Finance Summary By Anuva Paramartha INTRODUCTION TO ...

Finance Summary By Anuva Paramartha INTRODUCTION TO MANAGERIAL FINANCE Everything else equal, (1) more value is preferred to less; (2) the sooner cash is received, the more valuable it is; and (3) less-risky assets are more valuable than (preferred to) riskier assets. General Areas Of Finance: 1. Financial markets and institutions which include banks, insurance companies, savings and loans, and credit unions 2. Investments- focuses on the decisions made by businesses and individuals as they choose securities for their investment portfolios.3. Financial services- refers to functions provided by organizations that deal with the management of money. 4. Managerial (business) finance- deals with decisions that all firms make concerning their cash flows, including both inflows and outflows. Finance In Non-Finance Areas 1. Management: Strategic planning, which is one of the most important activities of management, cannot be accomplished without considering how such plans impact the overall financial well-being of the firm. 2. Marketing- the four Ps of marketing: product, price, place, and promotion-determine the success of products that are manufactured and sold by companies. 3. Accounting- the two disciplines are closely related, often accountants are involved in finance decisions and financial managers are involved in accounting decisions. One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. 4. Information Systems 5. Economics-. Many tools used to make financial decisions evolved from theories or models developed by economists. Perhaps the most noticeable difference between finance and economics is that financial managers evaluate information and make decisions about cash flows associated with a particular firm or a group of firms, whereas economists analyze information and forecast changes in activities associated with entire industries and the economy as a whole. FORMS OF BUSINESS ORGANIZATION A sole proprietorship is a business owned by one person. simplest type to start and is least regulated type. These are the most popular! The owner of a sole proprietorship keeps all the profits, but the owner has unlimited liability for business debts. All business income is taxed as personal income. When the owner dies, the business dies also. Selling a sole proprietorship is difficult because the entire business must be sold to a new owner. Partnership: same as a sole proprietorship, but there are more than one owners called partners. The partners make a complicated contract called the partnership agreement where they lay down all the rules. The partnership ends when a general partner wishes to sell out or dies. There are 2 types of partnerships: General Partnership: all partners share in gains and losses and all have unlimited liability. Limited partnership(LLP): has one or more general partners who run the business, and some limited partners who don’t participate. A limited partner’s liability for debts is limited to the amount he/she contributed. The three problems with sole proprietorships and partnerships: 1. Unlimited liability for business debts on the part of the owners, 2. Limited life of the business, and 3. Difficulty of transferring ownership Corporation is the most important form and has limited liability. It’s more complicated than starting the other forms of business. A corporation is a legal "person" separate from its owners, and behaves like an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. Stock holders control a corporation and the most they can lose is what they have invested. The corporate form is superior when it comes to raising cash. Ownership can be easily transferred (buying/selling stock) and a corporation can live forever. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws (rules).The bylaws are rules describing how the corporation regulates its own existence, such as how the directors are elected. Stockholders elect the board of directors, and the directors select the managers. Significant disadvantage: corporation must pay taxes, and dividends paid to stockholders are taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice. LLC is essentially a hybrid of partnership and corporation. It’s legal entity that is separate from its owners and managers. It offers the limited personal liability associated with a corporation, but the company's income is taxed like a partnership in that it passes through to the owners, so that it is taxed only once. As with a corporation, paperwork (articles of organization) must be filed with the state in which the business is set up. S Corporation is a domestic corporation that has no more than 100 stockholders and only one type of stock outstanding can elect to file taxes as an S corporation. Taxed the same as income earned by proprietorships and partnership. Management’s primary goal is stockholder wealth maximization, which, as we will see, translates into maximizing the value of the firm as measured by the price of its common stock. Agency problem is potential conflict of interest between outside shareholders (owners) and managers who make decisions about how to operate the firm. An agency relationship exists when one or more individuals, who are called the principals, hire another person, the agent, to perform a service and delegate decision-making authority to that agent. The potential conflict between two parties-the principals (outside shareholders) and the agents (managers)-is an agency problem. How To Fix The Agency Problem: Managerial compensation- tie managers' compensation to the company's performance. Shareholder intervention- In situations where large blocks of the stock are owned by a relatively few large institutions that have enough clout to influence a firm's operations, these institutional owners often have enough voting power to overthrow management teams that do not act in the best interests of stockholders. Thread of takeover (Hostile takeovers)- managers of the acquired firm generally are fired, and those who do stay on typically lose the power they had prior to the acquisition. Thus, to avoid takeover threats, managers have a strong incentive to take actions that maximize stock prices.

Business ethics can be thought of as a company's attitude and conduct toward its employees, customers, community, and stockholders. Sarbanes-Oxley Act of 2002. Passed by congress because of Enron, WorldCom etc. scandals. Establish standards for accountability and responsibility in reporting financial information for major corporations. The act provides that a corporation must 1. have a committee that consists of outside directors to oversee the firm's audits, 2. hire an external auditing firm that will render an unbiased (independent) opinion concerning the firm's financial statements, and 3. provide additional information about the procedures used to construct and report financial statements. In addition, the firm's chief executive officer (CEO) and CFO must certify financial reports submitted to the Securities and Exchange Commission. The act also stiffens the criminal penalties that can be imposed for producing fraudulent financial information and provides regulatory bodies with greater authority to prosecute such actions. Corporate governance deals with the set of rules that a firm follows when conducting business. These rules provide the "road map" that managers follow to pursue the various goals of the firm, including maximizing its stock price. 5 reasons to go international: 1. To seek new markets 2. To seek raw materials 3. To seek new technology 4. To seek production efficiency 5. To avoid political and regulatory hurdles. Multinational versus Domestic Managerial Finance: 6 factors distinguish managerial finance as practiced by firms operating within a single country from firms that operate in several different countries: 1. Different currency denominations-An analysis of exchange rates and the effects of fluctuating currency values must be included in all financial analyses. 2. Economic and legal ramifications-Each country in which the firm operates has its own political and economic institutions, and institutional differences among countries can cause significant problems. 3. Language differences-The ability to communicate is critical in all business transactions. United States often are at a disadvantage because they generally are fluent only in English, whereas European and Asian businesspeople usually are fluent in several languages. 4. Cultural differences 5. Role of governments 6. Political risk THE FINANCIAL ENVIRONMENT Financial markets are a system that includes individuals and institutions, instruments, and procedures that bring together borrowers and savers no matter the location. The primary role of financial markets is to facilitate the flow of funds from individuals and businesses that have surplus funds to individuals, businesses, and governments that need funds in excess of their incomes. Three financial phases: 1.Young adults borrow - young adults consume more than incomes to buy such items as houses and cars. 2.Older working adults save - earn more than we consume, so we save some of our income.3.Retired adults use savings- retirement. Funds transferred: 1.Direct transfer - occurs when business sells stocks or bonds directly to savers w/o going through any type of intermediary.2.Investment banking house - serves as a middleman that facilitates the issuance of securities by firms. The firm's securities and the savers' money merely "pass through" the investment banking house.3. Financial intermediary - a bank or a mutual fund. The existence of intermediaries greatly increases the efficiency of the financial markets. Economic Efficiency - Funds are allocated to their optimal use at the lowest costs Informational Efficiency - Investment prices are adjusted quickly to reflect current information Weak-form - all information contained in past price movements is reflected in current market prices. Semistrong-form - current prices reflect all publicly available information. An abnormal return is defined as a return that is greater than is justified by the risk associated with the investment. Strong-form - current prices reflect all pertinent information, both public and private. If this form of efficiency holds, even insiders would find it impossible to earn abnormal returns in the financial markets. Efficiency studies suggest that: the financial markets are highly efficient in the weak form and reasonably efficient in the semi-strong form, but strong-form efficiency does not appear to hold. Money versus capital markets The markets for short-term financial instruments are termed the money markets, for long-term financial instruments are called the capital markets. The money markets include debt instruments that have maturities equal to one year or less , and the capital markets include instruments with original maturities greater than one year. Debt versus equity markets Debt markets are where loans are traded, and the equity markets are where stocks are traded. Primary versus secondary markets The primary markets are where "new" securities are traded, and the secondary markets are where "used" securities are traded. Primary markets are the markets in which corporations raise new capital. Secondary markets are markets in which existing, previously issued securities are traded among investors. Derivatives markets Options, futures, and swaps are some of the securities traded in the derivatives markets. These securities called derivatives because their values are "derived," directly from other assets. Many investors use derivatives to speculate about the movements of prices in the financial markets, these instruments are typically employed to help manage risk. Individuals, corporations, and governments use derivatives to hedge risk. IPO market When stock in privately held corp is offered to public for first time, the co is said to be going public, and the market for stocks in

companies that have recently gone public is called the initial public offering (IPO) market. Physical stock exchanges: The physical stock exchanges are tangible physical entities. Operates as an auction market. Examples: 1. NYSE, 2.AMEX, 3. regional exchanges. NYSE generates greater than 50 percent of the daily dollar trading. Floor brokers act as agents for investors who want to buy or sell securities. Specialists are arguably the most important participants in NYSE transactions because their role is to ensure that the auction trading process is completed in a fair and efficient manner. To have a stock listed, a company. must: 1. Apply to the exchange 2. Pay a relatively small fee 3. Meet the exchange’s minimum requirements. Over The Counter (OTC) market does not operate as an auction market. Most stocks are traded over the counter. Most of the stocks traded over the counter involve small companies. Nasdaq. Brokers and dealers who participate in the OTC market are members of a self-regulating body known as the National Association ofSecurities Dealers (NASD), which licenses brokers and oversees trading practices. The computerized trading network used by NASD is known as the NASD Automated Quotation system, or Nasdaq. Today, the Nasdaq is considered a sophisticated market of its own, separate from the OTC market. Securities and Exchange Commission (SEC) U.S. government agency that regulates the issuance and trading of stocks and bonds. The primary elements of SEC regulations include: 1. Jurisdiction over most interstate offerings of new securities to the general public 2. Regulation of national securities exchanges 3. Power to prohibit manipulation of securities’ prices 4.Control over stock trades by corporate insiders Investment Banker: 1.Helps corporations design securities attractive to investors 2. Buys these securities from the corporation 3. Resells the securities to investors. Raising Capital: Stage I Decisions: 1. Dollars to be raised 2. Type of securities used 3. Competitive bid versus negotiated deal 4 .Selection of an investment banker. Raising Capital: Stage II Decisions 1. Reevaluating the initial decisions 2. Best efforts or underwritten issues: a. Underwritten Arrangement - investment bank guarantees the sale by purchasing the securities from the issuer. b. Best Effort Arrangement investment bank gives no guarantee that the securities will be sold. 3. Issuance (flotation) Costs. 4. Setting the offering price. Underwriting Syndicate: A syndicate of investment firms formed to spread the risk associated with the purchase and distribution of a new issuance of securities. Lead or Managing Underwriter: The member of an underwriting syndicate who actually manages the distribution and sale of a new security offering. Selling Group: A network of brokerage firms formed for the purpose of distributing a new issuance of securities. Shelf Registrations Securities registered with the SEC for sale at a later date, Held “on the shelf” until the sale. Financial Intermediaries: Commercial banks, Credit unions - A credit union is a depository institution that is owned by its depositors, who are members of a common organization or association, such as an occupation, a religious group, or a community. Credit unions operate as not-for-profit businesses and are managed by member depositors elected by other members.Savings and loan associations, Mutual funds - Mutual funds are investment companies that use funds provided by savers to buy various types of financial assets, including stocks and bonds. These organizations pool investors' funds, reducing risks through diversification. They also achieve economies of scale. Whole life insurance companies - The purpose of life insurance is to members, with protection against financial distress or insecurity that might result from the premature death of a "breadwinner" or other wage earner. Pension funds Pensions are retirement plans funded by corporations or government agencies for their workers. The most famous pension plan is Social Security, which is a government-sponsored plan established in 1935 that is funded by tax revenues collected by the federal government. Benefits of Financial Intermediaries: Reduced costs, Risk/diversification, Funds divisibility/pooling, Financial flexibility, Related services. U.S. financial institutions are more heavily regulated and U.S. financial institutions face greater limitations on branching, services and relationships with non-financial businesses. TIME VALUE OF MONEY The sooner cash is received, the more valuable it is. All dollars must be valued at the same time period-before they can be compared. Present value, or beginning amount, that can be invested. PV also represents the current value of some future amount. Future value, which is the value to which an amount invested today will grow at the end of n periods after accounting for interest that will be earned during the investment period. Lump-sum amount-A single payment that occurs either today or at some date in the future. Annuity - Multiple payments of the same amount over equal time periods. If the payment is made at the end of the period, the annuity is referred to as an ordinary annuity. If the payment is made at the beginning of the period, the annuity is referred to as an annuity due. Both PV and FV Value of annuity due > ordinary annuity because of extra interest earned. Uneven cash flows-Multiple payments of different amounts over a period of time.

Compounding The process of determining the future value to which an amount or a series of cash flows will grow in the future when compound interest is applied. Discounting The process of determining the present value of a cash flow or a series of cash flows to be received (paid) in the future; the reverse of compounding. We generally pay money, which is a cash outflow (a negative cash flow), to receive a benefit, which is a cash inflow (a positive cash flow). The future value of an uneven cash flow stream, sometimes called the terminal value, is found by compounding each payment to the end of the stream and then summing the future values. Perpetuities Streams of equal payments that are expected to continue forever. Annual compounding - interest is paid once per year. Semiannual compounding - interest is paid twice per year. Simple (quoted) Interest rate (rSIMPLE)- The rate quoted by borrowers and lenders that is used to determine the rate earned per compounding period (periodic rate. rPER). Annual percentage rate (APR) Another name for the simple interest rate. rSIMPLE; does not consider the effect of interest compounding. Effective Annual Rate (rEAR) The annual rate of interest actually being earned; considers the compounding of interest. If interest is computed once each year-that is, compounded annually, rEAR = rSIMPLE = APR. But, if, compounding occurs more than once per year, the effective annual rate is greater than the simple, or quoted, interest rate-that is, rEAR > rSIMPLE. Amortized loan A loan that requires equal payments over its life; the payments include both interest and repayment of the debt. Amortization schedule A schedule showing precisely how a loan will be repaid. It gives the payment required on each payment date and a breakdown of the payment, showing how much is interest and how much is repayment of principal. DEBT and BONDS Debt is a loan to a firm, government, or individual. Corporate debt holders have priority to assets and earnings: they must be paid before any stockholders can be paid. Corporate debt holders have no voting rights. Principal value of debt represents the amount owed to the lender, which must be repaid at some point during the life of the debt. Also called the maturity value, face value, and par value. Discounted securities are securities that sell for less than their par values when issued are called. Maturity Date The maturity date represents the date on which the principal amount of a debt is due. Installment loans, require the principal amount to be repaid in several payments during the life of the loan. Short-term debt generally refers to debt instruments with maturities of one year or less. Long-term debt refers to debt instruments with maturities greater than one year. Treasury bills (T-bills) are discounted securities issued by the U.S. government to finance its operations and programs. Used as the risk free rate (rf) for our calculations. Repurchase agreement An arrangement where one firm sells some of its financial assets to another firm with a promise to repurchase the securities at a later date. Federal funds Overnight loans from one bank to another. Banker’s acceptance An instrument issued by a bank that obligates the bank to pay a specified amount at some future date. Commercial paper A discounted instrument that is a type of promissory note, or "legal" IOU. issued by large, financially sound firms. Generally, commercial paper is issued in denominations of $100,000 or more, so few individuals can afford to directly invest in the commercial paper market. Certificate of deposit An interest-earning time deposit at a bank or other financial intermediary. Eurodollar deposit A deposit in a foreign bank that is denominated in U.S. dollars. Such deposits are not exposed to exchange rate risk, which is the risk associated with converting dollars into foreign currencies. Money market mutual funds Pools of funds managed by investment companies that are primarily invested in short-term financial assets. Term loan A loan, generally obtained from a bank or insurance company, on which the borrower agrees to make a series of payments consisting of interest and principal. Often referred to as private debt. 3 major advantages over public debt offerings such as corporate bonds: speed, flexibility, and low issuance costs. Not necessary for the loan to go through the Securities and Exchange Commission (SEC) registration process because it is not sold to the public. Bond A long-term debt instrument. The interest payments are determined by the coupon rate, which represents the total interest paid each year, stated as a percentage of the bond's face value. An increase in interest rates leads to a decline in the values of bonds. A decrease in interest rates leads to an increase in the values of bonds.The longer the maturity of the bond, the more significantly its price changes in response to a given change in interest rates. Typically, interest is paid semiannually. Government bonds are issued by the U.S. government, state governments, and local or municipal governments. U.S. government bonds are issued by the U.S. Treasury and are called either Treasury notes or Treasury bonds. Municipal bonds, or munis, are similar to Treasury bonds, except that they are issued by state and local governments. Corporate bonds are issued by businesses called corporations. A corporate bond issue generally is advertised, offered to the public, and sold to many different investors. The interest rate typically remains fixed. Mortgage bond, the corporation pledges certain tangible assets as security, or collateral, for the bond. Debenture A long-term bond that is not secured by a mortgage on specific property. Subordinated debenture is an unsecured bond that ranks below, or is "inferior to," other debt with respect to claims on cash distributions made by the firm. Indenture The formal agreement (contract) between the issuer of a bond and the bondholders.

Income bond A bond that pays interest to the holder only if the interest is earned by the firm. Putable bond A bond that can be redeemed at the bondhoIder's option when certain circumstances exist. Zero coupon bond A bond that pays no annual interest but sells at a discount below par. Junk bond A high-risk, high-yield bond; used to finance mergers, leveraged buyouts. and troubled companies. Call provision, which gives the issuing firm the right to call the bonds for redemption prior to maturity. A call provision generally states that the company must pay the bondholders an amount greater than the bond's par value when it is called. Sinking fund A required annual payment designed to amortize a bond issue. A sinking fund call does not require the company to pay a call premium. Conversion feature permits the bondholder (investor) to exchange, or convert, the bond into shares of common stock at a fixed price. Foreign debt is debt sold by a foreign borrower, but it is denominated in the currency of the country in which the issue is sold. Eurodebt is used to designate any debt sold in a country other than the one in whose currency it is denominated. Individuals who desire anonymity, whether for privacy reasons or for tax avoidance, find Eurobonds to their liking. Interest rates on short-term Eurodebt are tied to LIBOR, the London Interbank Offered Rate. LIBOR: the rate of interest offered by the largest and strongest London banks on deposits of other large banks of the highest credit standing. Bond Ratings: Bond ratings are based on both qualitative and quantitative factors. A bond's rating serves as an indicator of its default risk. Lower-grade bonds offer higher returns than high-grade bonds. If you buy a bond and hold it until it matures, the average rate of return you will earn per year is called the bond's yield to maturity (YTM). For callable bonds, we generally compute the yield to call (YTC) rather than the YTM. Substitute the call price of the bond for the maturity (par) value (FV in calculator) and the number of years until the bond can be first called for the years to maturity (N in calculator), solve for I in calculator. STOCKS Common stockholders are the "owners" of the firm. Common stockholders benefit when the firm performs well. Common stockholders who bear most of the risk associated with a firm's operations. Common stockholders can be paid dividends only after interest on debt and preferred dividends are paid. But, they have the right to elect the firm's directors, who in turn appoint the officers who manage the business. The firm has no obligation to pay common stock dividends. Common stock has no specified maturity, it is perpetual. Proxy A document giving one person the authority to act for another; typically it gives them the power to vote shares of common stock. Preemptive right in the corporate charter or bylaws that gives common stockholders the right to purchase new issues of common stock on a pro-rata basis. CIassified stock Common stock that is given a special designation, such as Class A. Class B, and so forth, to meet special needs of the company. Required Rate Of Return, r. The minimum rate of return that stockholders consider acceptable on a common stock. Expected Rate Of Return: The rate of return that an individual stockholder upects to receive on a common stock. It is equal to the expected dividend yield plus the expected capital gains yield. Dividend Yield The expected dividend divided by the current price of a share of stock. D1/P0. Preferred stock often is referred to as a hybrid security, because it is similar to bonds (debt) in some respects and similar to common stock in other respects-that is, the characteristics of preferred stock fall between debt and common stock. Preferred stock is safer to use than debt, because a firm cannot be forced into bankruptcy if it misses preferred dividend payments. Cumulative dividends, a feature that requires that any preferred dividends not paid in previous periods must be paid before common dividends can be distributed. No specific maturity date. Priority over common stockholders, but not debt holders, with regard to earnings and assets. Nearly all preferred stock is nonvoting stock, which means that preferred stockholders neither elect the members of the board of directors nor vote on corporate issues. A call provision gives the issuing corporation the right to call in the preferred stock for redemption. Call premium The amount in excess of par value that a company must pay when it calls a security. Income stocks Stocks of firms that traditionally pay large, relatively constant dividends each year. Growth stocks Stocks that generally pay little or no dividends so as to retain earnings to help fund growth opportunities. American depository receipts (ADRs) Certificates created by organizations such as banks; represent ownership in stocks of foreign companies that are held in trust by a bank located in the country where the stock is traded. ADRs provide U.S. investors with the ability to invest in foreign companies with less complexity and difficulty than might otherwise be possible. Foreign Stocks: Euro stock Stock traded in countries other than the home country of the company, not including the United States. Yankee stock Stock issued by foreign companies and traded in the United States. RISK AND RATES OF RETURN

Risk The chance that an outcome other than the expected one will occur. The greater the variability of the possible outcomes, the riskier the investment. Probability Distribution A listing of all possible outcomes or events, with a probability (chance of occurrence) assigned to each outcome. expected rate of return The rate of return expected to be realized from an investment; the mean value of the probability distribution of possible results. Standard Deviation, A measure of the tightness, or variability, of a set of outcomes. The greater the standard dev. the greater the risk. Coefficient Of Variation (CV) A standardized measure of the risk per unit of return. It is calculated by dividing the standard deviation by the expected return. CV = SD/r Risk Aversion Risk-averse investors require higher rates of return to invest in higher-risk securities. Risk Premium (RP) The portion of the expected return that can be attributed to the additional risk of an investment. It is the difference between the expected rate of return on a given risky asset and the expected rate of return on a less risky asset. Expected Return On A Portfolio, The weighted average expected return on stocks held in a portfolio. Realized Rate Of Return, The return that is actually earned. The actual return usually differs from the expected return. Diversification Reduction of stand-alone risk of an individual investment by combining it with other investments in a portfolio. Risk is not reduced if the portfolio contains perfectly positively correlated stocks. As long as the correlation between two stocks is less than positive 1, diversification reduces portfolio risk.

Minimum  attainable risk in  a portfolio of  average stocks

Firm-Specific (Diversifiable) Risk That part of a security's risk associated with random outcomes generated by events or behaviors, specific to the firm. It can be eliminated by proper diversification. Also called unsystematic risk. Market (nondiversifiable) risk: The part of a security's risk associated with economic, or market, factors that systematically affect most firms. It cannot be eliminated by diversification. Relevant Risk The portion of a security's risk that cannot be diversified away; the security's market risk. It reflects the security's contribution to the risk of a portfolio. Beta Coefficient, β: The measure of a stock's sensitivity to market fluctuations is called its The beta of the overall market is 1. The beta coefficient measures a stock's volatility relative to an average stock.

Slope = β

Return on the market 

Capital Asset Pricing Model (CAPM) A model used to determine the required return on an asset, which is based on the proposition that any asset's return should be equal to the risk-free return plus a risk premium that reflects the asset's non-diversifiable risk. r = rf + (rm – rf)*Beta. The equation of the Security Market line, SML. CAPM modelÆ SML: r = rf + (rm‐rf)*

β 

Underpriced 

Overpriced 

Underpriced stks plot above the SML. Overpriced stks plot below the SML. Equilibrium The condition under which the expected return on a security is just equal to its required return and the price is stable.