FINANCE

What three areas of finance does this book cover? Are these areas independent of one another, or are they interrelated in the sense that someone working in one area should know something about each of the other areas?

(1) financial management, (2) capital markets, and (3) investments. Interconnected

What are three techniques stockholders can use to motivate managers to maximize their stock's long-run price?

(1) reasonable compensation packages, (2) firing of managers who don't perform well, and (3) the threat of hostile takeovers.

What is a Dutch auction, and what company used this procedure for its IPO?

A Dutch auction is a unique IPO method where individual investors place direct bids for shares, and the actual transaction price is set at the highest price (clearing price) that sells all offered shares. Google utilized this approach in its highly publicized IPO in 2004, raising $1.67 billion. In this auction, investors who bid at or above the clearing price, which turned out to be $85, received the shares they subscribed to at that offer price. Despite the attention Google's IPO garnered, the Dutch auction method has been rarely adopted by companies in subsequent IPOs.

If we constructed a chart like Figure 2.2 for a typical S&P 500 stock, do you think it would show more or less volatility? Explain.

A chart for a typical S&P 500 stock would likely show less volatility compared to Figure 2.2. The S&P 500 represents a diversified index of large-cap stocks, including established companies from various industries. Such diversity tends to smooth out the individual stock volatility seen in Figure 2.2, which involves specific stocks and may include more volatile options like those on the NASDAQ. The S&P 500's broader representation generally results in a more stable and less volatile performance overall.

Explain in words the difference between total debt and total liabilities.

A company's total debt includes both its short-term and long-term interest-bearing liabilities. Total liabilities equal total debt plus the company's "free" (non-interest bearing) liabilities.

How does a cost-efficient capital market help reduce the prices of goods and services?

A cost-efficient capital market reduces the prices of goods and services by providing businesses with affordable access to capital, fostering competition, encouraging innovation and efficiency, and enhancing consumer purchasing power. Efficient capital allocation ensures resources are directed to productive projects, contributing to overall cost reduction and economic benefits for consumers.

Why are financial markets essential for a healthy economy and economic growth?

A healthy economy is dependent on efficient funds transfers from people who are net savers to firms and individuals who need capital. Without efficient transfers, the economy could not function: Carolina Power & Light Energy could not raise capital, so Raleigh's citizens would have no electricity; the Johnson family would not have adequate housing; Carol Hawk would have no place to invest her savings; and so forth. Obviously, the level of employment and productivity (i.e., the standard of living) would be much lower. Therefore, it is essential that financial markets function efficiently—not only quickly, but also inexpensively.

What would happen to the U.S. standard of living if people lost faith in the safety of the financial institutions? Explain.

A loss of trust in financial institutions could harm the U.S. standard of living significantly. It might trigger capital flight, liquidity crises, and economic downturns. Reduced investments and a credit crunch could follow, impacting individuals and businesses alike. This could lead to volatility in financial markets, requiring government intervention to prevent a systemic crisis. The resulting negative wealth effect might decrease consumer confidence and spending, contributing to an overall lower standard of living.

What's a muni bond, and how are these bonds taxed?

A municipal bond, or "muni bond," is a government-issued debt used to finance public projects. Investors who buy them lend money to the government and receive periodic interest payments. The interest income from most municipal bonds is often exempt from federal and sometimes state income tax. Investors should consider potential tax benefits and lower yields compared to taxable bonds when evaluating municipal bonds.

What is an IPO?

An IPO, or initial public offering, occurs when a privately held company offers its stock to the public for the first time. This process takes place in the IPO market, marking the transition from private ownership to becoming a publicly traded company. Examples include Google's IPO in 2004, selling shares initially at $85 and later seeing a substantial increase in value, and LinkedIn's IPO in 2011, where its shares doubled in value on the first day of trading. IPOs provide companies with a means to raise capital by allowing public investors to buy shares in the newly offered stock.

What is an S corporation, and what is its advantage over a C corporation? Why don't firms such as IBM, GE, and Microsoft choose S corporation status?

An S Corporation (S Corp) is a type of corporation that passes income directly to shareholders for tax purposes, avoiding the double taxation associated with C Corporations. The advantages include pass-through taxation and potential tax savings for shareholders. However, larger firms like IBM, GE, and Microsoft don't choose S Corporation status due to eligibility restrictions, ownership limitations, administrative complexities, and the impracticality of the structure for publicly traded companies with diverse ownership and global operations. C Corporation status provides more flexibility for large, complex organizations.

Why is it good for the economy that markets be efficient?

An efficient market is beneficial for the economy as it ensures that prices accurately reflect information, facilitating capital allocation to its most productive uses. It promotes fair pricing and reduces opportunities for individuals to consistently exploit market inefficiencies.

Is an initial public offering an example of a primary or a secondary market transaction? Explain.

An initial public offering (IPO) is an example of a primary market transaction. In an IPO, a privately held company makes its shares available to the public for the first time, aiming to raise new equity capital. The process involves issuing and selling newly created shares directly to investors through an underwriting process, often led by investment banks. The funds raised from the IPO go directly to the company, enabling it to finance business expansion, reduce debt, or pursue other corporate objectives. In contrast, secondary market transactions involve the buying and selling of existing shares among investors without the company's direct involvement.

What four financial statements are typically included in the annual report?

Balance sheet, income statement, statement of cash flows, statement of stockholders' equity. These statements are related to one another; and taken together they provide an accounting picture of the firm's operations and financial position.

What is behavioral finance? What are the implications of behavioral finance for market efficiency?

Behavioral finance is a field that combines insights from psychology and economics to study how individuals make financial decisions. It recognizes that investor behavior can deviate from rationality, leading to market inefficiencies. Implications for market efficiency include the possibility of overreactions or underreactions to new information, creating opportunities for abnormal returns for those who can identify and exploit such behavioral biases.

How can bondholders protect themselves from managers' actions that negatively impact bondholders?

Bondholders attempt to protect themselves by including covenants in the bond agreements that limit firms' use of additional debt and constrain managers' actions in other ways. We address these issues later in this book, but they are quite important and everyone should be aware of them.

How would you define business ethics?

Business ethics can be thought of as a company's attitude and conduct toward its employees, customers, community, and stockholders. A firm's commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and selling practices, the use of confidential information for personal gain, community involvement, and the use of illegal payments to obtain business.

Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital.

Capital can be transferred from suppliers to demanders through various channels, including financial intermediaries, capital markets, and direct transactions. Financial intermediaries, such as banks, facilitate this transfer by accepting deposits from savers and providing loans to borrowers. Capital markets, including stock and bond markets, allow entities to raise funds by issuing securities that investors purchase. Additionally, direct transactions involve individuals or institutions lending money directly to others. The transfer of capital is essential for economic growth and investment, and these diverse mechanisms cater to the preferences and needs of both suppliers and demanders of capital.

Why do changes in retained earnings occur?

Changes occur in retained earnings based on the money reinvested back into the business.

Differentiate between dealer markets and stock markets that have a physical location.

Dealer markets operate without a physical location, involving decentralized trading directly with dealers who facilitate transactions. In contrast, stock markets with a physical location, like traditional exchanges, have a central place where buyers and sellers place orders through brokers, and transactions are matched through an auction system on the trading floor.

Why might conflicts arise between stockholders and debtholders?

Debtholders, which include the company's bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two groups, to the extent that stockholders are typically more willing to take on risky projects.

What are the various forms of business organization? What are the advantages and disadvantages of each?

Different forms of business organization come with unique pros and cons. Sole proprietorships offer simplicity but have unlimited liability. Partnerships share responsibility but may lead to conflicts. Corporations provide limited liability and capital access but face regulatory complexity. Limited Liability Companies (LLCs) offer flexibility with potential legal uncertainties. Limited Liability Partnerships (LLPs) provide liability protection with limited capital options. S Corporations combine limited liability with pass-through taxation but have shareholder restrictions. The choice depends on factors like business size, liability concerns, and desired flexibility, requiring careful consideration of specific needs and goals.

Define economic value added (EVA).

EVA is an estimate of a business's true economic profit for a given year, and it often differs sharply from accounting net income.

What is EBITDA?

Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric that provides a measure of a company's operating performance without factoring in the effects of financing and accounting decisions. EBITDA is often used as an indicator of a company's ability to generate cash flow from its operational activities.

Why is earnings per share called "the bottom line"? What is EBIT, or operating income?

Earnings per share (EPS) is often referred to as "the bottom line" because it represents the net income available to common shareholders after deducting all expenses, including operating costs, interest, and taxes. It is considered the most crucial figure for stockholders as it indicates the profitability attributed to each share of common stock.

When is a stock said to be in equilibrium? Why might a stock at any point in time not be in equilibrium?

Equilibrium: A stock is said to be in equilibrium when the quantity of shares demanded equals the quantity supplied in the market, resulting in a stable market price. Factors for Not Being in Equilibrium: A stock may not be in equilibrium at any given time due to factors such as new information, shifts in market sentiment, external events, liquidity issues, market speculation, and psychological influences. These factors can disrupt the balance between buying and selling forces, causing fluctuations in stock prices.

Explain whether the following statements are true or false. Derivative transactions are designed to increase risk and are used almost exclusively by speculators who are looking to capture high returns. Hedge funds typically have large minimum investments and are marketed to institutions and individuals with high net worths. Hedge funds have traditionally been highly regulated. The New York Stock Exchange is an example of a stock exchange that has a physical location. A larger bid-ask spread means that the dealer will realize a lower profit.

False: Derivative transactions are not necessarily designed to increase risk; they are financial instruments used for risk management, speculation, and investment strategies. True: Hedge funds often have high minimum investment requirements and target institutional and high-net-worth individuals. False: Hedge funds have traditionally been less regulated compared to other investment vehicles like mutual funds. True: The New York Stock Exchange (NYSE) is an example of a stock exchange with a physical location where trading occurs on a centralized trading floor. False: A larger bid-ask spread means the dealer will realize a higher profit, not a lower one. The spread represents the dealer's markup or profit.

What is the relationship among economics, finance, and accounting?

Finance, as we know it today, grew out of economics and accounting. Economists developed the notion that an asset's value is based on the future 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. Figure 1.1 illustrates that in the modern corporation, the accounting department typically falls under the control of the CFO. This further illustrates the link among finance, economics, and accounting.

What types of changes have financial markets experienced during the last two decades? Have they been perceived as positive or negative changes? Explain.

Financial markets have undergone both positive and negative changes in the last two decades. Technological advancements and globalization have increased accessibility but also raised concerns about high-frequency trading and contagion risks. Financial innovation expanded options but contributed to increased risk, particularly evident in the 2008 financial crisis. Regulatory changes post-crisis aimed at stability have sparked debates on their impact on efficiency and innovation. Overall opinions differ on whether these changes have positively enhanced accessibility and stability or introduced complexities and systemic risks.

Is it better for a firm's actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.

For stockholders in general, it is generally preferable for a firm's actual stock price in the market to be equal to or slightly above its intrinsic value. This suggests a fair market valuation, promoting long-term shareholder interests by reducing the likelihood of overvaluation or undervaluation. However, for a CEO who is about to exercise a million dollars in options and then retire, the preference might be for the stock price to be over its intrinsic value. This allows the CEO to maximize personal financial gain from stock options. While this aligns with short-term personal interests, it may not necessarily correspond with the broader goal of maximizing shareholder wealth for all investors in the long term, potentially highlighting a conflict of interests.

What information does the statement of stockholders' equity provide?

How much a firm's equity changed during the year and why this change occurred.

If a company's board of directors wants management to maximize shareholder wealth, should the CEO's compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measure? Why?

If a company's board aims to maximize shareholder wealth, the CEO's compensation is typically tied to the firm's performance. Using metrics like the growth rate in intrinsic value is preferable over the growth rate in reported profits. Intrinsic value reflects the company's true worth, considering long-term factors and sustainability, aligning better with the goal of maximizing shareholder wealth. This approach encourages strategic decisions that contribute to the company's intrinsic value over short-term financial fluctuations.

What does it mean for a market to be "efficient"?

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.

Explain in words the difference between net working capital and net operating working capital.

If we subtract current liabilities from current assets, the difference is called net working capital.

Suppose you are relatively wealthy and are looking for a potential investment. You do not plan to be active in the business. Would you be more interested in investing in a partnership or in a corporation? Why?

If you're wealthy and not planning to be active in the business, you might be more interested in investing in a corporation. Corporations offer limited liability, passive investment opportunities, ease of share transferability, and the potential for perpetual existence. These features align with your preference for a hands-off investment approach while safeguarding your personal assets and providing liquidity.

What is a firm's intrinsic value? Its current stock price? Is the stock's "true" long-run value more closely related to its intrinsic value or to its current price?

Intrinsic Value: The estimated true worth of a firm based on fundamental analysis, future cash flows, and risk assessment. Current Stock Price: The market-determined price at which the firm's shares are trading, influenced by various factors. True Long-Run Value: More closely related to intrinsic value than the current stock price. In the long run, market prices tend to align with intrinsic value as fundamentals become more apparent.

List the major types of financial institutions, and briefly describe the primary function of each.

Investment banks traditionally assist in capital raising, while commercial banks (e.g., Bank of America) offer diverse financial services. Financial services corporations (e.g., Citigroup) integrate various financial institutions. Credit unions provide cooperative funds, pension funds manage retirement savings, and life insurance companies gather savings through premiums. Mutual funds pool funds for securities, ETFs trade on public markets, and hedge funds cater to institutional investors. Private equity companies buy and manage entire firms.

What's the difference between a commercial bank and an investment bank?

Investment banks, like Bear Stearns and Lehman Brothers, traditionally assist corporations in designing attractive securities, purchase them, and resell to savers, often guaranteeing capital raising. Recent events like the credit crisis had significant impacts, leading to collapses and transformations. Commercial banks, such as Bank of America and Citibank, are "department stores of finance," serving various savers and borrowers with checking services. Unlike investment banks, commercial banks have a broader role, influencing the money supply through the Federal Reserve System and catering to diverse financial needs beyond capital raising. The key difference lies in their specialized functions: investment banks focus on capital raising, while commercial banks offer comprehensive financial services.

Why are efficient capital markets necessary for economic growth?

It is difficult, if not impossible, for an economy to reach its full potential if it doesn't have access to a well-functioning financial system. In a well-developed economy like that of the United States, an extensive set of markets and institutions has evolved over time to facilitate the efficient allocation of capital. To raise capital efficiently, managers must understand how these markets and institutions work; and individuals need to know how the markets and institutions work to earn high rates of returns on their savings.

What are long-term capital gains? Are they taxed like other income? Explain.

Long-term capital gains are trading profits recognized on an investment held for more than one year. Currently, though, corporations' capital gains are taxed at the same rates as their operating income.

Define market value added (MVA).

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

Should managers estimate intrinsic values or leave that to outside security analysts? Explain.

Managers can benefit from estimating intrinsic values for their company's stock to inform internal decision-making, strategic planning, and communication with stakeholders. However, potential conflicts of interest and the need for expertise may lead some managers to rely on external analysts for such valuations. Balancing internal insights with external objectivity can enhance decision-making and value creation.

Why might different companies account for similar transactions in different ways?

Managers may choose to report numbers in a manner that helps them present either higher or more stable earnings over time. EX: Senior managers receive bonuses or other compensation based on earnings in the short run—they may try to boost short-term reported income to boost their bonuses.

Should managers focus directly on the stock's actual market price or its intrinsic value, or are both important? Explain.

Managers should focus on both the stock's actual market price and its intrinsic value. The market price is important for short-term performance, market feedback, and investor relations. Intrinsic value guides long-term value creation, strategic decision-making, and builds investor confidence. Balancing both aspects ensures that management decisions contribute to both short-term market perception and the long-term sustainability of the company.

Distinguish between money markets and 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.

Unethical acts are generally committed by unethical people. What are some things companies can do to help ensure that their employees act ethically?

Most firms today have strong written codes of ethical behavior; companies also conduct training programs to ensure that employees understand proper behavior in different situations. When conflicts arise involving profits and ethics, ethical considerations sometimes are so obviously important that they dominate. In other cases, however, the right choice is not clear.

What are some important differences between mutual funds, Exchange Traded Funds, and hedge funds? How are they similar?

Mutual funds pool funds for securities, offering diversification. ETFs operate similarly but trade on public markets. Hedge funds, largely unregulated, cater to institutional and high-net-worth investors, often taking on higher risks. Similarities include using funds to invest in securities, but hedge funds operate with fewer regulations and higher minimum investments.

When Boeing decides to invest $5 billion in a new jet airliner, are its managers certain of the project's effects on Boeing's future profits and stock price? Explain.

No, Boeing's managers cannot be certain of the effects on future profits and stock price when deciding to invest $5 billion in a new jet airliner. The financial evaluation involves uncertainties, risks, and considerations of societal and environmental factors that impact the project's success and the company's overall performance.

Can investors be confident that if the financial statements of different companies are accurate and are prepared in accordance with GAAP, the data reported by one company will be comparable to the data provided by another?

No, because, It's legal as long as they follow GAAP, managers may choose to report numbers in a manner that helps them present either higher or more stable earnings over time. However, these differences make it difficult for investors to compare companies and gauge their true performances.

If during the year a company has high cash flows from its operations, does this mean that cash on its balance sheet will be higher at the end of the year than it was at the beginning of the year? Explain.

No, high cash flows from operations during the year do not guarantee that the cash on the balance sheet will be higher at the end of the year. The ending cash balance is affected by other activities, such as investing and financing, which can offset the positive impact of operational cash flows.

Is maximizing shareholder value inconsistent with being socially responsible? Explain.

No, maximizing shareholder value is not inherently inconsistent with being socially responsible. The text suggests that enlightened managers recognize the importance of considering societal interests alongside shareholder value. The existence of socially responsible funds, B corporations, and the acknowledgment of legal and ethical obligations highlight the idea that companies can strive for profitability while being mindful of broader social concerns. Balancing both aspects is seen as crucial for long-term success.

Is the market for all stocks equally efficient? Explain.

No, the market for all stocks is not equally efficient. Markets can be more efficient for individual stocks compared to entire companies. Individual stocks may be subject to more accurate and rapid incorporation of information due to the scrutiny of a larger number of market participants.

Distinguish between physical asset markets and financial asset markets.

Physical asset markets (also called "tangible" 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.

What are the differences between the physical location exchanges and the NASDAQ stock market?

Physical exchanges, like NYSE, use a traditional auction system with floor brokers on a trading floor. NASDAQ, an electronic dealer market, operates without a physical trading floor, relying on electronic networks. The bid-ask spread dynamics differ, with physical exchanges having smaller spreads due to centralized auctions, while NASDAQ's spreads are influenced by electronic factors. NASDAQ's growth and competitive strategies have diversified its listings, challenging physical exchanges' dominance.

What's the difference between primary markets and secondary markets?

Primary markets are the markets in which corporations 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. Secondary markets are markets in which existing, already outstanding securities are traded among investors. 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.

Differentiate between private and public markets.

Private markets , where transactions are negotiated directly between two parties, are differentiated from public markets , where standardized contracts are traded on organized exchanges. Bank loans and private debt placements with insurance companies are examples of private 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.

How might astute bondholders react if stockholders take on risky projects?

Recognizing this incentive, they will view the bonds as being riskier and will demand a higher rate of return, and in some cases the perceived risk may be so great that they will not invest in the company, unless the managers can credibly convince bondholders that the company will not pursue excessively risky projects.

Explain why the following statement is true: The retained earnings account reported on the balance sheet does not represent cash and is not "available" for dividend payments or anything else.

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.

Why is FCF an important determinant of a firm's value?

Security analysts use FCF to help estimate the value of the stock, and Allied's managers use it to assess the value of proposed capital budgeting projects and potential merger candidates. FCF shows how much cash the firm can distribute to its investors.

How are LLCs and LLPs related to the other forms of organization?

Similar to Corporations: Both offer limited liability protection to owners. Different from Corporations: They are more flexible and often have pass-through taxation, avoiding double taxation. Similar to Partnerships: Both are pass-through entities with management flexibility. Different from Partnerships: LLCs and LLPs provide limited liability protection, unlike general partnerships.

What's the difference between spot markets and 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 future 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.

Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm's stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years, but another action keeps the stock at $20 for several years but then increases it to $40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.

Stockholder wealth maximization is viewed as a long-term goal, emphasizing decisions for sustained growth and value creation. Comparing scenarios, an action that keeps the stock price at $20 for several years before reaching $40 is generally favored over a short-term increase to $30. Specific corporate actions reflecting these tendencies include prioritizing long-term investments and strategic acquisitions over short-term tactics like cost-cutting or share buybacks. The overarching objective is to implement strategies that foster enduring growth and prosperity for shareholders, aligning with the principle of long-term stockholder wealth maximization.

If a firm could maximize either its current market price or its intrinsic value, what would stockholders (as a group) want managers to do? Explain.

Stockholders, as a group, would prefer managers to maximize the intrinsic value of the firm. This approach aligns with the goal of creating long-term, sustainable value for shareholders and promotes the alignment of interests between managers and investors. While market prices can be influenced by short-term factors, intrinsic value focuses on the fundamental worth of the company, contributing to strategic decision-making and risk mitigation.

Do stocks have known and "provable" intrinsic values, or might different people reach different conclusions about intrinsic values? Explain.

Stocks do not have known and "provable" intrinsic values. Intrinsic value is an estimate of the true worth of a stock based on various factors, and it involves subjective analysis and future assumptions. Different people can indeed reach different conclusions about intrinsic values for several reasons:

What's the AMT, and what is its purpose?

The Alternative Minimum Tax (AMT) is a parallel tax system in the United States designed to ensure that high-income individuals and corporations pay a minimum amount of tax, regardless of the deductions and credits they may otherwise qualify for under the regular income tax system.

What is free cash flow (FCF)?

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

What is the annual report, and what two types of information does it provide?

The annual report is the most important 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.

What is the balance sheet, and what information does it provide?

The balance sheet is a "snapshot" of a firm's position at a specific point in time. 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. 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 equipment in addition to intellectual property such as patents and copyrights. Plant and equipment is generally reported net of accumulated depreciation.

Which is more like a snapshot of the firm's operations—the balance sheet or the income statement? Explain your answer.

The balance sheet is more like a snapshot of the firm's operations. While the income statement reports on the company's performance over a specific period, such as a month, quarter, or year, the balance sheet provides a snapshot of the company's financial position at a specific point in time. It outlines the assets, liabilities, and equity of the company, offering a static view of its financial health at a particular moment. In contrast, the income statement reflects the company's dynamic performance over a given timeframe, showing revenues, expenses, and net income.

What is the bid-ask spread?

The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a security. It represents the dealer's profit and accounts for the risk they take in holding and trading the security. Wider spreads typically occur with more volatile or infrequently traded stocks to compensate for increased risk.

Who is the CFO, and where does this individual fit into the corporate hierarchy? What are some of his or her responsibilities?

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.

What's the difference between a stock's current market price and its intrinsic value?

The current market price is the actual trading price of a stock in the market. Intrinsic value is an estimate of the stock's true worth based on fundamental analysis. The difference between the market price and intrinsic value is known as the margin of safety, indicating whether the stock is undervalued, overvalued, or fairly valued. Investors often seek a positive margin of safety for reduced risk and potential long-term gains.

Briefly explain what is meant by the term efficiency continuum.

The efficiency continuum represents the spectrum of efficiency in financial markets, ranging from highly efficient markets where prices quickly incorporate information to less efficient markets with more opportunities for investors to find undervalued assets.

Suppose three honest individuals gave you their estimates of Stock X's intrinsic value. One person is your current roommate, the second person is a professional security analyst with an excellent reputation on Wall Street, and the third person is Company X's CFO. If the three estimates differed, in which one would you have the most confidence? Why?

The estimate of Stock X's intrinsic value from the professional security analyst with a reputable track record would inspire the most confidence. Professional analysts are trained, experienced, and known for unbiased assessments, while the CFO may have a potential conflict of interest, and your current roommate may lack the professional expertise and independence.

Why is the annual report of great interest to investors?

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

Explain this statement: Our tax rates are progressive.

The higher one's income, the larger the percentage paid in taxes.

Identify and briefly compare the two leading stock exchanges in the United States today.

The leading stock exchanges in the United States are the New York Stock Exchange (NYSE) and NASDAQ. NYSE operates with a physical trading floor, using an auction system, while NASDAQ is an electronic exchange functioning as a dealer market. NYSE is associated with larger, established companies, while NASDAQ often lists technology and growth-oriented firms. The competition between NYSE and NASDAQ has increased over time.

How does EVA differ 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.

What's the difference between marginal and average tax rates?

The marginal tax rate is specific to the next unit of income, reflecting how much tax will be paid on an additional dollar earned. The average tax rate, on the other hand, gives an overall percentage of income paid in taxes by considering the total tax liability and total income.

How is the order in which items are shown on the balance sheet determined?

The order of items on a balance sheet is typically based on liquidity and timing. It starts with current assets, listed in order of liquidity, followed by non-current assets. Current liabilities, due within a year, come next, followed by non-current liabilities. Equity is typically at the bottom, including common stock and retained earnings. This arrangement helps provide a clear picture of a company's short-term and long-term financial positions.

What is the logic behind allowing tax loss carrybacks/carryforwards?

The purpose of permitting this loss treatment is to avoid penalizing corporations whose incomes fluctuate substantially from year to year.

What is the statement of cash flows, and what are some questions it answers?

The statement of cash flows is an accounting report that outlines the sources and uses of cash by a company over a specific period, typically a year. It provides insights into how a company generates and utilizes cash, which is crucial for evaluating its financial health. The statement of cash flows answers questions such as: Where did the company's cash come from during the period? How was the generated cash used by the company? What were the cash flows from operating, investing, and financing activities? How did these cash activities impact the overall cash position of the company?

Identify and briefly explain the four sections shown in the statement of cash flows.

The statement of cash flows is divided into four sections: Operating activities: This section deals with items related to the company's normal ongoing operations. It includes net income, adjustments for non-cash items (like depreciation), and changes in working capital (e.g., inventory, accounts receivable, accounts payable). Investing activities: Covers activities involving long-term assets. It includes the acquisition or sale of fixed assets (property, plant, and equipment). Financing activities: Encompasses the company's financing sources and uses. It includes changes in debt, such as borrowing or repaying loans, and equity transactions, such as issuing or repurchasing stock.

What are some reasons why the value of a business other than a small one is generally maximized when it is organized as a corporation?

The value of a business, especially larger ones, is often maximized when organized as a corporation due to limited liability, access to capital through stock issuance, perpetual existence, transferability of ownership, tax planning opportunities, the ability to attract professional management, potential for public offerings, brand recognition, economies of scale, and diversification. These factors contribute to stability, investor confidence, and the ability to attract capital and talent, ultimately enhancing the business's overall value.

Differentiate between closely held and publicly owned corporations.

These firms are said to be privately owned, or closely held, corporations ; and their stock is called closely held stock. In contrast, the stocks of most large companies are owned by thousands of investors, most of whom are not active in management. These companies are called publicly owned corporations , and their stock is called publicly held stock.

Name three ways capital is transferred between savers and borrowers.

Three ways capital is transferred between savers and borrowers. Direct transfers occur when businesses sell stocks or bonds directly to savers, common among small firms but raising limited capital. Alternatively, transfers may involve an investment bank as an underwriter, facilitating securities issuance and assuming resale risks. Financial intermediaries like banks enhance market efficiency by obtaining funds from savers, acquiring securities from businesses, and creating new forms of capital, such as certificates of deposit. This indirect process provides safer and more liquid investment options for savers, contributing to the efficiency of money and capital markets.

What are some actions that stockholders can take to ensure that management's and stockholders' interests are aligned?

To align management and stockholder interests, stockholders can advocate for performance-based executive compensation, link stock options to long-term company performance, and foster transparent financial reporting. Regular communication through meetings and voting, promoting strong corporate governance, and engaging in shareholder activism when needed are key actions to ensure management's behavior aligns with the long-term interests of stockholders.

Indicate whether the following instruments are examples of money market or capital market securities. U.S. Treasury bills Long-term corporate bonds Common stocks Preferred stocks Dealer commercial paper

U.S. Treasury bills: Money market (short-term debt securities issued by the U.S. government) Long-term corporate bonds: Capital market (long-term debt securities issued by corporations) Common stocks: Capital market (equity securities representing ownership in a company) Preferred stocks: Capital market (equity securities with characteristics of both debt and equity) Dealer commercial paper: Money market (short-term, unsecured debt issued by corporations in the money market)

Can a firm's executive compensation plan lead to unethical behavior? Explain.

Yes, a firm's executive compensation plan can lead to unethical behavior. When compensation is heavily tied to short-term financial performance, there is a risk of executives prioritizing personal gain over the long-term interests of the company, engaging in excessive risk-taking, and eroding the ethical culture within the organization. A balanced and transparent compensation structure is essential to mitigate the potential for unethical behavior.

Would you expect a portfolio that consisted of the NYSE stocks to be more or less risky than a portfolio of NASDAQ stocks?

Yes, a portfolio consisting of NYSE stocks is generally expected to be less risky than a portfolio of NASDAQ stocks. The NYSE has larger, more established companies, while NASDAQ includes many high-tech firms with higher volatility. This distinction makes NYSE stocks more perceived as stable and less risky overall.

Should a firm's managers help investors improve their estimates of the firm's intrinsic value? Explain.

Yes, it is beneficial for a firm's managers to help investors improve their estimates of the firm's intrinsic value. This enhances transparency, builds trust, contributes to market efficiency, reduces information asymmetry, fosters long-term investor relations, aligns interests, positively impacts market perception, and may facilitate access to capital.

Does it make sense for not-for-profit organizations such as hospitals and universities to have CFOs? Why or why not?

Yes, they are in charge of accounting, finance, credit policy, and decisions regarding asset acquisitions. Including communications with stockholders and the press.

Is it possible that the market for individual stocks could be highly efficient, but the market for whole companies could be less efficient? Explain.

es, it is possible. The market for individual stocks may be more efficient than that for entire companies. This discrepancy can be attributed to factors such as the greater scrutiny and availability of information for individual stocks compared to entire companies.