and the like. Companies do not just pile up cash in a bank account. Thus, retained earnings as reported on the balance sheet do not represent cash and are not "available" for _______ or anything else.

dividends

The second group of ratios, the asset management ratios, measure how effectively the firm is managing its assets These ratios answer this question: 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 Allied and other companies acquire assets, they must obtain capital from banks or other sources and capital is ____. Therefore, if Allied has too many assets, its cost of capital will be too high, which will depress its profits. On the other hand, if its assets are too low, profitable sales will be lost. So Allied must strike a balance between too many and too few assets, and the asset management ratios will help it strike this proper balance.

expensive

The first term represents the amount of cash that the firm generates from its current operations. EBIT (1 − T) is often referred to as NOPAT, or net operating profit after taxes. Depreciation and amortization are added back because these are noncash expenses that reduce EBIT but do not reduce the amount of cash the company has available to pay its investors. The second bracketed term indicates the amount of cash that the company is investing in its fixed assets (capital expenditures) and operating working capital in order to sustain ongoing operations. A positive level of FCF indicates that the firm is generating more than enough cash to finance current investments in ___ assets and working capital. By contrast, negative free cash flow means that the company does not have sufficient internal funds to finance investments in fixed assets and working capital, and that it will have to raise new money in the capital markets in order to pay for these investments.

fixed

As you might imagine, over the years Congress has frequently adjusted the tax code for individuals to promote certain activities. For example, Individual Retirement Accounts (IRAs) have encouraged individuals to save more for retirement. There are two main types of IRAs, Traditional IRAs and Roth IRAs. In each case, investors receive valuable tax benefits as long as the money is held in their account until age . 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 and half. On the other hand, 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. In each case, investors in IRAs face penalties if they withdraw funds before age , unless there is a qualifying exception—for example, investors in a Roth IRA can withdraw up to $10,000 from their account to help pay for a first-time ___ without facing a penalty.

home

Finally, keep in mind that even if investors receive accurate accounting data, it is cash flows, not accounting __, that matters most.

income

As a very rough rule of thumb, Roth IRAs are more attractive for those individuals who believe that their tax rates will __ 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. For this reason, many younger investors who expect higher pay (and therefore higher tax rates!) over time tend to select Roth IRAs. Indeed, a Vanguard analyst in a recent article in The Wall Street Journal estimates that investors under 30 years old allocate 92% of their IRA funds into Roth accounts. But as you might expect, one size doesn't fit all, and it is important to review the specific eligibility requirements, potential penalties, and distribution policies before making any investments.

increase

The use of debt will __, or "leverage up," a firm's ROE if the firm earns more on its assets than the interest rate it pays on debt. However, debt exposes the firm to more risk than if it financed only with equity. In this section we discuss debt management ratios.

increase

Amortization amounts to the same thing except that it represents the decline in value of ____ assets such as patents, copyrights, trademarks, and goodwill. Because depreciation and amortization are so similar, they are generally lumped together for purposes of financial analysis on the income statement and for other purposes. They both write off, or allocate, the costs of assets over their useful lives.

intangible

Tax rates on dividends and capital gains have varied over time, but they have generally been lower than rates on ordinary income. Congress wants the economy to grow. For growth, we need investment in productive assets; and low capital gains and dividend tax rates encourage ____.

investment

Finance as taught in universities is generally divided into three areas: (1) financial management, (2) capital markets, and (3) ____.

investments

Inventories are typically the _____ liquid of a firm's current assets; and if sales slow down, they might not be converted to cash as quickly as expected. Also, inventories are the assets on which losses are most likely to occur in the event of liquidation. Therefore, the quick ratio, which measures the firm's ability to pay off short-term obligations without relying on the sale of inventories, is important. The industry average quick ratio is 2.2, so Allied's 1.2 ratio 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.

least

The 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), and (3) by firms when they are deciding how much to offer for another firm in a potential __.

merger

Compensation should be structured so that managers are rewarded on the basis of the stock's performance over the _____ run, not the stock's price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so that managers have an incentive to keep the stock price high over time.

long

We divide the ratios into five categories: Liquidity ratios, which give an idea of the firm's ability to pay off debts that are maturing within a year. Asset management ratios, which give an idea of how efficiently the firm is using its assets. 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 __-term debt. Profitability ratios, which give an idea of how profitably the firm is operating and utilizing its assets. Market value ratios, which give an idea of what investors think about the firm and its future prospects.

long

Beginning in 2013, the maximum tax rate on qualified dividends increased to 20% for taxpayers in the 39.6% tax bracket. However, for most taxpayers the top tax rate on qualified dividends is 15%. 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; and when what is left is paid out as dividends, it is taxed again. This double taxation motivated Congress to tax dividends at a ___ rate than the rate on ordinary income.

lower

However, accounting statements are designed primarily for use by creditors and tax collectors, not for managers and stock analysts. Therefore, corporate decision makers and security analysts often modify accounting data to meet their needs. The most important ___ is the concept of free cash flow (FCF), defined as "the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows." Here is the equation used to calculate free cash flow:

modification

Allied's inventory turnover of 4.9 is much lower than the industry average of 10.9. This suggests that it is holding too much inventory. Excess inventory is, of course, unproductive and represents an investment with a low or zero rate of return. Allied's low inventory turnover ratio also makes us question its current ratio. With such a low turnover, the firm may be holding ___ goods that are not worth their stated value

obsolete

Of course, it is generally not possible to finance exclusively with debt; and the risk of doing so would __ the benefits of the higher expected income. Still, the fact that interest is a deductible expense has a profound effect on the way businesses are financed—the corporate tax system favors debt financing over equity financing.

offset

As we noted in Chapter 1, the Tax Code allows small businesses that meet certain conditions to be set up as corporations and thus receive the benefits of the corporate form of organization—especially limited liability—yet still be taxed as proprietorships or partnerships rather than as corporations. These corporations are called S Corporations. (Regular corporations are called C corporations.) If a corporation elects to set up as an S corporation, all of its income is reported as personal income by its stockholders, on a pro rata basis, and thus is taxed at the stockholders' individual rates. Because the income is taxed only ______, this is an important benefit to the owners of small corporations in which all or most of the income earned each year will be distributed as dividends. The situation is similar for LLCs.

once

Accounting statements reflect events that happened in the past, but they also provide clues about what's really important—that is, what's likely to happen in the future. The liquidity, asset management, and debt ratios covered thus far tell us something about the firm's policies and operations. Now we turn to the profitability ratios, which reflect the net result of all of the firm's financing policies and ______ decisions.

operating

EVA is an estimate of a business's true economic __ for a given year, and it often differs sharply from accounting net income. The main reason for this difference is that although accounting income takes into account the cost of debt (the company's interest expense), it does not deduct for the cost of equity capital. By contrast, EVA takes into account the total dollar cost of all capital, which includes both the cost of debt and equity capital.

profit

Allied's FCF is negative, which is not good. Note, though, that the negative FCF is largely attributable to the $230 million expenditure for a new processing plant. This plant is large enough to meet production for several years, so another new plant will not be needed until 2020. Therefore, Allied's FCF for 2017 and the next few years should increase, which means that Allied's financial situation is not as bad as the negative FCF might suggest. Most rapidly growing companies have negative FCFs—the fixed assets and working capital needed to support a firm's rapid growth generally exceed cash flows from its existing operations. This is not bad, provided a firm's new investments are eventually ____ and contribute to its FCF.

profitable

All of the ratios are important, but different ones are more important for some companies than for others. For example, if a firm borrowed too much in the past and its debt now threatens to drive it into bankruptcy, the debt ___ are key. Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and manufacturing capacity, the asset management ratios take center stage. The 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, while they do have control over their firm's ROE. So ROE tends to be the main focal point.

ratios

However, if a firm's ratios are far removed from the averages for its industry, an analyst should be concerned about why this variance occurs. Thus, a deviation from the industry average should signal the analyst (or management) to check further. Note too that a high current ratio generally indicates a very strong, safe liquidity position; it might also indicate that the firm has too much old inventory that will have to be written off and too many old accounts ____ that may turn into bad debts. Or the high current ratio might 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. So it is always necessary to thoroughly examine the full set of ratios before forming a judgment as to how well the firm is performing.

receivable

One other tax feature should be addressed—the Alternative Minimum Tax (AMT). The 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 on real estate and municipal bond interest. Under the AMT law, people must calculate their tax under the "__" system and then under the AMT system, where many deductions are added back to income and then taxed at a special AMT rate. For many years, the AMT was not indexed for inflation; and literally millions of taxpayers found themselves subject to this very complex tax.Footnote New tax legislation also increased health care taxes for single taxpayers earning more than $200,000 and married taxpayers earning more than $250,000. These taxpayers will incur an additional 0.9% Medicare tax and a 3.8% net investment income tax on certain types of investment income.

regular

Finally, note that 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 is the ___ earnings for the year (e.g., 2016). Those retained earnings are added to the cumulative retained earnings from prior years to obtain the year-end 2016 balance for retained earnings. The retained earnings for the year are also reported in the statement of stockholders' equity. All four of the statements provided in the annual report are interrelated

retained

Current assets include cash, marketable __, accounts receivable, and inventories. Allied's current liabilities consist of accounts payable, accrued wages and taxes, and short-term notes payable to its bank, all of which are due within one year. If a company is having financial difficulty, it typically begins to pay its accounts payable more slowly and to borrow more from its bank, both of which increase current liabilities. If current liabilities are rising faster than current assets, the current ratio will fall; and this is a sign of possible trouble. Allied's current ratio is 3.2, which is well below the industry average of 4.2. Therefore, its liquidity position is somewhat weak, but by no means desperate.

securities

Individuals pay taxes on wages and salaries, on investment income (dividends, interest, and profits from the sale of ___), and on the profits of proprietorships and partnerships. The tax rates are progressive—that is, the higher one's income, the larger the percentage paid in taxes

securities

Investors are willing to pay less for a dollar of Allied's book value than for one of an average food processing company. This is consistent with our other findings. M/B ratios typically exceed 1.0, which means that investors are willing to pay more for ______ than the accounting book values of the stocks. This situation occurs primarily because asset values, as reported by accountants on corporate balance sheets, do not reflect either inflation or goodwill. Assets purchased years ago at pre-inflation prices are carried at their original costs even though inflation might have caused their actual values to rise substantially; and successful companies' values rise above their historical costs, whereas unsuccessful ones have low M/B ratios. This point is demonstrated by Google and Bank of America: In March 2015, Google's M/B ratio was 3.61× while Bank of America's was only 0.76×. Google's stockholders now have $3.61 in market value per $1.00 of equity, whereas Bank of America's stockholders have only $0.76 for each dollar they invested.

stocks

Suppose a firm has excess cash that it does not need for operations, and it plans to invest this cash in marketable securities. The tax factor favors ___, which pay dividends, rather than bonds, which pay interest. For example, suppose Allied had $100,000 to invest, and it could buy bonds that paid 8% interest, or $8,000 per year, or stock that paid 7% in dividends, or $7,000. Allied is in the 40% federal-plus-state tax bracket. Therefore, if Allied bought bonds and received interest, its tax on the $8,000 of interest would be , and its after-tax income would be $4,800. If it bought stock, its tax would be , and its after-tax income would be $6,160. Other factors might lead Allied to invest in bonds, but when the investor is a corporation, the tax factor favors stock investments.

stocks

Depreciation plays an important role in income tax calculations—the larger the depreciation, the lower the __ income, the lower the tax bill, and thus the higher the operating cash flow. Congress specifies the life over which assets can be depreciated for tax purposes and the depreciation methods that can be used. We discuss in detail how depreciation is calculated and how it affects income and cash flows when we study capital budgeting.

taxable

The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to pay interest will bring legal action by the firm's creditors and probably result in bankruptcy. Note that earnings before interest and taxes, rather than net income, are used in the numerator. Because interest is paid with pretax dollars, the firm's ability to pay current interest is not affected by ___.

taxes

Note too that while a high return on sales is good, we must also be concerned with ________. 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. It might generate a high profit margin but realize low sales, and hence experience a low net income.

turnover

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 _____ for stockholders. Positive EVA on an annual basis will help ensure that MVA is also positive. Note that whereas MVA applies to the entire firm, EVA can be determined for divisions as well as for the company as a whole, so it is useful as a guide to "reasonable" compensation for divisional as well as top corporate managers.

value

When deciding on its form of organization, a firm must trade off the advantages of incorporation against a possibly higher tax burden. However, 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

Primary markets versus secondary markets. Primary markets are the markets in which _____ raise new capital. If GE were to sell a new issue of common stock to raise capital, a primary market transaction would take place. The corporation selling the newly created stock, GE, receives the proceeds from the sale in a primary market transaction.

corporations

When the intrinsic value can be measured in an objective and verifiable manner, performance pay can be based on changes in ______ value. However, because intrinsic value is not observable, compensation must be based on the stock's market price—but the price used should be an average over time rather than on a specific date.

intrinsic

Globalization has exposed the need for greater cooperation among regulators at the international level, but the task is not easy. 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; and (3) the reluctance of individual countries to give up _____ over their national monetary policies. Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets.

control

Investing would be easy, profitable, and essentially riskless if we knew all stocks' intrinsic values; but, of course, we don't. We can estimate intrinsic values, but we can't be sure that we are right. A firm's managers have the best information about the firm's future prospects, so managers' estimates of intrinsic values are generally ___ than those of outside investors. However, even managers can be wrong.

better

A firm's value is dependent on its growth opportunities, which are dependent on its ability to attract ______. Because corporations can attract capital more easily than other types of businesses, they are better able to take advantage of growth opportunities.

capital

Banking is studied under _____ 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. In addition, 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.

capital

The board of directors is the top governing body, and the chairperson of the board is generally the highest-ranking individual. The CEO comes next, but note that the _________ of the board often also serves as the CEO. Below the CEO comes the chief operating officer (COO), who is often also designated as a firm's president. The COO directs the firm's operations, which include 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.

chairperson

To illustrate the growing importance of derivatives, consider the case of credit default swaps. Credit default swaps are contracts that offer protection against the ___ 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.

default

A 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 ______. Moreover, 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.

inexpensively

Capital markets relate to the markets where ___ rates, along with stock and bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together "savers" who have money to invest and businesses, individuals, and other entities that need capital for various purposes.

interest

Total debt versus 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-___ bearing) liabilities. Allied's short-term debt is shown as notes payable on its balance sheet:

interest

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

intrinsic

While many companies focus on maximizing a broad range of financial objectives, such as growth, earnings per share, and market share, these goals should not take precedence over the main financial goal, which is to create value for ____. Keep in mind that a company's stockholders are not just an abstract group—they represent individuals and organizations who have chosen to invest their hard-earned cash into the company and who are looking for a return on their investment in order to meet their long-term financial goals, which might be saving for retirement, a new home, or a child's education.

investors

The claims against assets are of two basic types—liabilities (or money the company owes to others) and stockholders' equity. Current liabilities consist of claims that must be paid off within __ year, including accounts payable, accruals (total of accrued wages and accrued taxes), and notes payable to banks and other short-term lenders that are due within one year. Long-term debt includes bonds that mature in more than a year.

one

These gambling experiments suggest that investors and managers behave differently in down markets than they do in up markets, which might explain why those who made money early in the stock market bubble continued to invest their money in the market even as prices went ever higher. Other evidence suggests that individuals tend to _______ their true abilities. For example, a large majority of people (upward of 90% in some studies) believe that they have above-average driving ability and above-average ability to get along with others.

overestimate

Cash versus other assets. Although assets are reported in dollar terms, only the cash and equivalents account represents actual __ 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.

spendable

A corporation is a legal entity created by a ________, and it is separate and distinct from its owners and managers. It is this separation that limits stockholders' losses to the amount they invested in the firm—the corporation can lose all of its money, but its owners can lose only the funds that they invested in the company. Corporations also have unlimited lives, and it is easier to transfer shares of stock in a corporation than one's interest in an unincorporated business. These factors make it much easier for corporations to raise the capital necessary to operate large businesses. Thus, companies such as Hewlett-Packard and Microsoft generally begin as proprietorships or partnerships, but at some point they find it advantageous to become a corporation.

state

LLCs and LLPs have been gaining in popularity in recent years, but large companies still find it advantageous to be C corporations because of the advantages in raising capital to support growth. LLCs/LLPs were dreamed up by lawyers; they are often structured in very complicated ways, and their legal protections often vary by ______. So, it is necessary to hire a good lawyer when establishing one.

state

To qualify for S corporation status, a firm can have no more than ______ 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 status and retain that status until they decide to sell stock to the public, at which time they become C corporations.

100

A major drawback to corporations is 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. However, as an aid to small businesses, Congress created S corporations, which are taxed as if they were proprietorships or partnerships; thus, they are _______ from the corporate income tax.

exempt

Depreciation. Most companies prepare two sets of financial statements—one is based on Internal Revenue Service (IRS) rules and is used to calculate taxes; the other is based on ____ and is used for reporting to investors. Firms often use accelerated depreciation for tax purposes but straight-line depreciation for stockholder reporting. Allied uses accelerated depreciation for both.

GAAP

Market values versus book values. Companies generally use __ 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"). For example, Allied purchased its headquarters in Chicago in 1991. Under GAAP, the company must report the value of this asset at its historical cost (what it originally paid for the building in 1991) less accumulated depreciation. Given that Chicago real estate prices have increased over the last 24 years (even considering the impact of the recent recession on real estate values), the market value of the building is higher than its book value. Other assets' market values also differ from their book values.

GAAP

Compensation packages should be sufficient to attract and retain able managers, but they should not go beyond what is needed. Compensation policies need to be ___ over time.

consistent

Net fixed assets represent the cost of the buildings and equipment used in operations minus the __ that has been taken on these assets. At the end of 2016, Allied has $10 million of cash; hence, it could write checks totaling that amount. The noncash assets should generate cash over time, but they do not represent cash in hand. And the cash they would bring in if they were sold today could be higher or lower than the values reported on the balance sheet.

depreciation

Economists developed the notion that an asset's value is based on the ___ cash flows the asset will provide, and accountants provided information regarding the likely size of those cash flows. People who work in finance need knowledge of both economics and accounting.

future

To give managers an incentive to focus on stock prices, stockholders (acting through boards of directors) awarded executives stock options that could be exercised on a specified ____ date. An executive could exercise the option on that date, receive stock, immediately sell it, and earn a profit. The profit was based on the stock price on the option exercise date, which led some managers to try to maximize the stock price on that specific date, not over the long run. That, in turn, led to some horrible abuses. Projects that looked good from a long-run perspective were turned down because they would penalize profits in the short run and thus lower the stock price on the option exercise day. Even worse, some managers deliberately overstated profits, temporarily boosted the stock price, exercised their options, sold the inflated stock, and left outside stockholders "holding the bag" when the true situation was revealed.

future

Other sources of funds. Most companies (including Allied) 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 ____ 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

hybrid

The third row of boxes shows that each stock has an intrinsic value, which 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, which is the actual market price based on perceived but possibly incorrect information as seen by the marginal investor.Footnote Not all investors agree, so it is the "____" investor who determines the actual price. When a stock's actual market price is equal to its intrinsic value, the stock is in equilibrium, which is shown in the bottom box in Figure 1.2. When equilibrium exists, there is no pressure for a change in the stock's price. Market prices can—and do—differ from intrinsic values; but eventually, as the future unfolds, the two values tend to converge.

marginal

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

private

Governmental organizations such as the Federal Reserve System, which ____ 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.

regulates

If a manager's bonus is tied solely to this year's earnings, it would not be a surprise to discover that the manager took steps to pump up current earnings—even if those steps were detrimental to the firm's long-run value. With these concerns in mind, a growing number of companies have used stock and stock options as a key part of executive pay. The intent of structuring compensation in this way is for managers to think more like ___ and to continually work to increase shareholder value.

stockholders

(1) Proprietors have unlimited personal liability for the business' debts, so they can lose more than the amount of money they invested in the company. You might invest $10,000 to start a business but be sued for $1 million if, during company time, one of your employees runs over someone with a car. (2) The life of the business is limited to the life of the individual who created it; and to bring in new equity, investors require a change in the _____ of the business. (3) 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.

structure

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

suppliers

Financial management, also called ____ 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; and as the title suggests, much of this book is concerned with financial management.

corporate

If the firm is publicly owned, the CEO and the CFO must both certify to the ____ that reports released to stockholders, and especially the annual report, are accurate. If inaccuracies later emerge, the CEO and the CFO could be fined or even jailed. This requirement was instituted in 2002 as a part of the Sarbanes-Oxley Act. The Act was passed by Congress in the wake of a series of corporate scandals involving now-defunct companies such as Enron and WorldCom, where investors, workers, and suppliers lost billions of dollars due to false information released by those companies.

SEC

Taking a closer look at the income statement, we see that depreciation and amortization are important components of operating costs. Recall from accounting that depreciation is an annual ____ against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were depleted in the production process.

charge

A proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easy—a person begins business operations. Proprietorships have three important advantages: (1) They are easy and inexpensive to form. (2) They are subject to few government regulations. (3) They are subject to lower income taxes than are ______. However, proprietorships also have three important limitations:

corporations

The second point deals with why mispricings can occur in the first place. Here insights from psychology come into play. For example, Kahneman and Tversky suggested that individuals view potential losses and gains ___. If you ask average individuals whether they would rather have $500 with certainty or flip a fair coin and receive $1,000 if a head comes up and nothing if a tail comes up, most would prefer the certain $500, which suggests an aversion to risk. However, if you ask people whether they would rather pay $500 with certainty or flip a coin and pay $1,000 if it's a head and nothing if it's a tail, most would indicate that they prefer to flip the coin. Other studies suggest that people's willingness to take a gamble depends on recent performance. Gamblers who are ahead tend to take on more risk, whereas those who are behind tend to become more conservative.

differently

Current liabilities include accounts payable, accruals, and notes payable to the bank. Financial analysts often make an important distinction between the "free" liabilities (accruals and accounts payable) and interest-bearing notes payable (which incur interest expense that is included as a financing cost on the firm's income statement). With this distinction in mind, analysts often focus on net operating working capital (NOWC) which __ from net working capital because interest-bearing notes payable are subtracted from current liabilities:

differs

If a bank or any other company reports that it invests in derivatives, how can one tell if the derivatives are held as a hedge against something like an increase in the price of wheat or as a speculative bet that wheat prices will rise? The answer is that it is very ___ to tell how derivatives are affecting the firm's risk profile. In the case of financial institutions, things are even more complicated—the derivatives are generally based on changes in interest rates, foreign exchange rates, or stock prices; and a large international bank might have tens of thousands of separate derivative contracts. The size and complexity of these transactions concern regulators, academics, and members of Congress. Former Fed Chairperson Alan Greenspan noted that in theory, derivatives should allow companies to better manage risk, but that it is not clear whether recent innovations have "increased or decreased the inherent stability of the financial system."

difficult

The balance sheet is a "snapshot" of a firm's position at a specific point in time. Figure 3.1 shows the layout of a typical balance sheet. The left side of the statement shows the assets that the company owns, and the right side shows the firm's liabilities and stockholders' equity, which are claims against the firm's assets. As Figure 3.1 shows, assets are divided into two major categories: current assets and fixed, or long-term, assets. Current assets consist of assets that should be converted to cash within one year, and they include cash and cash equivalents, accounts receivable, and inventory. Long-term assets are assets expected to be used for more than one year; they include plant and ___ in addition to intellectual property such as patents and copyrights. Plant and equipment is generally reported net of accumulated depreciation. Allied's long-term assets consist entirely of net plant and equipment, and we often refer to them as "net fixed assets."

equipment

A limited liability company (LLC) is a popular type of organization that is a _______ between a partnership and a corporation. A limited liability partnership (LLP) is similar to an LLC. LLPs are used for professional firms in the fields of accounting, law, and architecture, while LLCs are used by other businesses. Similar to corporations, LLCs and LLPs provide limited liability protection, but they are taxed as partnerships. Further, unlike limited partnerships, where the general partner has full control of the business, the investors in an LLC or LLP have votes in proportion to their ownership interest.

hybrid

The annual report is the most __ report that corporations issue to stockholders, and it contains two types of information. First, there is 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 that will affect future operations. Second, the report provides these four basic financial statements: 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, 2016. The income statement, which shows the firm's sales and costs (and thus profits) during some past period—for example, 2016. 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. 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.

important

Money markets versus 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 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. There is no hard-and-fast rule, but in a description of debt markets, short-term generally means less than 1 year, intermediate-term means 1 to 10 years, and long-term means more than 10 years. Secondary markets are markets in which existing, already outstanding securities are traded among ______. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market because it deals in outstanding, as opposed to newly issued, stocks and bonds. Secondary markets also exist for mortgages, other types of loans, and other financial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and thus does not receive funds from such a sale.

investors

The value of an asset also depends on its ______, which means the time and effort it takes to sell the asset for cash at a fair market value. Because the stock of a corporation is easier to transfer to a potential buyer than is an interest in a proprietorship or partnership, and because more investors are willing to invest in stocks than in partnerships (with their potential unlimited liability), a corporate investment is relatively liquid. This too enhances the value of a corporation.

liquidity

As noted previously, if the stock market is efficient, it is a waste of time for most people to seek bargains by analyzing published data on stocks. That follows 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. So rather than spending time and money trying to find undervalued stocks, it would be better to buy an index fund designed to ____ the overall market as reflected in an index such as the S&P 500. However, if we worked for an institution with billions of dollars, we would try to find undervalued stocks or companies because even a small undervaluation would amount to a great deal of money when investing millions rather than thousands. Also, markets are more efficient for individual stocks 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. Note, though, that a number of private equity players are doing exactly that; so the market for entire companies may soon be as efficient as that for individual stocks.

match

Professor Thaler and his colleague Nicholas Barberis argue that behavioral finance's criticism of the EMH rests on two key points. First, it is often difficult or risky for traders to take advantage of ___ assets. For example, even if you know that a stock's price is too low because investors have overreacted to recent bad news, a trader with limited capital may be reluctant to purchase the stock for fear that the same forces that pushed the price down may work to keep it artificially low for a long time. Similarly, during the recent stock market bubble, many traders who believed (correctly) that stock prices were too high lost a great deal of money selling stocks short in the early stages of the bubble, because prices went even higher before they eventually collapsed. Thus, mispricings may persist.

mispriced

Private markets versus public markets. Private markets, where transactions are _____ directly between two parties, are differentiated from public markets, where standardized contracts are traded on organized exchanges.

negotiated

Different firms have different amounts of debt, different tax carrybacks and 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. For example, suppose two companies have identical sales, operating costs, and assets. However, one company uses some debt, and the other uses only common equity. Despite their identical operating performances, the company with no debt (and therefore no interest expense) would report a higher net income because no interest was deducted from its operating income. Consequently, if you want to compare two companies' operating performances, it is best to focus on their ___ income.

operating

It has long been recognized that managers' personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth than their stockholders' wealth; therefore, managers might pay themselves excessive ______. Effective executive compensation plans motivate managers to act in their stockholders' best interests. Useful motivational tools include (1) reasonable compensation packages, (2) firing of managers who don't perform well, and (3) the threat of hostile takeovers.

salaries

In terms of numbers, most businesses are ____. However, based on the dollar value of sales, more than 80% of all business is done by corporations. Because corporations conduct the most business and because most successful businesses eventually convert to corporations, we focus on them in this book. Still, it is important to understand the legal differences between types of firms.

proprietorships

Speculation, on the other hand, is done in the hope of high returns; but it ____ risk exposure. For example, several years ago Procter & Gamble disclosed that it lost $150 million on derivative investments. More recently, losses on mortgage-related derivatives helped contribute to the credit collapse in 2008.

raises

Derivatives can be used to ___ risks or to speculate. Suppose a wheat processor's costs rise and its net income falls when the price of wheat rises. The processor could reduce its risk by purchasing derivatives—wheat futures—whose value increases when the price of wheat rises. This is a hedging operation, and its purpose is to reduce risk exposure.

reduce

Investments relate to decisions concerning stocks and bonds and include a number of activities: (1) Security analysis deals with finding the proper values of individual ______ (i.e., stocks and bonds). (2) 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. (3) 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.

securities

Another important trend in recent years has been the increased use of derivatives. A derivative is any _____ 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 six 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 and dollars. The market for derivatives has grown faster than any other market in recent years, providing investors with new opportunities but also exposing them to new risks.

security

Although the logic behind the EMH is compelling, many events in the real world seem inconsistent with the hypothesis, which has spurred a growing field called behavioral finance. Rather than assuming that investors are rational, behavioral finance theorists borrow insights from psychology to better understand how irrational behavior can be ___ over time. Pioneers in this field include psychologists Daniel Kahneman, Amos Tversky, and Richard Thaler. Their work has encouraged a growing number of scholars to work in this promising area of research.

sustained

Physical asset markets versus financial asset markets. Physical asset markets (also called "___" or "real" asset markets) are for products such as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, 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.

tangible