FIN 311 - Principles of Finance

How do bondholders and stockholders react to the company's financial state?

- Bondholders are not affected by the state of the company, as their ROR does not change. (bondholders implement "covenants" in bond agreements that limit the firm's use of additional debt & constrains managers from acting recklessly). - Stockholders care about the company's state, as they are paid last and their return depends on the state of the company (stock price).

What are CFO duties?

- Ensure accounting system provides "good numbers" - Ensure firm is financed in proper manner - Evaluate operating units to make sure they're operating at optimal levels - To evaluate all proposed capital expenditures to make sure they will increase the firm's value (stock price)

What are effective compensation plans?

- Giving rewards for long-run stock performance. - Compensation packages that have stocks that mature in years, not within six months (works as motivation) - Having a strong set salary - Bonuses - Should be based on MARKET PRICE, because IV price will always be unknown.

What increases value of a firm?

- Lower risk: greater value of the firm - A firm's value is dependent on its growth opportunities (ability to attract capital).

How has globalization affected regulators? Why is it more difficult for them to cooperate?

- The different structures in nation's banking/securities make trading inconsistent. - The trends are different between conglomerates. - There is a reluctance of individual countries to give up control over their national monetary policies.

More information of intrinsic value

- is a long-run concept - management's goal should be to take actions that maximize the firm's intrinsic value (not the current market price)

What is a proprietorship? What are the advantages/disadvantages?

A business owned by one person Advantages: easy and inexpensive to form, subject to few government regulations, lower income taxes Disadvantages: unlimited personal liability, life of business is limited to the life of owner, difficult to accumulate large sums of capital.

What is the difference between a closely-held corporation and a publicly owned corporation?

A closely-held corporation is owned by a few individuals, who are typically management and their stock is not publicly traded. A publicly owned corporation is owned by a large number of individuals who are not actively involved with management. There stock is sold publicly as well.

What is an investment bank?

A financial institution that helps companies raise capital. They help corporations design securities with features that are currently attractive to investors. IB's buy securities from corporations and resell them to savers.

What are credit unions?

A firm where members' monies are used to supply other members' loan, generally, for auto purchases, home improvement loans, home mortgages, etc. - These are usually the cheapest sources of funds available to individual borrowers.

What is an LLC (LLP)? What are the advantages/disadvantages?

A hybrid between a partnership and corporation. Advantages: Investors in a LLC have votes in proportion to their ownership interest, owners are taxed separately (have their own personal income), have limited liability (which lowers risk). Disadvantages: Complicated to form as laws change.

What are over-the-counter markets?

A large collection of brokers and dealers connected electronically by telephones and computers, that provides trading in unlisted categories. - For smaller companies.

What is a partnership? What are the advantages/disadvantages?

A legal arrangement between 2 or more people who decide to do business together. Advantages: partners are individually taxed (have their own incomes) and are protected, relatively inexpensive to form, income taxes are lower than other forms. Disadvantages: unlimited personal liability.

What is a corporation? What are the advantages/disadvantages?

A legal entity created by a state, and it is separate and distinct from its owners and managers. Advantages: corporation can lose money, but its owners can only lose as much as they invested in it, can transfer ownership, unlimited life, easier to transfer stocks and raise capital, stocks are highly liquid. Disadvantages: expensive to form, "double-taxation" (when a corps. earnings are taxed, and then after-tax earnings paid-out as dividends are taxed again as personal income to stockholders).

What is a physical location stock exchange?

A place where formal organizations meet-up to conduct auction markets in designated "list" areas (selling/buying shares). Ex. NYSE

Define "Trend Analysis"

An analysis of a firm's financial ratio over time; used to estimate the likelihood of improvement OR deterioration.

What is a private equity company?

An organization that operates like hedge funds, but rather than purchasing stocks, private equity players buy whole firms and then manage them as well as make improvements as well

What is a derivative?

Any security who's value is derived from the price of some underlying asset. - They 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.

What are spot markets?

Buying (selling) assets "on-the-spot", without giving much thought and time into making a decision (within a few days instead of 6+ months)

What are B Corporations?

Corporations that take action to support stakeholders, such as employees, customers, local communities, etc. They put stakeholders on even-ground with shareholders. -Shareholders are also considered stakeholders as well.

Liquidity ratios

Current ratio = current assets / current liabilities *Measures the ability of a firm to cover current liabilities with the use of current assets (short-term). Quick ratio = (current assets - inventory) / current liabilities *Measures the ability of a firm to cover liabilities without relying on the sale of inventories.

How do dealers "make a market" profit?

Dealers quote the price at which they'll pay for the stock (bid price) and a price that they'll sell the shares (ask price). The profit is calculated by finding the difference of the bid-ask spread and multiplying it by the amount of shares sold.

Debt Management Ratios

Debt Ratio = (Total Liabilities / Total Assets) *Ability for a firm to pay off long-term liabilities with assets. Total debt to total capital ratio = (total debt/total debt equity) *Measures the % of the firm's capital is PROVIDED by shareholders. Times-Interest-Earned (TIE) Ratio = (EBIT/Interest Charges) *Measures the extent as OI can decline before the firm is unable to pay its interest costs.

Operating Cash Flow Formula

EBIT + Dep. - Taxes

What is corporate governance?

Establishment of rules and practices by BOD to ensure that managers act in shareholders best interests while balancing needs of constituencies.

What are financial markets?

Financial institutions through which savers can directly provide funds to borrowers. These markets deal with stocks, bonds, notes, and mortgages. They also deal with derivative securities, whose values are derived from changes in prices of other assets.

What is a pension fund?

Financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide for pension benefit payments during workers' retirements.

What is financial management?

Financial management (i.e. corporate finance) focuses on decisions relating to how much and what type of assets to acquire, how to raise the capital needed to purchase assets, and how to run a firm to maximize value.

What are the three areas of finance?

Financial management, capital markets, investments

MV Ratio - Enterprise Value/EBITDA Ratio

First, get the Enterprise Value which is = (MV of equity + MV of total debt + MV of financial claims - (Cash & Equivalents)) Then, do (Enterprise Value/EBITDA) *This looks at the relative market value of the company's financial claims.

MV Ratio - Market/Book Ratio

First, get the book value per share, which is = (common equity/shares outstanding) Secondly, use the BV per share to get the Market/Book Ratio, which is = (market price per share/BV per share) *When the M/B values exceed 1.0, this usually means that investors are willing to pay MORE for stocks than the book values of the stock.

How to determine the amount that can be paid in dividends

From Stockholder's Equity Statement: End-year RE - Beg.-year RE = Net change in RE THEN, Current Net Income - Change in RE = Amount to be paid in dividends

What is a hostile takeover and when is it most likely to occur?

If a firm's stock is undervalued, there can be a hostile takeover, which means that there's an acquisition of a company's assets in opposition of management. - Gives incentive to managers to maximize stock price.

Asset management ratios

Inventory turnover ratio = (sales / inventories) *Indicates how many times inventory is turned over during the year. lower = company is holding inventory that is worth more. higher = company is holding inventory that is worth less. Days Sales Outstanding Ratio = (Receivables / Avg. sales per day) *Wait time for company to receive cash for its receivables (on account sales) Fixed Asset Turnover Ratio = (sales / net fixed assets) * Measures how well a firm manages its plant assets

What are investments?

Investments relate to the following: 1) Security analysis - finding the proper values of individual activities (i.e. stocks & bonds) 2) Portfolio theory - deals with portfolio baskets of stocks and bonds. Investors want to hold diversified portfolios in order to limit risks. 3) Market analysis - deals with the issue as to whether stocks are "too high" or "too low" or "just right".

What are financial service corporations?

Large conglomerates that combine many different financial institutions with a single corporation. For example, Citigroup owns Citibank, an investment bank, a securities brokerage organization, and insurance companies).

What are C corporations?

Large corporations.

What are the goals of firms (finance)?

MAXIMIZE shareholder value

What are money markets?

Markets for short-term, highly liquid debt securities that mature in less than a year.

What are future markets?

Markets in which a buyer or seller agrees to buy or sell an asset on a future set date. These type of transactions can reduce, or hedge, the risks faced.

What are capital markets?

Markets where intermediate to long-term debt (bonds) or stocks are sold and bought.

Profitability Ratios

Operating Margin = (EBIT/Sales) *Measures the OI, or EBIT, per $ of sales Profit Margin = (Net Income/Sales) *Measures net income per $ of sales Basic Earnings Power (BEP) Ratio = (EBIT/Total Assets) *This ratio shows the raw earning power of the firm's assets BEFORE the influence of taxes/debt.

P/E Ratio and EPS Ratio

P/E ratio - price per share (currently) /EPS (ttm) EPS ratio - net income/# of outstanding shares

What are physical asset markets?

Physical asset markets include tangible items such as auto sales, wheat, real estate, machinery, etc.

MV Ratio - Price/Earnings Ratio

Price/Earnings Ratio = (Price per share/Earnings per share) * Measures how much $ investors are willing to pay per dollar of reported profits. Lower P/E means greater risk.

What is the difference between primary and secondary markets?

Primary markets are where corporations raise new capital and have first-hand interactions with investors. The secondary markets are where existing, already outstanding securities, are traded among investors.

Define "Benchmarking"

Process by which companies compare their performances with top competitors in the industry.

Profitability Ratios Cont.

ROA = (Net Income / Total Assets) *Measures the rate of return on a firm's total assets. Higher>lower. A low ROA can result from the use of debt. ROE= (Net Income/Common Equity) *Measures the rate of return on the stockholders investment (IMPORTANT) Return on Invest Capital = (EBIT(1-T)/Total Inv. Cap.) *ROIC is based on tot. invest cap. instead of assets. The numerator uses NOPAT instead of NI because they want to measure the funds to pay BOTH stockholders/debtholders.

The DuPont Equation!!

ROE = [Profit Margin x Total Assets Turnover x Equity Multiplier] Remember, Profit Margin = (net income/sales) Total Assets Turnover = (sales/total assets) Equity Multiplier = (total assets/total common equity) The PM shows efficiency of operations, TAT shows volume of sales, and EM shows leverage (risk).

What are capital markets?

Refers to markets where interest rates, along with stock and bond prices, are determined. The Federal Reserve and the SEC are included in capital markets. - The Federal Reserve regulates banks and controls the supply of money. - The SEC regulates the trading of stocks/bonds in public markets.

What are S corporations?

Small businesses that are exempt from corporation income taxes (act as a partnership/proprietorship), but they must have less than 100 stockholders to qualify.

What is life insurance?

Taking savings in the form of annual premiums and investing these funds in stocks, bonds, real estate, and mortgages; make payments to the beneficiaries of the insured parties.

CEO and CFO must certify to the SEC...

That reports released to stockholders, especially the annual reports, are accurate (reference SOX 2002).

What does the Behavioral Finance Theory suggest?

The behavioral finance theory suggests that managers behave differently in down markets than they do up markets. Even when investors act rationally, this does not guarantee efficiency of a market. Overconfidence is another factor to consider.

What is the "true" / intrinsic value?

The cashflows and risk that investors could expect "if" they had all the info existing about the company. -What they aim for when setting stock price.

What is the "perceived" / market price?

The cashflows and risk that investors expect, given the limited information that they have.

What are dealer markets?

The dealer market system consists of: - relatively few dealers who hold inventories of securities and "make a market" in these securities. - Thousands of brokers act as "agents" and bring dealers together with investors. - The computers, terminals, and E-networks provide a communication link between dealers and brokers.

What is the IPO market?

The market for stocks of companies that are in the process of going public (becoming publicly owned/transitioning from a closely-held corp.) These take place in the primary markets.

What is shareholder wealth maximization?

The primary financial goal for managers of publicly owned companies. It implies that decisions should be made to maximize the long-run value of the firm's common stock.

What is a commercial bank?

The traditional department store of finance, which serves a variety of borrowers and savers (JP Morgan, Bank of America, Wells Fargo).

Determination of value

The value of an asset is the PV of the stream of cash flows that the asset provides to its owners over time.

Market Value (MV) Ratios Definition

These are ratios that relate to the firm's stock price to its earnings/book value per share. Market Value ratios are used in three ways: 1) By investors when they are deciding to buy/sell stock. 2) By investment bankers when they are setting the share price for a new stock issue (i.e. IPO) 3) By firms when they are deciding how much to offer another firm in a potential merger.

What are CEO duties?

To oversee the COO and CFO. The CEO can also serve as the Chairman, who serves as a public figure for the company.

Asset management ratios cont.

Total assets turnover ratio = (sales / total assets) *Measures the turnover of all a firm's assets. A lower ratio means that the firm is not generating enough sales with its given assets.

What is the difference between private and public markets?

Transactions in the private market are negotiated directly between 2+ partners (private debt/bank loans) and their contracts are designed uniquely for each party. In the public market, their contracts are standardized because their stocks/bonds are being held by a large amount of investors. These stocks/bonds are also more liquid.

What is market value?

What investors think about the firm and its future prospects.

What is a direct transfer?

When a business/person sells its stock/bonds to saves without going through a financial institution. Thus, the saver pays directly to the firm who loans the money.

What is a primary market transaction?

When the transfer of securities go through an investment bank (IB), such as JP Morgan (Chase). The company sells its stocks/bonds to the IB, who then underwrites (issues) the securities to the saver. This is somewhat risky because the IB holds onto (buys) these securities for a period of time.

What is a financial intermediary transaction?

When transfers of securities are made through a financial intermediary, such as a bank, insurance company, or mutual fund. The intermediaries obtain funds from savers, then intermediaries buy/hold securities of other businesses securities, and savers buy the financial intermediaries money. - Very liquid and safer - Increases the efficiency of money/capital markets.

What makes a stock market efficient?

excellent communication between corporations and investors and having all the information available easily accessible.

What are institutional investors?

large organizations that invest their own funds or the funds of others (insurance companies, pension funds, hedge funds, mutual funds, and private equity groups). - these groups are ready to step into/takeover underperforming firms - they act as lobbyists and can motivate a firm to perform better

What are hedge funds?

large pools of money that are managed and used to invest in activities that promise high return on investment - high minimum initial investment requirement - only the wealthy are able to be involved - similar to mutual funds except can be high risk - increases the chances of higher return on investment

What is profitability?

measures the ability of a firm's ability to efficiently operate and utilize its assets.

What is asset management?

monitoring and maintaining all assets that make up a network. it tells us how efficiently the firm is using its assets.

What are exchange traded funds (ETFs)?

programs that are operated by mutual fund companies where a portfolio of stocks and bonds are pooled (diversified). These are generally traded in the public market.

What is debt management?

the ability to tell how the firm has financed its assets, as well as its ability to repay LONG-TERM debt.

Free Cash Flow (FCF) Definition and Formula

the amount of cash that could be withdrawn without harming a firm's ability to operate and to produce future cash flows Formula: [EBIT (1-T) + Dep./Amor.] - [Cap. Exp. + Change in net operating working capital] [EBIT (1-T) + Dep./Amor.] - Additional Cap. Exp. - [(Increase in cash + increase in supplies) - (Increase in AP + Increase in Accru.)]

What is liquidity?

the ease with which an asset can be converted into the economy's medium of exchange

What is securitization?

the process of slicing up and bundling groups of loans, mortgages, corporate bonds, or other financial debts into distinct new securities. These are high-risk and some people think securitization is to blame for the 2008 crash.

What are the three ways to make transfers?

1) Direct Transfer 2) Primary Market Transfer (Indirect) 3) Financial Intermediary (Indirect)

What are the types of stock market transactions?

1) Outstanding shares 2) Additionally purchased shares 3) Initial public offerings (IPOs)

The Four Types of Organizations

1) Proprietorship 2) Partnership 3) Corporation 4) LLC & LLP

What is a mutual fund?

an investment program funded by shareholders that trades in diversified holdings (pooling) and is professionally managed. corporations accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses/gov. agencies. - businesses buy these short-term funds in money markets (highly liquid and safe).

What is a marginal investor?

an investor whose views determine the actual stock price