Fin 3000

Ch 1

 Capital budgeting/expenditure (CAPEX) decisions: investing decisions

o Acquires real assets
o Purchase of real assets
 Financing decisions: raise money the firm needs for investments and operations
o Acquires financial assets
o Sale of financial assets
 Corporation: a distinct, permanent legal entity
o Articles of incorporation set out the purpose of a business and how it will be financed,
managed, and governed
o Shareholders/Stockholders: owners of a corporation
o Limited liability: owners are not personally responsible for a company’s debts
o Double taxation
 Sole proprietorship: one owner with unlimited liability
 Partnership: 2+ owners with unlimited liability
o Do not pay income taxes
 Shareholders want managers to maximize market value
o If market value is not maximized – or at least maintained – the company won’t last long
term

Ch 2

 Cash retained and reinvested in the firm’s operations is cash saved and invested on behalf of the
firm’s shareholders
 The stock market (aka equity markets) is a financial market for corporations
 Financial market: where securities are issued and traded
o Security: a financial asset
 The NYSE (New York Stock Exchange) or NASDAQ is where a corporation issues its IPO (initial
public offering)
o Buyers of the IPO help to finance a firm’s real assets
 Primary market: a new issue of shares that increases the amount of cash held by the company
and the number of shares held by the public
 Secondary market: the purchases and sales of existing securities (they were already owned)
 Most corporate debt securities are traded over the counter through banks and securities dealers
 Fixed income market: the market for debt securities
 Capital markets: the markets for long term debt and equity
 Money market: where short term securities are traded (short term is less than 1 year)
 Financial intermediary: an organization that raises money from investors and provides financing
for individuals, companies, and other organizations
 Important source of financing for corporations
 Raises money in different ways (ex: taking deposits or selling insurance policies)
 Invests that money in financial assets
 o Mutual funds: raise money by selling shares to investors
 Offers investors low-cost diversification and professional management
 Its easier to buy a mutual fund than it is to assemble a diverse portfolio of stocks
and bonds on your own
 Fund managers take out a management fee
o Hedge funds: usually follow complex and high risk investment strategies and access is
usually restricted to knowledgeable investors such as pension funds, endowment funds,
and wealthy individuals.
 Some try to make a profit by overvalued stocks and selling short
 Manage less money than mutual funds but take big positions and have a large
impact on the market
o Pension fund: fund set up by an employer to provide for employees’ retirement
 Designed for long run investment
 Financial institutions: bank and insurance companies
o Raise financing in special ways like accepting deposits and they provide additional
financial services
 Commercial banks: major sources of loans for corporations
 Raise money from depositors and then make loans to businesses and
individuals
 Investment banks: advise and assist companies in obtaining finance
 Ex: underwrite stock offerings by purchasing new shares at a negotiated
prices and reselling to investors
 Also advise on takeovers, mergers, and acquisitions
 Insurance companies: long term financing of business. Massive investors in
corporate stocks and bonds and make long term loans to corporations
 Money to make the loan comes from people buying insurance policies

Ch 3

 Balance sheet: a snapshot of the firms assets and liabilities at a moment in time
o Assets: use of funds raised (on left)
 Liquid assets: can be turned more easily into cash (most liquid at top)
 Receivables: current asset
 Turned into cash in the near future
 Fixed assets: longer lived (ex: buildings and land)
o Liabilities: sources of funding (on right)
 Payables
 Current liabilities: to be paid within one year
o Stockholders equity
o Current assest – current liabilities = net working capital
 GAAP
 Book values: based on the past cost of the assets, not historical value
 Income statement: shows how profitable a firm has been during the past year
o Earnings before interest and taxes (EBIT) = total revenues + other income – costs –
depreciation
  Statement of Cash Flows: shows the firms inflows and outflows of cash through investing and
financing activities
 Corporate tax 35%
 Average tax rate = total tax bill / total income
 Marginal tax rate: the tax an individual pays for every extra dollar of income

Ch 4

 Performance Measures
o Market capitalization: total market value of equity = share price * number of share
outstanding
o Market value added (MVA) = market cap – book value of equity
o Financial analysts like to see how much market value was added for each dollar
shareholders have invested
o Market – to – book ratio = market value of equity/book value of equity
 Profitability Measures
o Economic value added (EVA): the profit after deducting all costs, including the cost of
capital. It is also called residual income. = net income – a charge for the cost of capital
employed
 = after tax interest + net income – (cost of capital * total capitalization)
 = after tax operating income – (cost of capital * total capitalization)
 Total capitalization = long term debt + shareholders equity
 After-tax operating income = (1 - tax rate) × interest expense + net income
o EVA is a better measure of a company’s performance than accounting income because it
also includes opportunity costs
o Return on Capital (ROC) = after tax operating income/total capitalization
o Return on assets (ROA) = after tax operating income/total assets
o Return on equity (ROE) = net income/equity
 Efficancy Measures
o Asset turnover ratio = sales/total assets at the start of the year
o Inventory turnover = cogs/inventory at the start of the year
o average days in inventory = inventory at the start of the year/daily cogs
o Receivables turnover = sales/receivables at the start of the year
o average collection period = receivables at the start of the year/average daily sales
o Profit margin = net income/sales
o Operating profit margin = after tax operating income/sales
 Leverage measures
o Long term debt ratio = long term debt/(long term debt +equity)
o Long term debt equity ratio = long term debt/ratio
o Total debt ratio = total liabilities/total assets
o Times interest earned = EBIT/interest payments
o Cash coverage ratio = (EBIT + depreciation)/interest payments
 Liquidity measures
o Net working capital to assets = net working capital/total assets
o Current ratio = current assets/current liabilities
 o Quick ratio = (cash + marketable securities + receivables)/current liabilities
o Cash ratio = (cash + marketable securities)/current liabilities

Ch 5

 Interest (after one year) = initial investment * (1 + r)

 Future value (FV) = initial investment* (1+r)
o For t years you use (1+r)t
o t is the number of years
o r is the interest rate
 compound interest: earning interest on interest
o you are earning interest on the original investment and the interest from the years
before
 simple interest: earning interest only on your original investment
 present value (PV) = future value / interest rate
o we discounted the future value at the interest rate
o this is a discounted cash flow and the interest rate is the discount rate
o for t years you use (1+r)t
o can also = future payment/(1+r)t
 discount factor is 1/(1+r)t
 to find the value at some future date of the stream of cash flows, add up all future values
 the present value of the stream of future cash flows is the amount you need to generate that
stream
 financial calculator stuff:
o n – number of periods
o i – interest rate at a percent
o PV – present value
o FV – future value
o PMT – amount of any reoccurring payment (before the date of future value is
calculated)
 Annuity: any sequence of equally spaced, level cash flows
o PV of t-value annuity = C[(1/r)-(1/(r(1+r)t))]
o T- year annuity factor ( in the brackets)
o Future value of an annuity = PV of annuity * (1+r)t= (((1+r)t-1)/r)
o PV annuity factor = [1-(1/(1+r)t)-1]/r
o FV annuity factor = [(1+r)t-1]/r
 Perpetuity: a payment stream that lasts forever
o Cash payment from perpetuity = r * PV
o PV of perpetuity = cash payment/r
 Annuity due: a level stream of payments starting immediately
o PV of annuity due = PV of ordinary annuity * (1+r)
o FV of annuity due = FV of ordinary annuity * (1+r)
 Effective annual interest rate: the rate at which your money grows allowing for the effect of
compounding
o 1 + effective annual interest rate = (1+monthly rate)12
  Annual percentage rates (APRs)
o Monthly interest rate = APR/12
 Inflation: the general rise in prices
 Nominal – actual number of dollars
 Real – amount of purchasing power
 The Fischer Effect: investors require compensation for inflation
o R = nominal rate
o r = real rate
o h = inflation rate
o 1+R = (1+r)*(1+h) OR R=r+h+r*h

Ch 6

 Bond: a security that obligates the issuer to make specified payments to bondholders
 Face value: aka principal or par value; this is payment at the maturity of the bond
 Coupon: interest payments paid to the bondholder
 PV of a bond = PV (coupons)+PV(face value) =(coupon*annuity factor)+(face value*discount
factor)
o Annuity factor = [1/r – 1/((1+r)^t)]
 When the market interest rate > coupon rate  bonds sell for < face value
 When the market interest rate < coupon rate  bonds sell for > face value
 When interest rate rises, the pv of payments to be received by the bondholder falls and bond
prices fall
 When interest rate rises, the pv of payments to be received by the bondholder rise and the
bond prices rise
 Interest rate changes day by day  this effects the pv of the coupon but not the payment
amount
 Current market price = annual coupon / current yield
 Coupon rate: annual interest payment as a percentage of face value
o Interest payment/face value
 Interest rate risk: the risk to bond prices due to fluctuations in interest rates
 Current yield: annual coupon payment/bond price
o Does not measure the bond’s total rate of return (its overstates for premiums and
understates for discounts)
 Premium: a bond priced above face value
 Discount: a bond priced below its face value
 Yield to maturity: discount rate at which the pv of the bond’s payments = the price
 Rate of return = (coupon income + price change)/investment
 Yield curve: the plot of the relationship between bond yields to maturity and time to maturity
 1+real interest rate = (1+nominal interest rate)/(1+ inflation rate)
 Default risk (or credit risk): the risk a bond issuer may default on its bonds
 Default premium: the additional yield on a bond that investors require for bearing credit risk
 Investment grade: bonds rated Baa or above by Moody’s or BBB or above by Standard’s&Poor’s
or Fitch
  Junk bond: a bond rated with below Baa or BBB
 How bondholders can minimize risk
o Senority
o Security: debt that has first claim on a specified asset
o Protective covenants: conditions imposed on borrowers to protect lenders from
unreasonable risks
 Zero-coupon bonds: repay principle at maturity but do not have coupon payments along the
way
 Floating-rate bonds: have coupon payments that are not fixed but fluctuate with short term
interest rates
 Convertible bonds: can be exchanged for a specific number of shares of the issuing company’s
corporate stock

Ch 7

 Common stock: ownership shares in a publicly owned company

 Initial Public Offering/IPO: first offering of a stock to the general public
 Primary offering: the company sells shares in the firm
 Primary market: market for the sale of new securities by corporations
 Secondary markets: market in which previously issued securities are traded among investors
 Book value: net worth of the firm according to the balance sheet
 Liquidation value: net proceeds that can be realized by selling the firms assets and paying off its
creditors
 Market value treats the firm as going concern
o The value investors are willing to pay for the shares of a firm. This depends on the
earning power of todays assets and the expected profitability of future investments
 Earnings per share (EPS) = net income/total shares outstanding
 Dividends per share = total dividends/total shares outstanding
 Valuation of comparable – financial analysts examine the price people are willing to pay for
shares of similar firms
 V0 = (DIV1 + P1)/1+r
o V0 – intrinsic value: the present value of future cash payoffs from a stock or other
security
o DIV1 – expected dividend per share
o P1 – price in one year
 Expected return = (DIV1 + P1 – P0)/P0
 Dividends in the future = Pt = Dt * (1+g)/R-g
o D0 *(1+g)t
 P0 = (DIV1 + P1)/1+r = [D0 * (1+ g)]/(R-g)
 Dividend discount model – do P0 but add for each year while also changing the exponent in
the denominator
 Valuation of a no growth stock = P0 = DIV1/r
 Constant growth – see dividend discount model = Do * (1+g)
 Sustainable growth rate:
 Ch 11

 Percentage return = (capital gain + dividend)/initial share price

 Capital gain = end of year price – beginning of year price
 Dividend yield = dividend/initial share price
 Percentage capital gain = capital gain/initial share price
 1+real rate of return = (1+nominal rate of return)/(1+inflation rate)
 Market index: measure of the investment performance of the overall market
 Dow jones – blue chip stocks (30)
 S&P – 500 large stocks
 Discount rate = risk free rate + extra premium over risk free rate for common stocks
 Price of Stock today = (Year End Price + Dividend) / (1 + r)
 Rate of return = interest rate on treasury bills + market risk premium
o Risk premium: expected return in excess of risk free return as compensation for risk
= ra - rf

Ch 12

 Market portfolio: portfolio of all assets in an economoy

 Defensive stocks: not sensitive to market fluctuations, have low betas (<1)
 Aggressive stocks: sensitive to market flucutations, have high betas (>1)
 To measure betas
o Observe rate of returns
o Plot observations
o Fit a line showing average return
 Portfolio beta = (fraction of portfolio in stock 1 * beta of stock 1) + (fraction of portfolio in
stock 2 * beta of stock 2)
 Market risk premium = rm (market return) – rf (treasury bill rate)
 Risk premium = r – rf = β(rm – rf)
 Capital assest pricing model = Expected return = risk free rate + expected risk premium = rf + β
(rm – rf)
 Risk premium on investment = beta * expected market risk premium