The Four Types of Firms

- Sole proprietorship is a business owned and run by one person

o Sole proprietorships are straightforward to set up
o The principal limitation of a sole proprietorship is that there is no separation
between the firm and the owner
o Owner has unlimited personal liability for any of the firms debts. An owner
who cannot afford to repay the loan must declare personal bankruptcy
o The life of a sole proprietorship is limited to the life of the owner
- Partnership is identical to sole proprietorship but more than one owner
o All partners are liable for the firms debt. Lender can require any partner to
repay all the firms outstanding debts
o The partnership ends on the death or withdrawal of any single partner,
although liquidation can be avoided if partnership agreement provides for
alternative
- Limited Liability Company (LLC) is a limited partnership without a general partner
o However unlike limited partners, they can also run the business
Corporations is a legally defined, artificial being, separate from its owners which means
it can enter into contracts, acquire assets, incur obligation, and, enjoys protection under
seizure of its property
Double Taxation is when a corporation pays tax on its profits, and then when the
remaining profits are distributed to the shareholders, the shareholders pay their own
personal income tax on this income
S Corporation are not subject to corporate tax but the burden is placed on the
shareholder however restrictions include that individuals are citizens and no more than
100. C subject to tax and are most corps
Agency problem when managers, despite being hired as the agents of shareholders,
put forth own interest
Liquid if an investment is able to sell it quickly and easily for a price very close to the
price of market
Financial statements are accounting reports with past performance information that a
firm issues periodically
10-Q are statements issued by quarter and 10-K are statements which are issued
annually
GAAP or generally accepted accounting principles provide a common set of rules and a
standard format for when public companies use to file their reports. Auditors are used
to check if statements are prepared right
Balance sheet is a statement of financial position which lists the firms assets and
liabilities
Stockholders Equity the difference between the firms assets and liabilities, is a
measure of firms net worth
Current Assets are either cash or assets that could be converted into cash within the
year, this includes cash and other marketable securities, accounts receivable which are
amounts owed to the firm by customers who have purchased goods, and inventories are
raw materials, work-in-progress, finished goods
Long Term assets include net property, plant, and equipment. These include examples
such as real estate, machinery that produce tangible benefits for more than a year. Net
property, plant, and equipment depict the book value of investments
Goodwill/Intangible Assets are the difference between the total acquisition price and
the book value of tangible assets. If these intangible assets value decline over time, the
amounts are listed as amortization

Current Liabilities include accounts payable or the amounts owed to suppliers for
products or services, short-term debt and maturities of long-term debt, repayments of
debt that will occur within the year, items such as salary or taxes that are owed but not
yet paid, deferred or unearned revenue
Net Working Capital (NWC) difference between a firms current assets and liabilities,
capital available
Long-Term Liabilities include long-term debt, capital leases which are contracts that
obligate the firm to make regular lease payments in exchange for use of an asset.
Deferred taxes are taxes that are owed but have not yet been paid which arise when
firms financial income exceeds its income for tax purposes.
Book Value of equity or stockholders equity which is the difference between a firms
assets and liabilities
Market Value of Equity = Shares outstanding x market price per share, also know as
market capitalization
Market-to-Book Ratio = Market Value of Equity / Book Value of Equity
Value stocks have low market-to-book ratios while high market-to-book ratios are
known as growth stocks
Enterprise Value = Market Value of Equity + Debt Cash
Income Statement lists the firms revenue and expenses over a period of time, the
bottom line depicts the net income and this statement is sometimes called a profit and
loss and net income refers to earnings
First two lines list the revenues from sales of products and the costs incurred to make
and sell the products, the third line represents gross profit
EBIT is earnings before interest and taxes and EPS = Net Income / Shares Outstanding
or earnings per share
Capital expenditures are purchases of new property, plant, and equipment and do not
appear immediately
Retained Earnings = Net Income Dividends
Statement of stockholders equity breaks down the stockholders equity computed
on the balance sheet into the amount that came from issuing shares (par value plus
paid-in capital) versus retained earnings
Change in Stockholders Equity = Retained Earnings + Net sales of stock = net
income dividends + sales of stock repurchases of stock
Gross margin = gross profit / sales, operating margin = operating income / sales,
EBIT margin = (EBIT/sales)
Net Profit margin = net income/sales, current ratio = current assets/current
liabilities, cash ratio = cash/cur lia
Account receivable days is to evaluate the speed at which a company turns sales into
cash
Accounts receivable days = accounts receivable / average daily sales
Accounts payable days are accounts payable days = accounts payable / average daily
cost of sales
Turnover ratios are an alternative way to measure working capital
Inventory turnover = annual cost of sales / inventory
Leverage or the extent to which it relies on debt as a source of financing, to assess this,
we do
Debt-equity ratio = total debt / total equity
Time value of money is the difference in value between money today and money in
the future
PV is the present value, FV is the future value and the discount rate is 1/1+r or risk-free
interest rate

Law of One Price which is if equivalent investment opportunities trade simultaneously

in different competitive markets then they must trade of the same price in both markets
Short sale is when the person who intends to sell the security first borrows it from
someone who already own it and the person must either return the security by buying it
back or pay the owner the cash flow
Value additivity which is Price(C) = Price(A + B) = Price(A) + Price(B)
Stream of cash flows are cash flows that last several periods and can be represented
on a timeline
Present Value of Perpetuity is PV(C in perpetuity) = C / r
C1
1
(1
) Future Value of Annuity
Present Value of Annuity is
N
r
(1+ r)
C1
((1+ r) N 1)
r
Present Value of a Growing Perpetuity PV(growing perpetuity) = C / r g
C1
1+ g N
Present Value of a Growing Annuity PV =
(1(
) )
rg
1+ r
Effective annual rate (EAR) which indicates the actual amount of interest that will be
earned at the end of one year annual percentage rate (APR) indicates the amount of
simple interest earned in one year, which is the amount of interest earned without the
effect of compounding 1 + EAR = (1 + APR/k)^k
Adjustable rate mortgages (ARMs) have interest rates that are not constant over the
life of the loan
When the interest rate on such a loan changes, the loan payments are recalculated
based on the loans outstanding balance
r i
r i the real interest rate is approximately equal to
The real interest rate is r=
1+ i
the nominal interest rate less the rate of inflation
Term structure is the relationship between the investment term and the interest rate
and we can plot this relationship on a graph called the yield curve
Federal funds rate which is the rate at which banks can borrow cash reserves on an
overnight basis
Opportunity cost of capital which is the best available expected return offered in the
market on an investment of comparable risk and term to the cash flow being discounted
Bond certificate are the terms of the bond where payments or coupons are made until
the final repayment date or the maturity date. The time remaining until the repayment
date is known as the term of the bond
CPN = Coupon Rate x Face Value / Number of Coupon Payments per year
Zero coupon bond does not make any coupon payments, simply pays face value at
maturity date. An example of this are treasury bills. PV of future cash flow less than
actual cash flow so trade at discount aka pure discount bonds. Although the bond
pays no interest, investor is compensated for time value of money
Yield to maturity (YTM) or the special name given to the IRR of an investment in a
FV 1/ n
1
bond YTM n =
P
Risk-Free interest rate is simple the yield to maturity
CPN1
1
FV
1
+
Yield to Maturity of Coupon Bond P=
N
y
( 1+ y )
( 1+ y ) N
Coupon bonds may trade at a discount, at a premium(price greater than face value), or
at par(price = to face)

( )

NPV Investment Rule which is when making an investment decision, take alternative
with highest NPV.
IRR Investment Rule take any investment opportunity where the IRR exceeds the
opportunity cost of capital and turn down any opportunity whose IRR is less than the
opportunity cost of capital
For IRR Investment Rule three pitfalls, one is delayed investments, the other is when
there are two IRRs, and the final is when there are no IRRs
Payback investment rule states that you should only accept a project if its cash flows
pay back its initial investment within a pre-specified period.
When comparing two projects, pick the project with the highest NPV. However,
selecting the highest IRR doesnt always make sense because of differences in the timing
of cash flow or their riskiness
Incremental IRR which is the IRR of the incremental cash flow that would result from
replacing one project with the other. Profitability Index = Value Created / Resource
Consumed
Two shortcomings of the profitability index are the set of projects taken following
the profitability index ranking completely exhausts the available resource, only a single
relevant resource constraint
Capital budget list the projects and investments that a company plans to undertake
during the coming year
Incremental earnings which is the amount by which the firms earnings are expected
to change as a result of the investment decision. Earnings are not actual cash flows
Straight-line depreciation in which the assets cost is divided equally over its
estimated useful life
Unlevered Net Income = EBIT x (1 tax-rate) = (Revenues Costs Depreciation) x (1
tax-rate)
Project externalities are indirect effects of the project that may increase of decrease
the profits of other business activities of the firm. Sales of new product displace the sales
of an existing product, the situation is often referred to as cannibalization
Free cash flow or FCF is the incremental effect of a project on the firms available cash
Net Working Capital = Current Assets Current Liabilities = Cash + inventory +
Receivables Payables
Free Cash Flow = Unlevered Net Income + Depreciation CapEx change in NWC
Depreciation Tax shield is the tax savings that results from the ability to deduct
depreciation
Equity cost of capital for the stock which is the expected return of other investments
1 + P1
available in the market with equivalent risk to the firms shares. To buy, P0
1+ r E
Dividend yield which is the expected annual dividend of the stock divided by its current
price
Capital gain the difference between the expected sale price and purchase price for the
stock, dividing this by the current stock price, capital gain is expressed as a percentage
return called the capital gain rate
The total return = equity cost of capital of a stock is the sum of the dividend yield
and the capital gain rate
1
Constant dividend growth model which is P0=
r Eg
Dividend payout rate as the fraction of its earnings that the firm pays as dividends
each year.

The dividend at a time t

t =

Earningst
Divident Payout Rate
Shares Outstandingt

earnings per

share(EPS) Shares O
Change in Earnings = New Investment x Return on New Investment, Earnings Growth
ChangeEarnings
Rate =
Earnings
Retention rate, the fraction of current earnings that the firm retains EGR=retention
rate x ret on new invest
If there is a change in the growth rate, we simply get the PV of that constant growth rate
in the future