Examenvragen-180-pagines[1].pdf

# Corporate goals and governance The primary objective of corporate management is to maximize the value of the company's shares, which is intrinsically linked to achieving profitability and ensuring long-term financial health through effective governance structures [2](#page=2). ### 1.1 The primary goal of corporate management The most appropriate goal for corporate management is maximizing the market value of the company's shares. This objective supersedes simply maximizing current profits or market share, as it reflects the overall long-term health and success of the firm. Smart investment decisions are crucial for creating value, often more so than financing decisions alone. Financial managers have a fiduciary duty to stockholders [2](#page=2) [8](#page=8). #### 1.1.1 Maximizing shareholder wealth Maximizing shareholder wealth is the overarching goal, and management decisions should be in the best interests of the corporation's shareholders. Decisions that create value for shareholders are favored, and corporate raiders are viewed favorably if their actions increase current shareholder wealth [2](#page=2) [3](#page=3) [5](#page=5). #### 1.1.2 Investment decisions and profitability A firm should only accept investment projects that are expected to generate returns superior to what shareholders could earn elsewhere in the capital market. This implies that spare cash should be paid out to shareholders if the firm cannot earn a higher rate of return on it than the shareholders themselves could [5](#page=5). #### 1.1.3 Financing decisions A financing decision involves how a firm obtains its long-term sources of funding. For example, deciding to fund a small investment project through an increase in short-term bank loans is a financing decision. The "capital structure" refers to the mix of long-term debt and equity financing [2](#page=2) [5](#page=5) [8](#page=8). #### 1.1.4 The role of dividends A reduction in cash dividends can be in the best interests of current shareholders if the firm has available cash to increase current investments and future profits [8](#page=8). ### 1.2 Corporate governance Corporate governance refers to the mechanisms and structures in place to direct and control a corporation. It is essential for the proper functioning of a business, particularly in large corporations where ownership and control are separated [2](#page=2). #### 1.2.1 The board of directors The board of directors is elected as a representative of the corporation's shareholders. Directors can be voted out of power by the shareholders. The board should provide support for the top management team under all circumstances [3](#page=3) [4](#page=4). #### 1.2.2 Roles of financial management In large corporations, the preparation of financial statements is typically conducted by the controller. The chief financial officer (CFO) usually supervises both the treasurer and the controller. The treasurer is generally involved with obtaining financing for the firm, cash management, and banking relationships. The controller, on the other hand, is most likely involved with internal auditing and tax reporting [3](#page=3) [4](#page=4) [5](#page=5). ##### 1.2.2.1 Treasurer's responsibilities The corporate treasurer's duties include raising capital, cash management, and overseeing banking relationships [5](#page=5). ##### 1.2.2.2 Controller's responsibilities The controller typically handles financial statements, tax reporting, and internal auditing [4](#page=4) [5](#page=5). #### 1.2.3 Agency problems Agency problems arise from differing incentives between managers and owners. These problems can be characterized by the spending of corporate resources in ways that benefit managers more than shareholders. Examples include lavish spending on expense accounts and plush remodeling of executive suites [9](#page=9). ##### 1.2.3.1 Mitigating agency problems Agency problems can be reduced when managers' compensation plans are meaningfully tied to the value of the firm. This can be achieved through compensation packages that align managers' goals with those of the shareholders. While executive incentive compensation plans are common, their effectiveness can be difficult to evaluate. Ethical decision-making by management can lead to an enhanced firm reputation, which is an important firm asset and has value for shareholders. Good internal controls and corporate governance structures are also key to controlling agency problems [5](#page=5) [8](#page=8) [9](#page=9). ##### 1.2.3.2 Sole proprietorships and agency problems Sole proprietorships resolve agency problems primarily by forcing owners to bear the full cost of their actions, as there is no separation of ownership and management [9](#page=9). #### 1.2.4 Closely held corporations A corporation is considered closely held when only a few shareholders exist. A common problem for closely held corporations is the lack of access to substantial amounts of capital. In such structures, management may also serve as the board of directors [2](#page=2) [8](#page=8). #### 1.2.5 Double taxation "Double taxation" refers to profits being taxed at the corporate level and then dividends paid to shareholders being taxed again at the personal level. This is a disadvantage to incorporating a business [3](#page=3) [8](#page=8). #### 1.2.6 Stakeholders Stakeholders are individuals or groups who have an interest in the firm. Competitors are least likely to be considered a stakeholder of the firm [9](#page=9). ### 1.3 Characteristics of Corporations Corporations are distinct legal entities with permanence due to the separation of ownership and control and limited liability for their owners. When a corporation fails, the maximum an individual shareholder can lose is the amount of their initial investment. Corporations are considered public companies when their stock is publicly traded [2](#page=2) [3](#page=3) [5](#page=5). #### 1.3.1 Advantages of incorporation Advantages include limited liability, easier access to financial markets, and becoming a permanent legal entity [3](#page=3) [4](#page=4). #### 1.3.2 Disadvantages of incorporation Disadvantages include legal requirements, a limited firm life if not managed properly, and the issue of double taxation of profits [3](#page=3) [4](#page=4). #### 1.3.3 Securities Financial assets like corporate bonds are considered securities. However, a mortgage loan issued and held by a bank is not considered a security [3](#page=3) [4](#page=4). #### 1.3.4 Real assets A real asset is a tangible or intangible asset with intrinsic value, such as a patent. Examples include machines and factories. In contrast, financial assets represent claims on real assets [3](#page=3) [8](#page=8). --- # Financial markets and institutions Financial markets and institutions are crucial components of the economy, facilitating the flow of funds and the management of risk. ## 2. Financial markets and institutions Financial markets serve several vital functions for the economy, including providing liquidity, facilitating risk reduction, and supplying pricing information. They are essential for allowing individuals and firms to manage their finances effectively [10](#page=10) [14](#page=14). ### 2.1 Functions of financial markets Financial markets play a critical role in the economy by: * **Providing liquidity:** This allows investors to convert assets into cash quickly without significant loss of value. Liquidity is particularly important for mutual funds because their shareholders may wish to redeem their shares at any time. Real estate is an example of an asset that is least liquid while bank deposits and U.S. Treasury bonds are generally considered more liquid. Foreign currency is also considered highly liquid [10](#page=10) [12](#page=12) [14](#page=14). * **Facilitating risk reduction:** Individuals can diversify their risk by investing in various assets through financial markets. Financial intermediaries, such as banks, help in matching lenders to borrowers and can shift loan risk to their deposit customers, which can be a more efficient process than individuals attempting to do this themselves. Actions like contracting to sell farm produce to a grocery store, buying foreign currency for future use, or converting a money market account into a mutual fund account can help reduce risk. Property insurance companies protect themselves from large-scale damage like hurricanes by selling many policies to different homeowners, factoring costs into prices, and buying reinsurance [10](#page=10) [14](#page=14). * **Providing pricing information:** Financial markets establish prices for various assets, helping to inform economic decisions. This includes information on the cost of borrowing funds over specific periods or the price of commodities like gold [10](#page=10). * **Providing funds to companies:** They enable companies to obtain the necessary capital to expand their operations [10](#page=10) [13](#page=13). Financial markets are used for trading securities, such as shares of IBM. They are not used for trading goods, services, or raw materials directly [13](#page=13). #### 2.1.1 Primary vs. Secondary Markets A key distinction in financial markets is between primary and secondary markets [10](#page=10) [13](#page=13). * **Primary Market:** This is where securities are initially issued for the first time. Corporations rely on the primary market when they need to raise funds through new stock or debt issues. When securities are initially issued, it is considered a primary market transaction. Companies that do not issue financial securities like stock or debt may generate sufficient funds internally to meet their needs [12](#page=12) [13](#page=13). * **Secondary Market:** This is where investors buy and sell previously issued securities. When an individual investor sells a share of IBM stock to another investor, the profits accrue to the investors, and the corporation (IBM) receives nothing from this transaction, as the funds are exchanged between the investors. An investor is least likely to interact directly with a public corporation in the secondary market or the foreign exchange market compared to the primary or bond markets [10](#page=10) [11](#page=11) [12](#page=12) [13](#page=13). > **Tip:** Understanding the difference between primary and secondary markets is crucial for comprehending how companies raise capital versus how investors trade existing assets. #### 2.1.2 Types of Financial Markets * **Money Markets:** These markets deal with short-term financing decisions and securities with maturities of less than one year. An example of a money market security is commercial paper. Corporate debt instruments are most commonly traded in the over-the-counter market, which can encompass money market instruments [11](#page=11) [13](#page=13) [9](#page=9). * **Capital Markets:** These markets are for longer-term debt and equity instruments [13](#page=13). * **Bond Market:** This market involves the trading of bonds, which are debt instruments. Major holders of corporate bonds include banks, households, and insurance companies [11](#page=11). * **Foreign Exchange Market:** This market facilitates the exchange of currencies [11](#page=11). * **Over-the-Counter (OTC) Market:** This is a decentralized market where securities are traded directly between two parties, often without the need for a central exchange [9](#page=9). #### 2.1.3 Information Provided by Financial Markets Financial markets provide crucial information, such as: * The cost of borrowing specific amounts for specific durations [10](#page=10). * The price of commodities like gold [10](#page=10). * The cost of converting one currency to another, for example, one million yen to U.S. dollars [10](#page=10). However, financial markets do not directly provide a company's historical earnings data; this information is typically found in company financial reports [10](#page=10). ### 2.2 Financial Institutions Financial institutions act as intermediaries, facilitating the flow of funds between savers and borrowers. They play a vital role in the economy by pooling savings, spreading risk, and providing a payment mechanism [11](#page=11) [13](#page=13). > **Tip:** Financial intermediaries help individuals shift their consumption from the present to the future by providing options like savings accounts or lines of credit. They can also assist in shifting consumption forward in time through services like opening a passbook account or starting a life insurance policy [14](#page=14). #### 2.2.1 Types of Financial Institutions * **Investment Banks:** These institutions typically do not accept deposits but specialize in underwriting stock offerings and assisting corporations in raising capital [12](#page=12). * **Mutual Funds:** These funds pool the savings of many investors to invest in a diversified portfolio of securities. They offer professional management and portfolio diversification to investors. Investors can generally buy additional shares in a mutual fund at any time. Liquidity is essential for mutual funds so they can meet potential shareholder redemptions. "Balanced" mutual funds invest in both stocks and bonds. Some mutual funds, like pension funds, may offer tax advantages. Mutual funds are considered financial institutions [10](#page=10) [11](#page=11) [12](#page=12) [14](#page=14). * **Commercial Banks:** These institutions accept deposits and make loans. Banks cover their service costs primarily through an interest rate differential (the difference between the interest they pay on deposits and the interest they charge on loans). Banks are often better than individuals at matching lenders to borrowers because they have information to evaluate creditworthiness [14](#page=14). * **Insurance Companies:** Property insurance companies protect themselves against catastrophes by diversifying their risk and reinsuring against large potential payouts. They are also major holders of corporate bonds [11](#page=11) [14](#page=14). * **Microfinance Institutions:** These institutions provide small loans, often referred to as micro loans, to individuals, such as a mother in a developing country looking to start a small restaurant [10](#page=10). #### 2.2.2 The Role of Financial Intermediaries Financial intermediaries perform several crucial roles: * **Accumulating funds:** They gather savings from numerous small investors [13](#page=13). * **Pooling risk:** They spread investment risk among a larger group of individuals [13](#page=13). * **Providing payment mechanisms:** They facilitate transactions within the economy [13](#page=13). * **Investing in real assets:** While they primarily deal with financial assets, their activities indirectly support investment in real assets [13](#page=13). > **Example:** When a mother in a developing country seeks a small loan to start a family restaurant, she is likely looking for a micro loan from a microfinance institution. This is a key example of financial institutions supporting entrepreneurship, even at a small scale [10](#page=10). ### 2.3 Other Financial Concepts * **Opportunity Cost of Capital:** This represents the minimum acceptable rate of return on a project, reflecting the returns forgone by investing in one project instead of another. The cost of capital for risky investments is typically higher than the firm's borrowing rate [12](#page=12). * **Reinvestment:** This refers to the reinvestment of earnings into new projects or additional investment in existing operations [13](#page=13). * **Firm's Reputation:** A firm's reputation is considered an important asset and is not irrelevant to shareholders [9](#page=9). * **Stakeholders:** Stakeholders of a firm include customers and employees, and typically also governments, but not competitors [9](#page=9). * **New Firms Raising Capital:** Following a model like Apple Computer Inc., new firms typically raise capital in an order that begins with owners, then venture capitalists, followed by suppliers, and finally public investors [10](#page=10). * **Exchange Traded Funds (ETFs):** These are considered more efficient securities because they allow trading throughout the day and do not have managers with discretionary investment authority, unlike some traditional funds [10](#page=10). --- # Valuing stocks and bonds This topic explores the fundamental methods used to determine the intrinsic value of stocks and bonds by considering their expected future cash flows and associated risks. ### 3.1 Valuing bonds Bonds are debt instruments that represent a loan made by an investor to a borrower (typically a corporation or government). The value of a bond is derived from the present value of its future cash flows, which consist of periodic coupon payments and the principal repayment at maturity [41](#page=41). #### 3.1.1 Key bond characteristics and terminology * **Coupon payments:** Periodic interest payments received by the bondholder [41](#page=41). * **Coupon rate:** The stated interest rate on a bond, used to calculate coupon payments. This rate is fixed for the life of the bond [43](#page=43) [44](#page=44). * **Par value (Face value):** The principal amount of the bond that is repaid at maturity [44](#page=44). * **Maturity date:** The date on which the principal amount of the bond becomes due and is repaid. * **Yield to maturity (YTM):** The total return anticipated on a bond if the bond is held until it matures. YTM is expressed as an annual rate and takes into account both coupon payments and any capital gain or loss from selling the bond at par value. It is the discount rate that equates the present value of the bond's future cash flows to its current market price [41](#page=41) [45](#page=45). * **Current yield:** The annual coupon payment divided by the current market price of the bond. #### 3.1.2 Factors influencing bond prices Bond prices move inversely to interest rates [41](#page=41). * **Coupon rate vs. Market interest rates:** * If a bond's coupon rate is **higher** than the prevailing market interest rates (or yield to maturity), it will sell for **more than par value** (at a premium). This is because investors are willing to pay a premium for the higher-than-market coupon payments [41](#page=41) [44](#page=44). * If a bond's coupon rate is **lower** than the prevailing market interest rates, it will sell for **less than par value** (at a discount). Investors will demand a lower price to compensate for the below-market coupon payments [41](#page=41) [44](#page=44). * If a bond's coupon rate is **equal** to the prevailing market interest rates, it will sell **at par value** [41](#page=41). * **Yield to Maturity (YTM):** The YTM is the discount rate that makes the present value of a bond's expected future cash flows equal to its current market price. When market interest rates (and thus YTM) decline, existing bonds with higher coupon rates become more attractive, causing their prices to increase. Conversely, when market interest rates rise, the prices of existing bonds fall [42](#page=42) [45](#page=45). * **Credit Quality (Default Risk):** Bonds with lower credit ratings (e.g., speculative-grade or junk bonds) carry a higher risk of default and therefore demand a higher yield to compensate investors for this risk. This higher yield is often reflected in a lower bond price compared to a bond with a similar maturity but a higher credit rating. U.S. Treasury bonds, considered to have minimal default risk, do not include a default premium in their yield, unlike bonds with lower credit ratings [41](#page=41) [43](#page=43). * **Liquidity:** Highly liquid bonds are easier to sell quickly without a significant price concession. Therefore, they tend to have lower yields compared to less liquid bonds with similar characteristics [42](#page=42). * **Inflation Premium:** Nominal bond yields include an inflation premium, which compensates investors for the expected erosion of purchasing power due to inflation [40](#page=40). * **Maturity:** The relationship between bond yields and their time to maturity is depicted by the yield curve. An upward-sloping yield curve indicates that short-maturity bonds yield less than long-maturity bonds [42](#page=42). #### 3.1.3 Calculating bond values The price of a bond is the present value of its future coupon payments and its par value, discounted at the yield to maturity. For a bond with annual coupon payments: $$P_0 = \sum_{t=1}^{n} \frac{C}{(1+y)^t} + \frac{FV}{(1+y)^n}$$ Where: * $P_0$ = Current bond price [41](#page=41) [43](#page=43) [44](#page=44) [45](#page=45). * $C$ = Annual coupon payment [41](#page=41) [44](#page=44). * $y$ = Yield to maturity [41](#page=41) [44](#page=44) [45](#page=45). * $n$ = Number of years to maturity [41](#page=41) [43](#page=43) [44](#page=44). * $FV$ = Face value (par value) [44](#page=44). If coupon payments are semi-annual, the formula is adjusted accordingly, with the coupon payment, yield, and number of periods halved. #### 3.1.4 Types of bonds * **Convertible bonds:** These bonds provide the holder with the option to convert the bond into shares of common stock of the issuing company [43](#page=43). * **Eurobonds:** Bonds denominated in a currency other than that of the country in which they are issued [42](#page=42). * **Municipal bonds:** Bonds issued by state and local governments, often attractive due to their income being exempt from federal taxes [43](#page=43). * **Zero-coupon bonds:** Bonds that do not pay periodic interest but are sold at a discount to their face value, with the entire return realized at maturity [43](#page=43). ### 3.2 Valuing stocks Valuing stocks involves determining the intrinsic value of an ownership stake in a company. This is typically done by forecasting future cash flows attributable to shareholders and discounting them back to the present. #### 3.2.1 Dividend discount models (DDM) The Dividend Discount Model (DDM) is a method for valuing a stock by discounting its expected future dividends to their present value [45](#page=45) [51](#page=51) [52](#page=52). * **Zero-growth model:** Assumes dividends remain constant. The value is simply the dividend divided by the required rate of return. $$P_0 = \frac{D}{r}$$ Where: * $P_0$ = Current stock price * $D$ = Expected annual dividend * $r$ = Required rate of return > **Example:** A stock with no growth prospects paying a $4.32 annual dividend and a required return of 12.5% would be valued at $4.32 / 0.125 = USD 34.56 [51](#page=51). * **Constant-growth model (Gordon Growth Model):** Assumes dividends grow at a constant rate indefinitely. $$P_0 = \frac{D_1}{r - g}$$ Where: * $D_1$ = Expected dividend in the next period [47](#page=47) [49](#page=49). * $r$ = Required rate of return [45](#page=45) [47](#page=47) [48](#page=48). * $g$ = Constant dividend growth rate [46](#page=46) [47](#page=47) [49](#page=49). The required rate of return ($r$) can be expressed as the sum of the dividend yield ($D_1/P_0$) and the capital gains yield ($g$) [49](#page=49). $$r = \frac{D_1}{P_0} + g$$ The sustainable growth rate ($g$) is the rate at which a firm can grow while maintaining its financial policies, and it can be calculated as: $$g = \text{Return on Equity} \times \text{Plowback Ratio}$$ The plowback ratio is 1 minus the dividend payout ratio [48](#page=48) [50](#page=50) [52](#page=52). * **Non-constant growth model:** This model accounts for periods of higher or lower growth rates before settling into a constant growth rate. The terminal value is calculated using the constant growth model at the point where growth becomes stable, and this terminal value is then discounted back to the present [51](#page=51). #### 3.2.2 Other stock valuation concepts * **Price-to-Earnings (P/E) Ratio:** A valuation metric that relates a company's stock price to its earnings per share. High P/E ratios often suggest investors expect higher future growth [48](#page=48). * **Price-to-Book (P/B) Ratio:** Compares a company's market value of equity to its book value of equity. A P/B ratio of 4 with a book value per share of $10 would imply a stock price of $40 [52](#page=52). * **Present Value of Growth Opportunities (PVGO):** The portion of a stock's price that is attributable to future growth opportunities beyond current earnings. A positive PVGO indicates that the firm has investment opportunities with returns exceeding the cost of capital [46](#page=46) [50](#page=50). * **Liquidation Value:** The net amount realized from selling all of a firm's assets and paying off its creditors. If liquidation value exceeds market value, the firm may have no value as a going concern [47](#page=47) [52](#page=52). * **Going-concern value:** The value of a firm as an operating entity, which includes its intangible assets [47](#page=47). #### 3.2.3 Efficient Market Hypothesis (EMH) The EMH posits that asset prices fully reflect all available information [47](#page=47) [49](#page=49). * **Weak-form efficiency:** Prices reflect all past market data, such as prices and trading volumes. This implies technical analysis is not consistently profitable [45](#page=45). * **Semi-strong form efficiency:** Prices reflect all publicly available information, including financial statements and news. This suggests that fundamental analysis based on public information is also not consistently profitable [45](#page=45) [48](#page=48). * **Strong-form efficiency:** Prices reflect all information, both public and private (insider information). This is generally considered not to hold in reality [45](#page=45). Evidence suggests that stock prices adjust very rapidly to new information. However, newly issued stocks tending to underperform the market over subsequent years is considered inconsistent with the semi-strong form of EMH. The idea that there are "no free lunches on Wall Street" suggests that security prices reflect all available information, making it difficult to consistently earn abnormal returns [46](#page=46) [49](#page=49) [50](#page=50) [52](#page=52). #### 3.2.4 Total Return on Stock The total return on a stock investment is comprised of the dividend yield and the capital gains yield [46](#page=46) [49](#page=49). $$ \text{Total Return} = \frac{\text{Dividend} + (\text{Selling Price} - \text{Purchase Price})}{\text{Purchase Price}} $$ This can also be expressed as: $$ \text{Expected Return} = \frac{D_1}{P_0} + \frac{P_1 - P_0}{P_0} $$ or $$ \text{Expected Return} = \text{Dividend Yield} + \text{Capital Gain Rate} $$ > **Tip:** When calculating the expected return, remember that the capital gain rate is the expected change in price relative to the current price. The expected stock price one year from now ($P_1$) can be calculated using the current price ($P_0$), the required return ($r$), and the expected dividend ($D_1$): $$ P_1 = (P_0 \times (1+r)) - D_1 $$ --- # Capital budgeting and investment appraisal Capital budgeting and investment appraisal are crucial financial processes that guide firms in making decisions about long-term investments. This involves evaluating potential projects to determine their profitability and contribution to shareholder wealth, ensuring that resources are allocated to opportunities that maximize firm value [1](#page=1) [53](#page=53). ### 4.1 Core investment appraisal techniques Several techniques are employed to evaluate capital projects, each with its strengths and weaknesses. The most prominent among these are Net Present Value (NPV), Internal Rate of Return (IRR), and the Profitability Index (PI). #### 4.1.1 Net present value (NPV) The Net Present Value (NPV) is considered the "gold standard" of investment criteria. It measures the difference between the present value of future cash inflows and the present value of cash outflows, discounted at the firm's opportunity cost of capital. A project is considered worthwhile if its expected rate of return exceeds its opportunity cost of capital, resulting in a positive NPV [53](#page=53) [55](#page=55). **Decision Rule:** * **Accept** projects with a positive NPV [55](#page=55). * **Reject** projects with a negative NPV [53](#page=53) [57](#page=57). * If two projects offer the same positive NPV, they add the same amount of value to the firm [54](#page=54). **Formula:** The NPV is calculated as the sum of the present values of all future cash flows, including the initial investment (which is typically negative). $$ NPV = \sum_{t=0}^{T} \frac{C_t}{(1+r)^t} $$ Where: * $C_t$ = Net cash flow at time $t$ [53](#page=53). * $r$ = Discount rate (opportunity cost of capital) [53](#page=53). * $T$ = Project life **Factors affecting NPV:** * **Discount rate:** As the discount rate increases, the NPV of a project decreases. Conversely, a decrease in the discount rate will increase the NPV [53](#page=53) [55](#page=55). * **Initial cost:** An increase in the initial cost of a project will decrease its NPV [53](#page=53). * **Cash inflows:** A decrease in the size or number of cash inflows will decrease the NPV [53](#page=53). **Opportunity Cost of Capital:** This is the minimum acceptable rate of return on a project representing the return shareholders could expect by investing their money in alternative financial markets of similar risk. It is crucial for determining the discount rate used in NPV calculations [12](#page=12) [54](#page=54) [55](#page=55). **Tip:** When evaluating mutually exclusive projects, always choose the one with the highest NPV, as this maximizes the value added to the firm [58](#page=58). #### 4.1.2 Internal rate of return (IRR) The Internal Rate of Return (IRR) is the discount rate at which the Net Present Value (NPV) of a project equals zero. It represents the project's effective rate of return [54](#page=54) [57](#page=57). **Decision Rule:** * **Accept** projects where the IRR exceeds the opportunity cost of capital [59](#page=59). * **Reject** projects where the IRR is less than the opportunity cost of capital [59](#page=59). **Considerations:** * A project can have multiple IRRs if there are changes in the sign of cash flows [58](#page=58). * The IRR is most reliable when evaluating a single project with only cash inflows following the initial cash outflow [59](#page=59). * When projects are mutually exclusive, the project with the highest IRR is not always the best choice, as it may not yield the highest NPV, especially if the projects differ in size or cash flow timing [54](#page=54) [56](#page=56) [58](#page=58). #### 4.1.3 Profitability Index (PI) The Profitability Index (PI), also known as the benefit-cost ratio, is calculated as the ratio of the present value of future cash flows to the initial investment. **Formula:** $$ PI = \frac{PV \text{ of future cash flows}}{ \text{Initial Investment}} $$ or $$ PI = \frac{NPV + \text{Initial Investment}}{\text{Initial Investment}} $$ **Decision Rule:** * For independent projects, accept if PI > 1 [53](#page=53) [57](#page=57). * When evaluating mutually exclusive investments without capital rationing, the NPV method is preferred over the PI. However, if forced to choose based on PI, select the project with the higher PI [53](#page=53). **Tip:** In simple cases with hard capital rationing, the PI can be used to evaluate projects [54](#page=54). #### 4.1.4 Payback Period The payback period is the time it takes for a project's cash inflows to equal its initial investment. While simple to calculate, it ignores the time value of money and cash flows beyond the payback period. Firms using the payback rule may be biased toward rejecting projects with late cash inflows or long lives [53](#page=53). ### 4.2 Risk and capital rationing #### 4.2.1 Risk considerations * **Opportunity Cost of Capital:** This is a crucial input for NPV and IRR calculations and reflects the riskiness of the project and the firm. Higher risk generally leads to a higher opportunity cost of capital [12](#page=12) [54](#page=54) [55](#page=55). * **Real vs. Nominal Cash Flows:** Real cash flows should be discounted at a real discount rate, and nominal cash flows should be discounted at a nominal discount rate. Using the wrong combination can distort the NPV calculation [60](#page=60) [62](#page=62) [64](#page=64). * $(1 + \text{nominal rate}) = (1 + \text{real rate}) \times (1 + \text{inflation rate})$ [60](#page=60). * The approximation "real rate $\approx$ nominal rate - inflation rate" is often used [60](#page=60). #### 4.2.2 Capital rationing Capital rationing occurs when a firm has a limited amount of capital to invest. * **Soft Capital Rationing:** Imposed by management, often due to internal policies or strategies. It is costly to shareholders as it may lead to the rejection of positive NPV projects [54](#page=54) [56](#page=56). * **Hard Capital Rationing:** Imposed by the capital markets, such as limitations on borrowing capacity. [54](#page=54). When capital rationing exists, techniques like the Profitability Index or modified IRR might be more appropriate for project selection, especially for mutually exclusive projects. Selecting the project with the highest NPV is not always the correct rule when capital rationing is in place [53](#page=53) [54](#page=54). ### 4.3 Other relevant concepts #### 4.3.1 Depreciation and taxes Depreciation expense is a non-cash expense used to allocate the historical cost of an asset over its useful life. While it does not directly affect cash flow, it reduces taxable income, creating a "depreciation tax shield" which represents a cash inflow [15](#page=15) [61](#page=61) [66](#page=66). **Depreciation Tax Shield:** $$ \text{Depreciation Tax Shield} = \text{Depreciation Expense} \times \text{Tax Rate} $$ The present value of the depreciation tax shield should be included in capital budgeting analyses. Bonus depreciation and accelerated depreciation methods can increase the present value of the tax shield compared to straight-line depreciation [60](#page=60) [61](#page=61) [62](#page=62) [63](#page=63) [67](#page=67). #### 4.3.2 Working capital Changes in net working capital (NWC) are critical to capital budgeting. An increase in NWC represents a cash outflow at the beginning of a project, while its recovery at the end of the project is a cash inflow. NWC is generally recovered at the end of a project's life [60](#page=60) [63](#page=63) [64](#page=64). **Impact on NWC:** * Increase in inventory: Cash outflow [60](#page=60) [66](#page=66). * Increase in accounts receivable: Cash outflow [60](#page=60) [66](#page=66). * Increase in accounts payable: Cash inflow [60](#page=60) [66](#page=66). **Formula for NWC change:** $$ \Delta NWC = (\Delta \text{Inventory} + \Delta \text{Accounts Receivable}) - \Delta \text{Accounts Payable} $$ #### 4.3.3 Sunk costs Sunk costs are expenses that have already been incurred and cannot be recovered. They should not be included in capital budgeting decisions because they have no incremental effect on project cash flows. The statement "We've got too much invested in that project to pull out now" is an example of a sunk cost fallacy [61](#page=61) [62](#page=62) [66](#page=66) [67](#page=67). #### 4.3.4 Incremental cash flows Capital budgeting decisions should focus on incremental cash flows, which are the additional cash flows that result directly from undertaking the project. This includes considering the opportunity cost of any assets used for the project and accounting for any cannibalization of existing product sales. Allocated overhead costs should only be included if the project actually changes the total amount of overhead expenses [60](#page=60) [61](#page=61) [62](#page=62) [63](#page=63) [65](#page=65) [67](#page=67). #### 4.3.5 Investment timing The investment timing problem arises when there is a choice between investing now or postponing the investment to a future date. The optimal decision is to invest at the date that provides the highest NPV today. To justify postponing a project for one year, the NPV needs to increase over that year by a rate at least equal to the cost of capital [55](#page=55) [56](#page=56) [59](#page=59). #### 4.3.6 Sensitivity and scenario analysis These techniques help assess the impact of uncertainty on project viability. * **Sensitivity analysis** examines how the NPV changes if one key variable is altered while others remain constant. It helps identify which variables are most critical to the project's success [68](#page=68). * **Scenario analysis** involves recalculating project NPV by changing several inputs to new but consistent values, reflecting different potential future states. This is particularly useful for analyzing projects with interrelated variables [68](#page=68). --- # Risk, return, and the cost of capital This topic explores the fundamental relationship between the level of risk an investment carries and the expected return an investor should anticipate, and how this influences a firm's overall cost of capital. ### 5.1 Understanding risk and return Investment risk can be defined as the dispersion of possible returns. A wider dispersion of returns on a stock signifies a higher standard deviation. Investors are generally compensated for taking on more risk through a higher expected rate of return [73](#page=73) [74](#page=74) [75](#page=75). #### 5.1.1 Types of risk Investment risk can be broadly categorized into two main types: systematic risk and specific risk. * **Systematic risk (or market risk)**: This is risk that affects the entire market or a large number of assets. It is inherent to the overall economy and cannot be eliminated through diversification. Examples include changes in interest rates, inflation, or the business cycle. Companies exposed to the business cycle tend to have high market risk. Cyclical firms tend to have high betas because their earnings are particularly sensitive to the state of the economy [74](#page=74) [76](#page=76) [78](#page=78) [81](#page=81). * **Specific risk (or diversifiable risk, unsystematic risk)**: This is risk that affects only a single firm or a small group of firms. Risks peculiar to a single firm are called specific risks and can be progressively eliminated by adding stocks to a portfolio. Examples include a fire at a company's factory or delays in launching a new product [75](#page=75) [76](#page=76) [78](#page=78). #### 5.1.2 Portfolio diversification Diversification involves spreading investments across various assets to reduce overall risk. The major benefit of diversification is the reduction in the portfolio's total risk. As more stocks are added to a portfolio, specific risk is increasingly diversified away. Adding one more stock to a well-diversified portfolio of 15 stocks is likely to result in only a slight decrease in the portfolio's standard deviation [73](#page=73) [75](#page=75) [76](#page=76). > **Tip:** For a well-diversified investor in common stocks, market risk is the most important type of risk to consider, as specific risk can be diversified away [73](#page=73). #### 5.1.3 Measuring return The total return on an investment is composed of capital gains and any income received (like dividends) [75](#page=75) [76](#page=76). * **Nominal return**: The total return in terms of money [74](#page=74). * **Real return**: The nominal return adjusted for inflation, reflecting the actual purchasing power of the return. The actual real rate of return will be positive as long as the nominal return exceeds the inflation rate [75](#page=75) [77](#page=77). The formula for percentage return is: $$ \text{Percentage Return} = \frac{\text{Capital Gain} + \text{Dividends}}{\text{Initial Share Price}} $$ Variance is a measure of the volatility of the rates of return. Standard deviation is often reported rather than variance because it is stated in understandable percentages [76](#page=76) [77](#page=77). #### 5.1.4 Expected return in different scenarios The expected return of an investment can be calculated when different economic scenarios have associated probabilities. $$ \text{Expected Return} = \sum_{i=1}^{n} (\text{Probability}_i \times \text{Return}_i) $$ **Example:** A stock is expected to return 11% in a normal economy, 19% in a boom, and lose 8% in a recession. If the probabilities are 65% for normal, 25% for boom, and 10% for recession, the expected return is: $$ (0.65 \times 0.11) + (0.25 \times 0.19) + (0.10 \times -0.08) = 0.0715 + 0.0375 - 0.008 = 0.1010 \text{ or } 10.10\% $$ *(Note: The provided example in the document calculates this as 11.98%, which suggests a potential discrepancy in the example's calculation or interpretation.)* [77](#page=77). ### 5.2 The Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model (CAPM) is a model used to determine the expected return on an asset based on its systematic risk. The basic tenet of the CAPM is that a stock's expected risk premium should be proportionate to the stock's beta [78](#page=78) [83](#page=83). #### 5.2.1 Beta ($\beta$) Beta is a measure of a stock's sensitivity to the market portfolio's movements. It quantifies the stock's systematic risk [78](#page=78). * A beta of 1.0 indicates that the stock's price is expected to move in line with the market. The average of the betas for all stocks is exactly 1.0, as these stocks represent the market [78](#page=78) [80](#page=80). * A beta greater than 1.0 indicates an aggressive stock, which is expected to increase more than the market increases and decrease more than the market decreases. Investors with aggressive stocks will likely experience losses greater than the market decline when the market experiences a decline [78](#page=78) [82](#page=82). * A beta less than 1.0 indicates a defensive stock, which is expected to increase less than the market increases and decrease less than the market decreases. Investors with defensive stocks will likely experience positive portfolio returns less than the market's gain when the market is up [78](#page=78) [80](#page=80). * A Treasury bill has a beta of 0 as it is considered risk-free [79](#page=79). The slope of the line measuring a stock's historic returns against the market's historic returns represents the stock's beta. A positive slope means the stock has a positive beta [78](#page=78) [81](#page=81). **Formula for Beta:** The relationship between a stock's return and the market return can be approximated by: $$ E(R_i) - R_f = \beta_i \times (E(R_m) - R_f) $$ Where: * $E(R_i)$ is the expected return on asset $i$. * $R_f$ is the risk-free rate of return. * $\beta_i$ is the beta of asset $i$. * $E(R_m)$ is the expected return on the market portfolio. * $(E(R_m) - R_f)$ is the market risk premium. This can be rearranged to calculate the expected return: $$ E(R_i) = R_f + \beta_i \times (E(R_m) - R_f) $$ #### 5.2.2 The Security Market Line (SML) The Security Market Line (SML) graphically represents the CAPM. It shows the expected return for any asset given its beta. * If a security plots *above* the SML, it is offering a higher return than predicted for its level of risk, suggesting it may be underpriced (or will be temporarily) [79](#page=79) [82](#page=82). * If a security plots *below* the SML, it is offering a lower return than predicted for its level of risk, suggesting it is offering too little return to justify its risk [79](#page=79) [82](#page=82). > **Tip:** Stock market investors should ignore specific risks when calculating required rates of return because specific risks can be diversified away [79](#page=79). #### 5.2.3 The market portfolio The market portfolio is a theoretical portfolio that includes all risky assets in the world, weighted by their market value. In practice, a diversified stock market index is often used to represent the market portfolio. Macro events are reflected in the market portfolio's performance because specific risks have been diversified away [78](#page=78) [82](#page=82). ### 5.3 The Cost of Capital The cost of capital represents the required rate of return on a firm's investments. It is essentially the opportunity cost of making an investment in a particular project. #### 5.3.1 The company cost of capital The company cost of capital is the return expected on a portfolio of the company's existing securities. It serves as a benchmark discount rate that may be adjusted for the riskiness of each project [86](#page=86) [87](#page=87). The company cost of capital is an inappropriate discount rate for a capital budgeting proposal if the project has a different degree of risk from the company [83](#page=83). #### 5.3.2 The Weighted Average Cost of Capital (WACC) The Weighted Average Cost of Capital (WACC) is the average rate of return a company expects to compensate all its different investors (debt holders, preferred stockholders, and common stockholders). It is calculated using the market values of each component of the firm's capital structure. **Formula for WACC:** $$ WACC = w_d \times R_d \times (1-T) + w_p \times R_p + w_e \times R_e $$ Where: * $w_d$, $w_p$, and $w_e$ are the weights of debt, preferred stock, and common equity in the capital structure, respectively. * $R_d$ is the pre-tax cost of debt. * $T$ is the corporate tax rate. * $R_p$ is the cost of preferred stock. * $R_e$ is the cost of common equity. Market values, rather than book values, should be used when calculating WACC [89](#page=89). **Key aspects of WACC:** * **Cost of Debt:** The interest paid on debt is tax-deductible, creating a "tax shield" where taxable income is reduced by the amount of interest paid. This makes the after-tax cost of debt lower than the pre-tax cost [87](#page=87) [89](#page=89). * **Cost of Preferred Stock:** Preferred stock dividends are not tax-deductible for the issuing firm, so the cost of preferred stock is not adjusted for taxes in the WACC calculation [85](#page=85) [88](#page=88). * **Cost of Equity:** This represents the return required by the company's shareholders [89](#page=89). > **Tip:** For a firm with no corporate taxes, its WACC will be equal to the expected return on its assets, which is a blend of the expected returns on its debt and equity [89](#page=89). #### 5.3.3 WACC in capital budgeting WACC is used to determine the value of a firm by discounting its free cash flows. It serves as the discount rate for projects that have the same risk as the firm's overall operations. If a firm earns its WACC on its assets, then all investors (both bondholders and equity holders) will earn their minimum required rate of return [86](#page=86) [90](#page=90). If a proposed project has a different risk profile than the firm's average projects, a specific project cost of capital should be used instead of the company's WACC. Discounting a project's cash flows at the company cost of capital when the project's cost of capital is lower can lead to the project appearing more attractive than it should, potentially causing it to be erroneously accepted. Conversely, if the project's cost of capital is higher, using the company WACC might lead to a rejection of a good project [83](#page=83) [84](#page=84) [90](#page=90). **Example:** A firm has a WACC of 12%. A project requires an investment of $10 million and offers an annual after-tax cash flow of $1,250,000 indefinitely. The project's NPV is calculated as: $$ NPV = \text{Cash Flow} / \text{WACC} - \text{Investment} $$ $$ NPV = \$1,250,000 / 0.12 - \$10,000,000 = \$10,416,666.67 - \$10,000,000 = \$416,666.67 $$ Since the NPV is positive, and the project has the same risk as the firm's overall operations, it should be accepted [90](#page=90). --- # Working capital management and short-term financial planning Working capital management and short-term financial planning are crucial for ensuring a firm's liquidity and operational efficiency by managing current assets and liabilities effectively. ### 6.1 Understanding working capital Net working capital (NWC) is a key metric representing a company's short-term financial health and its ability to cover immediate obligations. #### 6.1.1 Definition and calculation of net working capital Net working capital is calculated as the difference between current assets and current liabilities. A positive NWC indicates that current assets exceed current liabilities, signifying greater liquidity. Conversely, a negative NWC occurs when current liabilities surpass current assets [22](#page=22). * **Formula:** $$NWC = Current \, Assets - Current \, Liabilities$$ > **Tip:** While NWC is a vital measure, it's important to note that NWC is not necessarily positive for all firms [22](#page=22). #### 6.1.2 Components of net working capital Working capital management involves the strategic oversight of various current asset and current liability accounts. * **Current Assets:** These are assets expected to be converted to cash within one year or one operating cycle, whichever is longer. Key components include: * Marketable securities [20](#page=20). * Accounts receivable [20](#page=20). * Inventories [20](#page=20). * Other current assets, including items like deferred income taxes [19](#page=19). * **Current Liabilities:** These are obligations expected to be paid within one year or one operating cycle. Key components include: * Accounts payable [20](#page=20). * Other current liabilities [19](#page=19). #### 6.1.3 Inventory management Inventory represents a significant portion of current assets and its management is critical to working capital. * Inventory management aims to balance the costs of holding inventory against the risks of stockouts. * **Carrying costs** are the expenses associated with holding inventory, such as storage, insurance, obsolescence, spoilage, and the opportunity cost of capital tied up in inventory . * **Order costs** are incurred each time an order is placed. * The **economic order quantity (EOQ)** model helps determine the optimal order size to minimize total inventory costs by balancing carrying and order costs . * **Field warehousing** is a method where inventory is held by an independent warehousing company as collateral for a loan . #### 6.1.4 Accounts receivable management Managing accounts receivable involves setting credit policies and monitoring collections to optimize cash inflows. * **Credit policy** determines whether credit should be extended to customers. Key elements include the five C's of credit: character, capacity, capital, collateral, and condition . * **Terms of trade credit**, such as "2/10, net 30," offer cash discounts for early payment and set a final due date. For example, "2/10, net 30" means a 2% discount is available if paid within 10 days; otherwise, the full amount is due in 30 days . * **Stretching payables** by a firm means delaying payments to suppliers, which can be a form of short-term financing but may incur costs like forgone discounts or damage supplier relationships . * The **break-even probability of collection** is the minimum probability of payment required for granting credit to be profitable. It is calculated as : $$Break-even \, Probability = \frac{Present \, Value \, of \, Cost}{Present \, Value \, of \, Revenue}$$ * **Aging schedules** are used to analyze the composition of accounts receivable based on the length of time outstanding, helping to identify potential collection issues . * The **receivable period** is the average number of days it takes to collect accounts receivable. #### 6.1.5 Accounts payable management Accounts payable represent a source of short-term, often interest-free, financing if managed strategically. * Firms can intentionally delay payments (stretch payables) to conserve cash, but this can have implications for supplier relationships and may lead to higher costs if discounts are forgone . * The cost of stretching payables can be significant when measured as an effective annual interest rate, especially if it involves forfeiting cash discounts . ### 6.2 Short-term financial planning Short-term financial planning, primarily through cash budgeting, is essential for managing liquidity and ensuring that a firm can meet its short-term obligations. #### 6.2.1 Cash budgets A cash budget is a forecast of a firm's expected cash inflows and outflows over a specific period. * It helps managers anticipate potential cash shortages or surpluses . * **Cash inflows** typically come from cash sales, collections from credit sales, and the sale of assets. * **Cash outflows** include payments for inventory, operating expenses, capital expenditures, interest, taxes, and dividends. * **Depreciation**, while an expense that reduces net income, is a non-cash expense and is not directly included as a cash outflow in the operating activities section of the cash flow statement. However, capital expenditures are included as uses of cash and can make budgets "lumpy" [22](#page=22). #### 6.2.2 Short-term financing strategies When cash needs exceed available sources, firms must consider various short-term financing options. * **Sources of short-term funds** can include stretching accounts payable, obtaining bank loans (e.g., revolving lines of credit), issuing commercial paper, and selling marketable securities . * **Uses of cash** are activities that deplete a firm's cash balance, such as increasing inventory, increasing accounts receivable, paying down debt, or paying dividends. Conversely, decreases in payables or increases in receivables are uses of cash, while increases in payables and decreases in receivables are sources of cash . * The **principle of matched maturities** suggests that firms should finance long-term assets with long-term debt and short-term assets with short-term debt. Violating this principle can increase financial risk . * A firm with no spare capacity often needs to increase fixed assets to expand sales . * The **sustainable rate of growth** assumes that the debt-equity ratio is held constant . #### 6.2.3 Cash flow considerations Understanding the timing of cash flows is critical for effective planning. * **Accrual accounting** recognizes revenues when earned and expenses when incurred, regardless of when cash is exchanged, to match revenues and expenses. This differs from cash accounting [20](#page=20) [22](#page=22). * The **cash cycle** measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales. It is calculated as: $$Cash \, Cycle = Inventory \, Period + Receivable \, Period - Payable \, Period$$ * When sales are projected to grow, associated costs like the cost of goods sold are also expected to grow proportionally . * Decisions regarding capital expenditures directly impact cash flows. Issuing long-term debt is a source of cash, while purchasing both long-term and short-term assets are uses of cash . > **Example:** A firm purchases $32 million of materials in January, with 40% paid on delivery and the remainder in the following month. The cash outflow in February would include the 60% of January's purchases ($32 million \times 0.60 = 19.2$ million dollars) plus any cash payments for February's purchases in February (if any). If 40% of February's purchases ($28 million) were paid on delivery, that would be $28 million \times 0.40 = 11.2$ million dollars. The total cash outflow in February would be $19.2$ million dollars + $11.2$ million dollars = $30.4$ million dollars . --- # Corporate finance and financial markets This topic delves into the fundamental aspects of corporate finance, exploring the structure of corporations, the mechanisms of financial markets, and the crucial decisions made by financial managers concerning capital structure, dividend policy, and the issuance of securities. ## 7. Corporate finance and financial markets Corporate finance is concerned with the decisions that corporations make to increase the value of the firm for their shareholders. The primary goal of corporate management should be to maximize shareholder wealth. This involves making sound investment and financing decisions [2](#page=2) [5](#page=5) [6](#page=6). ### 7.1 Corporate structure and governance A corporation is a legal entity separate from its owners. This separation of ownership and control gives corporations their permanence [2](#page=2). * **Types of business organizations:** * **Sole proprietorship:** Owned and run by one individual, with no legal distinction between the owner and the business. Agency problems are least likely in this structure as the owner bears the full cost of their actions [1](#page=1) [9](#page=9). * **Partnership:** A business owned by two or more individuals. Income tax liability is incurred by the partners individually [7](#page=7). * **Corporation:** A distinct legal entity. Profits are taxed at the corporate level and again when distributed to shareholders as dividends, leading to "double taxation". Corporations offer limited liability to their owners [1](#page=1) [2](#page=2) [3](#page=3) [7](#page=7) [8](#page=8). * **Closely held corporation:** A corporation with only a few shareholders. A common problem is the lack of access to substantial amounts of capital [2](#page=2) [8](#page=8). * **Public company:** A corporation whose stock is publicly traded [3](#page=3). * **Limited liability partnership (LLP) / Limited liability company (LLC):** These structures can offer limited liability to the firm while allowing professionals within the firm to be sued personally in some cases [7](#page=7). * **Corporate governance:** * **Board of Directors:** Elected by shareholders to represent their interests. They should provide support to top management under all circumstances [3](#page=3) [4](#page=4). * **Agency problems:** Arise from conflicts of interest between managers and owners. They can be reduced through compensation packages aligning manager and shareholder goals and good corporate governance. Lavish spending on expense accounts and plush executive suites are examples of agency problems [8](#page=8) [9](#page=9). * **Managerial compensation:** Compensation plans tied to firm value or company shares can help align manager and shareholder interests. However, incentive plans focused on quarterly profitability can lead to a focus on short-term, rather than long-term, profits [5](#page=5) [6](#page=6). * **Stakeholders:** Include government, customers, competitors, and employees [9](#page=9). ### 7.2 Financial management responsibilities Financial managers are responsible for making decisions that maximize firm value [2](#page=2). * **Controller:** Primarily responsible for financial statements, cost monitoring, and internal auditing [4](#page=4). * **Treasurer:** Responsible for managing cash, banking relationships, and raising capital [4](#page=4) [5](#page=5). * **Chief Financial Officer (CFO):** Typically supervises both the treasurer and controller [4](#page=4). * **Financial analyst:** Involved in monitoring risk and analyzing investment projects, but not typically purchasing assets [5](#page=5). ### 7.3 Financial decisions Financial managers make decisions in three key areas: * **Capital budgeting decisions:** Decisions about long-term investments, such as whether to buy a new machine or repair an old one. The goal is to maximize the value added to the firm [1](#page=1) [4](#page=4). * **Financing decisions:** Decisions about how to raise capital, such as choosing between issuing stock or debt [1](#page=1) [7](#page=7). * **Working capital management:** Short-term decisions related to managing current assets and liabilities to ensure the firm has sufficient liquidity to meet its obligations [6](#page=6). ### 7.4 Financial markets and institutions Financial markets provide a platform for trading financial assets [10](#page=10). * **Functions of financial markets:** * Provide pricing information [10](#page=10). * Provide liquidity [10](#page=10). * Reduce risk through diversification [10](#page=10). * Facilitate the flow of funds to companies [10](#page=10). * **Primary vs. Secondary Markets:** * **Primary market:** Where securities are initially issued. Firms rely on the primary market for new stock issues [12](#page=12) [13](#page=13). * **Secondary market:** Where existing securities are traded. When Patricia sells her General Motors stock to Brian, GM receives nothing from the transaction [12](#page=12) [13](#page=13). * **Money Markets:** Deal with short-term debt instruments. Commercial paper is a money market security [11](#page=11) [13](#page=13). * **Capital Markets:** Deal with long-term debt and equity securities [13](#page=13). * **Over-the-counter (OTC) market:** Corporate debt instruments are most commonly traded here. NASDAQ is an example of an OTC market [13](#page=13) [9](#page=9). * **Financial Institutions:** Intermediaries that pool and invest savings [11](#page=11). * **Investment banks:** Help companies sell their securities to investors. They do not accept deposits [12](#page=12) [1](#page=1). * **Mutual funds:** Pool savings and offer professional management and diversification. They raise money by selling shares to investors and shareholders may want to redeem shares at any time, making liquidity important [10](#page=10) [11](#page=11). * **Commercial banks:** Collect deposits and relend cash [1](#page=1). * **Insurance companies:** Major holders of corporate bonds [11](#page=11). * **Securities:** Financial assets representing claims on income. A mortgage loan held by a bank is not considered a security [3](#page=3) [4](#page=4). * **Liquidity:** The ease and cost with which an asset can be converted to cash. Real estate is typically less liquid than bank deposits or Treasury bonds [12](#page=12) [26](#page=26). ### 7.5 Accounting and finance Understanding accounting is crucial for financial analysis and decision-making. * **Balance Sheet:** A snapshot of a firm's assets, liabilities, and equity at a specific point in time. Assets are generally listed in order of decreasing liquidity [20](#page=20) [23](#page=23). * **Book value:** The historical cost of an asset less accumulated depreciation. * **Market value:** The current price at which an asset can be sold. Market values reflect investors' expectations [21](#page=21). * **Goodwill:** An intangible asset arising from past acquisitions [16](#page=16). * **Net working capital (NWC):** Current assets minus current liabilities, measuring a company's short-term financial health [19](#page=19) [22](#page=22). * **Income Statement:** Reports a firm's financial performance over a period [60](#page=60). * **Depreciation:** An expense that allocates the historical cost of an asset over its life, reducing book value but not cash flow directly. It reduces taxable income creating a depreciation tax shield [15](#page=15) [17](#page=17) [20](#page=20) [61](#page=61). * **EBIT (Earnings Before Interest and Taxes):** Calculated by subtracting cost of goods sold and operating expenses from revenue [18](#page=18) [21](#page=21). * **Net Income:** Calculated after deducting all expenses, including interest and taxes [17](#page=17) [19](#page=19). * **Statement of Cash Flows:** Tracks the cash generated and used by a firm over a period, categorized into operating, investing, and financing activities [18](#page=18) [19](#page=19). * **Free Cash Flow:** Cash available after all expenses and investments in fixed assets and working capital. It can be used for debt repayment, dividends, or share repurchases [16](#page=16) [17](#page=17). * **Accrual Accounting:** Records revenues when earned and expenses when incurred, regardless of when cash is exchanged. This aims to match revenues with expenses for better profitability reporting [18](#page=18) [20](#page=20) [22](#page=22). * **Taxation:** Corporate profits are subject to corporate tax, and dividends paid to shareholders are taxed again at the personal level (double taxation). Interest expense is tax-deductible, creating a tax shield [87](#page=87) [8](#page=8) [91](#page=91). ### 7.6 Valuing bonds Bonds are debt securities that pay periodic interest (coupon payments) and return the principal at maturity [41](#page=41). * **Bond Pricing:** The price of a bond is the present value of its future cash flows (coupon payments and principal) discounted at the market yield to maturity [41](#page=41) [43](#page=43). * If market interest rates are lower than the coupon rate, the bond sells at a premium [41](#page=41). * If market interest rates are higher than the coupon rate, the bond sells at a discount [44](#page=44). * **Yield to Maturity (YTM):** The total return anticipated on a bond if it is held until it matures. It accounts for current yield and any price changes [41](#page=41). * **Bond Yield Components:** Include the real rate of return, inflation premium, default premium, and maturity premium [41](#page=41). * **Bond Ratings:** Agencies like Moody's rate bonds based on credit quality, influencing their yields. Lower ratings (e.g., Ba, CCC) imply higher risk and thus higher yields [43](#page=43) [44](#page=44). * **Convertible Bonds:** Can be converted into a specified number of shares of common stock [43](#page=43). * **Callable Bonds:** Give the issuer the right to redeem the bond before its maturity date, typically when interest rates have fallen significantly [43](#page=43) [52](#page=52). * **Yield Curve:** Depicts the relationship between bond yields and their maturities. An upward-sloping yield curve indicates that longer-maturity bonds yield more than shorter-maturity bonds [42](#page=42) [43](#page=43). ### 7.7 Valuing stocks The value of a stock is the present value of its expected future cash flows, typically dividends and capital gains [45](#page=45). * **Dividend Discount Models (DDM):** * **Constant Growth DDM:** Assumes dividends grow at a constant rate. The required return on equity comprises the dividend yield and the capital gains yield. The sustainable growth rate is the rate at which a firm can grow using only internal financing [46](#page=46) [47](#page=47). * **Required return:** $r = \frac{D_1}{P_0} + g$ [47](#page=47). * $r$: required return * $D_1$: expected dividend next year * $P_0$: current stock price * $g$: constant growth rate of dividends * **Price-to-Earnings (P/E) Ratio:** Indicates how much investors are willing to pay for each dollar of earnings. High P/E ratios often suggest expectations of higher growth opportunities [48](#page=48). * **Present Value of Growth Opportunities (PVGO):** Represents the value derived from a firm's investment opportunities with superior returns [46](#page=46). * **Market Efficiency:** Suggests that security prices reflect all available information [48](#page=48). * **Weak-form efficiency:** Prices reflect past price information. * **Semi-strong form efficiency:** Prices reflect all publicly available information [48](#page=48). * **Strong-form efficiency:** Prices reflect all information, including private (insider) information [45](#page=45). * **Random Walk Theory:** Suggests that future price movements are unpredictable based on past price changes [46](#page=46). * **Liquidation Value:** The amount realized from selling all assets and paying off creditors [47](#page=47). ### 7.8 Risk, return, and opportunity cost of capital Understanding risk and return is fundamental to financial decision-making. * **Risk:** The dispersion of possible returns [75](#page=75). * **Specific Risk (Unsystematic Risk):** Risks that affect only a single firm or industry and can be diversified away by holding a portfolio of assets [75](#page=75) [76](#page=76). * **Market Risk (Systematic Risk):** Risks that affect the entire market and cannot be diversified away [73](#page=73) [75](#page=75). * **Return:** The gain or loss on an investment over a period, including capital gains and dividends [76](#page=76). * **Risk Premium:** The additional return expected for bearing risk above the risk-free rate. It is typically proportional to beta [75](#page=75) [78](#page=78). * **Diversification:** The process of reducing risk by holding a portfolio of different assets. As more stocks are added to a portfolio, specific risk is diversified away [73](#page=73) [74](#page=74) [75](#page=75). * **Capital Asset Pricing Model (CAPM):** A model that relates the expected return of an asset to its systematic risk (beta) [78](#page=78) [83](#page=83). * Expected return: $E(R_i) = R_f + \beta_i (E(R_m) - R_f)$ * $E(R_i)$: Expected return on asset $i$ * $R_f$: Risk-free rate of return (e.g., Treasury bills) [74](#page=74). * $\beta_i$: Beta of asset $i$ [78](#page=78). * $E(R_m)$: Expected market return [78](#page=78). * $(E(R_m) - R_f)$: Market risk premium [79](#page=79). * **Beta ($\beta$):** A measure of a stock's sensitivity to market movements. A beta greater than 1.0 indicates an aggressive stock that is expected to move more than the market. A beta of 1.0 signifies that the stock's movements are expected to mirror the market. A beta of 0 typically represents the risk-free rate [78](#page=78) [79](#page=79) [80](#page=80). * **Security Market Line (SML):** The graphical representation of the CAPM. Securities plotting below the SML are considered underpriced (offering too little return for their risk), while those above are overpriced [79](#page=79). ### 7.9 Capital Budgeting Techniques These techniques help evaluate investment projects: * **Net Present Value (NPV):** The difference between the present value of future cash inflows and the initial investment cost. A positive NPV indicates an acceptable project. NPV decreases as the discount rate increases [53](#page=53) [55](#page=55) [57](#page=57). * **Internal Rate of Return (IRR):** The discount rate at which a project's NPV equals zero. Projects with an IRR greater than the cost of capital are generally acceptable. Projects can have multiple IRRs if cash flows change sign multiple times [55](#page=55) [57](#page=57) [58](#page=58) [59](#page=59). * **Payback Period:** The time required for a project's cumulative cash inflows to equal its initial investment. It may bias decisions against projects with later cash inflows [53](#page=53). * **Profitability Index (PI):** The ratio of the present value of future cash inflows to the initial investment. A PI greater than 1 indicates an acceptable project [56](#page=56) [57](#page=57). * **Equivalent Annual Cost (EAC):** Used to compare mutually exclusive projects with different lives by converting their NPVs into an equivalent annual cost [56](#page=56). * **Sensitivity Analysis:** Examines how changes in a single variable affect a project's NPV or other metrics [68](#page=68) [69](#page=69). * **Scenario Analysis:** Analyzes project outcomes under different combinations of assumptions for key variables [68](#page=68). * **Break-Even Analysis:** Determines the sales level at which a project's profit is zero (accounting break-even) [69](#page=69) [70](#page=70). ### 7.10 Financing and Payout Policy * **Capital Structure:** The mix of long-term debt and equity financing a firm uses [2](#page=2) [8](#page=8). * **MM Propositions:** * **Proposition I (no taxes):** Firm value is unaffected by capital structure . * **Proposition I (with taxes):** Firm value increases with leverage due to the interest tax shield . * **Proposition II (no taxes):** The expected return on equity increases linearly with leverage . * **Proposition II (with taxes):** The cost of equity increases with leverage, but the WACC decreases due to the tax shield . * **Trade-off Theory:** Firms balance the tax benefits of debt against the costs of financial distress . * **Pecking-Order Theory:** Firms prefer internal financing, then debt, then equity due to information asymmetry . * **Weighted Average Cost of Capital (WACC):** The average cost of all sources of capital, weighted by their market values. It is the appropriate discount rate for projects with average firm risk [74](#page=74) [83](#page=83) [85](#page=85) [86](#page=86) [88](#page=88). * **Payout Policy:** Decisions on how to distribute earnings to shareholders. * **Dividends:** Cash payments to shareholders. Dividend changes are often interpreted as signals of future earnings. Managers tend to smooth dividends, increasing them only when sustainable. The stock price typically drops on the ex-dividend date by the amount of the dividend . * **Stock Repurchases:** Companies buying back their own shares. This can be a signal that the firm's shares are underpriced. It reduces the number of outstanding shares and can increase EPS . * **Stock Dividends:** Issuing additional shares to existing shareholders, usually expressed as a percentage of current holdings. This does not change the firm's value or the shareholder's proportionate ownership . ### 7.9 Mergers, Acquisitions, and Corporate Control These activities involve changing the ownership and structure of firms. * **Types of Mergers:** * **Horizontal:** Between firms in the same industry . * **Vertical:** Between firms at different stages of the production process . * **Conglomerate:** Between firms in unrelated industries . * **Motivations for Mergers:** Economies of scale, synergies, diversification (though often less effective for investors), access to distribution channels, and reducing free cash flow misuse . * **Financing Mergers:** Can be done with cash or stock. Stock financing can mitigate the effects of overvaluation of the target firm . * **Corporate Control Mechanisms:** Methods used to change management or influence corporate decisions. * **Takeovers:** Acquisitions where control changes hands . * **Leveraged Buyouts (LBOs):** Acquisitions financed heavily with debt, often taking the firm private . * **Proxy Fights:** Shareholder efforts to gain votes to oust management . * **Tender Offer:** A public offer to buy shares from existing stockholders to gain control . * **Poison Pills/Shark Repellents:** Defensive measures to make a firm less appealing to potential acquirers . ### 7.10 International Financial Management This area deals with financial decisions in a global context. * **Exchange Rates:** The price of one currency in terms of another . * **Spot Rate:** The exchange rate for immediate delivery . * **Forward Rate:** The exchange rate agreed upon today for future delivery. Hedging exchange risk involves using forward contracts . * **Direct Quote:** States how many units of the domestic currency are needed to buy one unit of foreign currency (e.g., USD1.35 = EUR1) . * **Indirect Quote:** States how many units of foreign currency can be bought with one unit of domestic currency (e.g., EUR0.74 = USD1) . * **Theories of Exchange Rate Determination:** * **Purchasing Power Parity (PPP):** Exchange rates adjust to equalize the prices of goods across countries, reflecting differences in inflation rates. If US prices rise less than Canadian prices, the US dollar is expected to depreciate against the Canadian dollar . * **International Fisher Effect:** Differences in nominal interest rates reflect differences in expected inflation rates . * **Hedging Exchange Risk:** Strategies to protect against adverse currency fluctuations. * **Forward Contracts:** Lock in a future exchange rate . * **Currency Swaps:** Exchange principal and interest payments in different currencies . * **Political Risk:** Risks associated with operating in foreign countries due to political factors. It can be hedged by borrowing in the host country or adjusting discount rates/cash flows . ### 7.11 Options Options are contracts giving the holder the right, but not the obligation, to buy or sell an asset at a specified price by a certain date. * **Call Option:** Gives the holder the right to buy an asset. Its value at expiration is the maximum of zero or the stock price minus the exercise price. The buyer profits when the stock price exceeds the exercise price plus the option premium . * **Put Option:** Gives the holder the right to sell an asset. Its value at expiration is the maximum of zero or the exercise price minus the stock price . * **Option Valuation:** Factors influencing option value include stock price, exercise price, time to expiration, interest rates, and stock price volatility. Increases in interest rates reduce call option values by decreasing the present value of the exercise price . * **Convertible Bonds:** Bonds that can be converted into a fixed number of common shares. Their value is the greater of the straight bond value or the conversion value . * **Warrants:** Similar to call options, often attached to bonds as a "sweetener" to increase the bond's attractiveness . * **Callable Bonds:** Bonds that the issuer can redeem before maturity, typically when interest rates fall. Their value is the straight bond value minus the value of the issuer's call option . * **Put-Call Parity:** A relationship between the prices of a stock, a call option, a put option, and the present value of the exercise price . * **Real Options:** Options embedded in real assets, such as the option to expand, abandon, or delay an investment . ### 7.12 Risk Management and Derivatives Derivative contracts (forwards, futures, swaps, options) are used to manage financial risks. * **Futures Contracts:** Standardized agreements to buy or sell an asset at a specified price on a future date. They are traded on exchanges and are marked-to-market daily, meaning profits and losses are settled daily . * **Forward Contracts:** Customized agreements to buy or sell an asset at a specified price on a future date. They are over-the-counter and not marked-to-market daily . * **Hedging:** Using derivatives to reduce or offset specific risks . * A producer worried about future price decreases can hedge by selling a futures contract or buying a put option . * A buyer worried about future price increases can hedge by buying a futures contract or a call option . * **Swaps:** Agreements to exchange cash flows based on different financial instruments (e.g., interest rate swaps, currency swaps) . * **Speculators:** Participants who take positions in derivatives to profit from anticipated price changes, increasing market liquidity but also risk . * **Mark-to-Market:** The process of updating futures contract values daily to reflect current market prices, settling profits or losses . --- # Derivatives and risk management Financial derivatives are instruments whose value is derived from an underlying asset, and they play a crucial role in managing various financial risks. ### 8.1 Financial derivatives Derivatives can be broadly categorized into forwards, futures, options, and swaps. #### 8.1.1 Forwards and futures **Forwards** are customized agreements between two parties to buy or sell an asset at a specified price on a future date. They are traded over-the-counter (OTC) and are not standardized. The buyer of a forward contract agrees to purchase the product at a later date at a price set today. A key characteristic of forward contracts is that future transactions are conducted at a price agreed upon earlier . **Futures contracts** are standardized agreements traded on organized exchanges. Unlike forwards, futures are marked to market daily, meaning profits and losses are settled each day. This daily settlement is similar to closing the current position and opening a new one daily. In financial futures markets, a major use is protection from interest rate risk. When a futures contract reaches expiration, the futures price approaches the spot price of the asset. At expiration, the futures price will be equal to the spot price of the asset . * **Speculators** invest in derivatives to increase risk for potential profit betting on price changes . * **Hedgers** use derivatives to reduce risk. For example, a farmer concerned about declining prices can hedge by selling a futures contract. Similarly, a clothes producer can hedge future cotton purchases by buying cotton futures . > **Tip:** The buyer of a futures contract has an obligation to purchase, not a choice, unlike an option buyer . > **Example:** If a farmer shorts 2 futures contracts for wheat at 550 cents per bushel and at expiration the spot and futures prices are both 510 cents, the farmer's total proceeds after closing the contract and selling the wheat will be USD 51,000, reflecting a gain on the futures contracts which offsets the lower cash market price . #### 8.1.2 Options Options provide the holder with the right, but not the obligation, to buy or sell an underlying asset at a specified price (the exercise price) on or before a certain date [151-158](#page=151-158). * **Call options:** Give the holder the right to buy the underlying asset. * The value of a call option at expiration is the maximum of zero or the stock price minus the exercise price . * The profit potential for the owner of a call option is unlimited . * The writer (seller) of a call option hopes the stock price will decrease . * The maximum an investor can lose if they sell a call option is unlimited . * The value of a call option increases as the stock price moves farther above the exercise price . * An increase in the exercise price or interest rates will reduce the value of a call option . * The present value of the exercise price being reduced explains why the value of a call option increases as interest rates increase . * **Put options:** Give the holder the right to sell the underlying asset. * The maximum possible payoff to the owner of a put option is theoretically unlimited, but in practice it's the exercise price minus the stock price . * The value of a put at expiration is the maximum of zero or the exercise price minus the stock price . * The buyer of a put option needs to fulfill her obligation when the stock price has declined below the exercise price . * An investor who sells a put option profits if stock prices go up . * Selling a put option results in a maximum payoff of the maximum of the exercise price minus the stock price or zero . > **Tip:** The payoffs from investing in an option contract are structured so that the seller's gain is the buyer's loss . > **Example:** If you pay $4 for a call option with an exercise price of $20, and exercise it when the stock is $26, your net profit is $2 ($26 - $20 - USD 4) . #### 8.1.3 Convertible bonds and warrants **Convertible bonds** are debt instruments that can be converted into a predetermined number of shares of the issuing company's stock. They can be viewed as a straight bond with an embedded call option owned by the bondholder. The value of a convertible bond is the greater of its straight bond value or its conversion value . **Warrants** are similar to call options, often issued by corporations attached to bonds as a "sweetener" to increase the bond's attractiveness. They essentially give the holder a call option on the firm's equity . > **Example:** A $1,000 convertible bond has a conversion ratio of 50. If the firm's equity is selling for $22 per share, the bond should trade for at least $1,100 ($22 * 50) . #### 8.1.4 Swaps Swaps are derivative contracts where two parties agree to exchange streams of cash flows over a period of time . * **Currency swaps:** Used to effectively transform loans originated in one currency to a different currency. Two borrowers in a currency swap agree to make payments to each other in a different currency. For instance, Zeta Corp. might borrow dollars in the U.S. for better terms, exchange them for francs, and arrange a currency swap to obtain francs for its operations . * **Interest rate swaps:** Involve exchanging fixed-rate interest payments for variable-rate payments, or vice versa. A bond investor worried about interest rate fluctuations might enter into a swap to pay a fixed rate and receive a floating rate . > **Example:** Big Corp. borrows $1 million at a fixed rate of 7% (which is $70,000 per year) and swaps this loan for a SOFR + 1% loan, with SOFR at 2%. The company will receive SOFR (2% of $1 million = $20,000) + 1% ($10,000) from the bank at the annual settlement, resulting in a net receipt of $30,000 ($70,000 - ($20,000 + USD 10,000)) . ### 8.2 Risk management applications Derivatives are primarily used for risk management, allowing individuals and corporations to hedge against adverse price movements. #### 8.2.1 Hedging strategies Hedging involves taking an offsetting position to reduce the risk of an existing position . * **Operational hedging:** Involves actions like manufacturing goods in the country where they will be sold to align production with sales locations, thereby mitigating currency or political risks . * **Futures for hedging:** A farmer can hedge the risk of downward price movements by selling a futures contract. A commodity producer worried about future prices can best hedge by selling a futures contract . * **Options for hedging:** Buying a put option can protect against downside risk. For instance, to protect from downside risk, an investor can buy the stock and buy a put option. A producer wishing to be protected from future price decreases while benefiting from increases would buy a put option . > **Tip:** A sensible corporate risk strategy involves identifying major risks, determining if the company is paid for taking these risks, and assessing if the probability of a bad outcome can be reduced. Spotting mispriced derivative contracts is not a primary strategic question . > **Example:** A firm worried about upward movements in raw material prices can reduce this risk by selling a futures contract . #### 8.2.2 Speculation Speculators use derivatives to profit from anticipated price movements, thereby increasing their exposure to risk. They do not have an offsetting position in the underlying commodity . #### 8.2.3 Real options Real options are options on real assets, such as the option to abandon a project or expand operations. They are often implicit rather than explicit contracts. An example of a real option is having flexibility during negotiations for a new stadium . > **Example:** If oil prices rise, a company having the option to switch to using gas is an example of a real option, whereas replacing an aging machine tool is not . #### 8.2.4 Other derivative concepts * **Option premium:** The price paid by the buyer to the seller of an option is called the option premium . * **Marking to market:** This process in futures contracts means profits or losses are settled daily. It is similar to closing and opening a position daily . * **Callable bonds:** The value of a callable bond equals the value of a straight bond minus the value of the issuer's call option. An investor in a callable bond does not own the call option; the issuer does . * **Put-call parity:** This relationship links the prices of European put options, call options, the underlying stock, and the present value of the exercise price . > **Tip:** Hedging is not always a zero-sum game and can add value by reducing the costs of financial distress. However, transactions to reduce risk are unlikely to add value if investors can easily undertake similar transactions . --- # Time value of money and compound interest The time value of money is a fundamental financial concept that states that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This chapter explores how to calculate the value of money across different time periods, considering the impact of interest rates and compounding [32](#page=32) [33](#page=33). ### 9.1 Core concepts #### 9.1.1 Present value (PV) The present value represents the current worth of a future sum of money or stream of cash flows, given a specified rate of return. It is calculated by discounting future cash flows back to the present using a discount rate [34](#page=34). **Formula for Present Value of a Single Sum:** $$ PV = \frac{FV}{(1+r)^t} $$ Where: * $PV$ = Present Value * $FV$ = Future Value * $r$ = discount rate per period * $t$ = number of periods **Example:** What is the present value of USD 10,000 to be received in 4 years, with a discount rate of 8%? $PV = \frac{\$10,000}{(1+0.08)^4} = \$7,350.27$ [32](#page=32). **Example:** What is the present value of your trust fund if you have projected that it will provide you with USD 50,000 7 years from today and it earns 10% compounded annually? $PV = \frac{\$50,000}{(1+0.10)^7} = \$25,657.91$ [34](#page=34). #### 9.1.2 Future value (FV) The future value is the value of a current asset at a specified date in the future on the assumption that it will grow at a certain rate of interest [36](#page=36). **Formula for Future Value of a Single Sum:** $$ FV = PV(1+r)^t $$ Where: * $FV$ = Future Value * $PV$ = Present Value * $r$ = interest rate per period * $t$ = number of periods **Example:** What will be the value of an investment of USD 100 at the end of 3 years, earning 2.5% interest per quarter? $FV = \$100(1+0.025)^{(3 \times 4)} = \$100(1.025)^{12} = \$134.49 USD [36](#page=36). **Example:** What is the future value of USD 10,000 on deposit for 2 years at 6% simple interest? $FV = \$10,000 + (\$10,000 \times 0.06 \times 2) = \$11,200 USD [39](#page=39). #### 9.1.3 Compound interest Compound interest is the interest earned on both the initial principal and the accumulated interest from previous periods. This leads to exponential growth of the investment over time [35](#page=35). **Key Principle:** The more frequent the compounding period, the higher the effective annual interest rate. If interest is paid $m$ times per year, the per-period interest rate equals the annual percentage rate (APR) divided by $m$ [38](#page=38) [39](#page=39). #### 9.1.4 Annuities An annuity is a series of equal cash payments made at regular intervals for a specified period [33](#page=33). * **Ordinary Annuity:** Payments occur at the end of each period [33](#page=33). * **Annuity Due:** Payments occur at the beginning of each period. The future value of an annuity due is greater than that of a similar ordinary annuity because each payment has one extra period to earn interest [33](#page=33). **Formula for Future Value of an Ordinary Annuity:** $$ FV_A = C \times \left[ \frac{(1+r)^t - 1}{r} \right $$ Where: * $FV_A$ = Future Value of the Annuity * $C$ = Cash payment per period * $r$ = interest rate per period * $t$ = number of periods **Formula for Present Value of an Ordinary Annuity:** $$ PV_A = C \times \left[ \frac{1 - (1+r)^{-t}}{r} \right $$ Where: * $PV_A$ = Present Value of the Annuity * $C$ = Cash payment per period * $r$ = discount rate per period * $t$ = number of periods **Example:** What is the present value of the following payment stream, discounted at 8% annually: $1,000 at the end of year 1, $2,000 at the end of year 2, and USD 3,000 at the end of year 3? $PV = \frac{\$1,000}{1.08} + \frac{\$2,000}{(1.08)^2} + \frac{\$3,000}{(1.08)^3} = \$925.93 + \$1,714.68 + \$2,383.78 = \$5,024.39 USD [37](#page=37). **Example:** How much do you need when you retire to provide a USD 2,500 monthly check that will last for 25 years? Assume that your savings can earn 0.5% a month. $PV_A = \$2,500 \times \left[ \frac{1 - (1+0.005)^{-(25 \times 12)}}{0.005} \right = \$2,500 \times \left[ \frac{1 - (1.005)^{-300}}{0.005} \right = \$2,500 \times 165.7802 = \$414,450.50$ [38](#page=38). **Example:** What will be the monthly payment on a USD 75,000 30-year home mortgage at 1% interest per month? Using the ordinary annuity present value formula solved for C: $C = \frac{PV_A \times r}{1 - (1+r)^{-t}} = \frac{\$75,000 \times 0.01}{1 - (1+0.01)^{-(30 \times 12)}} = \frac{\$750}{1 - (1.01)^{-360}} = \frac{\$750}{1 - 0.03019} = \frac{\$750}{0.96981} = \$773.35 USD [32](#page=32). #### 9.1.5 Perpetuities A perpetuity is a stream of equal cash payments that continues indefinitely [33](#page=33). **Formula for Present Value of a Perpetuity:** $$ PV = \frac{C}{r} $$ Where: * $PV$ = Present Value of the Perpetuity * $C$ = Cash payment per period * $r$ = discount rate per period **Example:** An investment offers to pay USD 100 a year forever starting at the end of year 6. If the interest rate is 8%, what is the investment’s value today? The value of the perpetuity at the end of year 5 is $C/r = \$100/0.08 = \$1,250$. The present value today is then $PV = \frac{\$1,250}{(1.08)^5} = \$850.73$ [37](#page=37). ### 9.2 Interest Rates and Compounding #### 9.2.1 Nominal vs. Effective Interest Rates * **Nominal Interest Rate (APR):** The stated interest rate before taking into account compounding [33](#page=33) [38](#page=38). * **Effective Annual Interest Rate (EAR):** The actual interest rate earned or paid on an investment or loan after considering the effect of compounding. The EAR is higher than the APR when compounding occurs more than once a year [33](#page=33). **Formula for Effective Annual Interest Rate:** $$ EAR = \left(1 + \frac{APR}{m}\right)^m - 1 $$ Where: * $APR$ = Annual Percentage Rate * $m$ = number of compounding periods per year **Example:** Would a depositor prefer an APR of 8% with monthly compounding or an APR of 8.5% with semiannual compounding? * 8% APR compounded monthly: $EAR = (1 + \frac{0.08}{12})^{12} - 1 = (1.006667)^{12} - 1 \approx 0.0830$ or 8.30%. * 8.5% APR compounded semiannually: $EAR = (1 + \frac{0.085}{2})^{2} - 1 = (1.0425)^{2} - 1 \approx 0.0876$ or 8.76%. The depositor would prefer 8.5% with semiannual compounding [34](#page=34). #### 9.2.2 Real vs. Nominal Rates * **Nominal Rate:** The stated rate of return before accounting for inflation [35](#page=35). * **Real Rate of Return:** The rate of return after accounting for the effects of inflation [35](#page=35). **Formula for Real Rate of Interest (Fisher Equation):** $$ (1 + \text{Nominal Rate}) = (1 + \text{Real Rate}) \times (1 + \text{Inflation Rate}) $$ Or, approximated as: $$ \text{Nominal Rate} \approx \text{Real Rate} + \text{Inflation Rate} $$ $$ \text{Real Rate} \approx \frac{1 + \text{Nominal Rate}}{1 + \text{Inflation Rate}} - 1 $$ **Example:** What is the expected real rate of interest for an account that offers a 12% nominal rate of return when the rate of inflation is 6% annually? Real Rate $= \frac{1.12}{1.06} - 1 = 1.0566 - 1 = 0.0566$ or 5.66% [35](#page=35). **Example:** What is the minimum nominal rate of return that you should accept if you require a 4% real rate of return and the rate of inflation is expected to average 3.5% during the investment period? Nominal Rate $= (1.04 \times 1.035) - 1 = 1.0764 - 1 = 0.0764$ or 7.64% [36](#page=36). #### 9.2.3 Discount Factors A discount factor is the reciprocal of $(1+r)^t$, used to calculate the present value of a future cash flow [34](#page=34). **Formula for Discount Factor:** $$ DF = \frac{1}{(1+r)^t} $$ **Example:** What is the discount factor for USD 1 to be received in 5 years at a discount rate of 8%? $DF = \frac{1}{(1+0.08)^5} = \frac{1}{1.469328} \approx 0.6806$ [39](#page=39). > **Tip:** A higher discount rate or fewer time periods will result in a lower present value. Conversely, decreasing the interest rate will increase the present value of an annuity, other things being equal [38](#page=38). ### 9.3 Loan Amortization #### 9.3.1 Amortizing Loans An amortizing loan is one where the principal balance is reduced with each payment. The portion of each payment applied to principal increases with each succeeding payment, while the portion applied to interest decreases [33](#page=33) [37](#page=37). **Example:** USD 50,000 is borrowed, to be repaid in three equal, annual payments with 10% interest. Approximately how much principal is amortized with the first payment? First, calculate the annual payment: $C = \frac{\$50,000 \times 0.10}{1 - (1+0.10)^{-3}} = \frac{\$5,000}{1 - (1.1)^{-3}} = \frac{\$5,000}{1 - 0.75131} = \frac{\$5,000}{0.24869} = \$20,105.74 USD. Interest in the first year is $\$50,000 \times 0.10 = \$5,000$. Principal amortized = Annual Payment - Interest = $\$20,105.74 - \$5,000 = \$15,105.74 USD [35](#page=35). ### 9.4 Important Considerations #### 9.4.1 Comparing Cash Flows Cash flows occurring in different periods should not be compared unless they have been discounted to a common date. This ensures an apples-to-apples comparison by accounting for the time value of money [33](#page=33). #### 9.4.2 Real Cost of Purchasing a Home If mortgage payments are fixed in nominal terms and inflation exists, the real cost of purchasing a home decreases over time. This is because the fixed nominal payment becomes worth less in real terms as the general price level rises [39](#page=39). #### 9.4.3 "Free" Credit When a dealer offers "free" credit, the stated price without credit is typically lower than the total payments made with the credit offer. The difference in cost reflects the implicit interest rate being charged for the credit [36](#page=36). #### 9.4.4 APR vs. Effective Annual Rate The Annual Percentage Rate (APR) must be equal to the effective annual rate when compounding occurs annually. For loans requiring monthly payments, the APR is generally lower than the annually compounded rate because it does not account for the effect of intra-year compounding on the actual return [34](#page=34) [38](#page=38). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Agency Problems | Conflicts of interest that arise between managers (agents) and owners (principals) due to differing incentives and information asymmetry. | | Board of Directors | A group elected by shareholders to represent their interests and oversee the management of a corporation. They are responsible for major corporate decisions and ensuring that management acts in the best interests of the shareholders. | | Capital Budgeting Decision | A decision regarding the acquisition or disposal of long-term assets, typically involving significant investment and long-term consequences for the firm's profitability and growth. | | Capital Structure | The specific mix of debt and equity a company uses to finance its operations and investments. It represents how a firm obtains its long-term sources of funding. | | Chief Financial Officer (CFO) | The senior executive responsible for managing the financial actions of a company, including financial planning, risk management, record-keeping, and financial reporting. The CFO typically supervises both the treasurer and the controller. | | Closely Held Corporation | A corporation where a small number of shareholders own all or a significant portion of the company's stock. Often, management and ownership are not separated. | | Corporate Governance | The system of rules, practices, and processes by which a company is directed and controlled. It involves balancing the interests of a company's many stakeholders, such as shareholders, senior management, customers, suppliers, financiers, government, and the community. | | Corporate Goals | The primary objectives that corporate management aims to achieve, such as maximizing shareholder wealth, increasing profitability, or expanding market share. The most appropriate goal is generally considered to be maximizing the market value of the company's shares. | | Controller | A financial manager primarily responsible for accounting operations, including financial reporting, internal auditing, and tax preparation. | | Double Taxation | A tax characteristic of corporations where profits are taxed first at the corporate level, and then again at the individual shareholder level when dividends are distributed. | | Financial Asset | An intangible asset whose value is derived from a contractual claim, such as stocks, bonds, bank deposits, and mutual funds. It is a claim on the income generating real assets of an entity. | | Financial Manager | An individual responsible for managing the financial activities of a firm, including investment decisions, financing decisions, and working capital management. Their primary duty is to act in the best interests of the firm's shareholders. | | Financial Markets | A broad term encompassing any marketplace where buyers and sellers engage in the trade of financial securities like stocks, bonds, currencies, and commodities. | | Financing Decision | A decision concerning how a company raises funds to finance its operations and investments. This includes choosing between debt and equity financing. | | Firm Reputation | An intangible asset reflecting the public perception of a company, built on its past performance, ethical conduct, and product quality. A good reputation can enhance firm value and reduce agency costs. | | Investment Decision | Decisions made by financial managers about how to allocate capital to projects or assets that are expected to generate future returns. | | Limited Liability | A legal protection for owners of a corporation that shields their personal assets from business debts and lawsuits. The maximum amount an individual shareholder can lose is typically the amount of their initial investment. | | Maximizing Shareholder Wealth | The primary objective of corporate management, which involves making decisions that increase the market value of the company's stock over the long term. | | Real Asset | A tangible asset that has intrinsic physical worth, such as property, plant, equipment, and inventory, as opposed to a financial asset which represents a claim on real assets. | | Security | A fungible, negotiable financial instrument that holds monetary value. Common examples include stocks and bonds, which represent ownership or debt claims, respectively. | | Stakeholders | Individuals or groups who have an interest in a company and can affect or be affected by the business. This includes shareholders, employees, customers, suppliers, and the government. | | Treasurer | A financial manager responsible for a firm's cash management, banking relationships, and obtaining financing for the company. | | Financial Institutions | Organizations that provide financial services to individuals and businesses, acting as intermediaries in the financial system by pooling savings and facilitating investment, lending, and other financial transactions. | | Liquidity | The ease and speed with which an asset can be converted into cash without significant loss of its value, a key function provided by financial markets to ensure investors can readily buy or sell assets. | | Pricing Information | Data and signals generated within financial markets that reflect the perceived value of financial assets, helping investors make informed decisions about buying, selling, or holding securities. | | Investment Banks | Financial institutions that specialize in assisting corporations and governments in raising capital through the issuance of stocks and bonds, and also provide advisory services for mergers and acquisitions. | | Mutual Funds | Investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities, offering professional management and diversification benefits. | | Primary Market | The market where new securities are issued for the first time directly by the issuer to investors, enabling companies to raise initial capital from public offerings or private placements. | | Secondary Market | The market where previously issued securities are traded among investors, such as stock exchanges, allowing for the buying and selling of assets that already exist and providing liquidity to investors. | | Micro Loan | A small loan provided to low-income individuals or small businesses that typically lack access to traditional banking services, often used to fund entrepreneurial ventures in developing economies. | | Exchange Traded Fund (ETF) | An investment fund that holds assets such as stocks, bonds, or commodities and trades on stock exchanges like a regular stock, offering diversification and intraday trading capabilities. | | Venture Capitalists | Investors or firms that provide capital to startups and small businesses with high growth potential in exchange for equity ownership, often playing a significant role in the early stages of a company's funding. | | Money Market | A segment of the financial market where short-term debt instruments with high liquidity and low risk are traded, typically with maturities of less than one year, such as commercial paper and Treasury bills. | | Commercial Paper | An unsecured, short-term debt instrument issued by corporations to finance their immediate needs, typically with maturities ranging from a few days to 270 days, traded in the money market. | | Bond Market | A financial market where debt securities, known as bonds, are issued and traded, representing loans made by investors to corporations or governments in exchange for periodic interest payments and the return of principal. | | Opportunity Cost of Capital | The minimum acceptable rate of return that an investor or company expects to earn on an investment, reflecting the return forgone from the next best alternative investment. | | Financial Intermediaries | Institutions that act as go-betweens for savers and borrowers, facilitating the flow of funds by pooling savings and channeling them into investments, such as banks, insurance companies, and mutual funds. | | Reinvestment | The act of using earnings from an investment or business to purchase more of the same asset or to fund new projects and operations, thereby growing the initial capital or business. | | Stakeholder | Any individual, group, or organization that has an interest in or is affected by a company's operations and performance, including employees, customers, suppliers, shareholders, and the community. | | Real Estate | Physical property, including land and buildings, which is generally considered less liquid than financial assets due to the time and effort required to sell it. | | Reinsurance | Insurance purchased by an insurance company from another insurance company (the reinsurer) to protect itself against large losses or catastrophic events, spreading risk further. | | Coupon Payment | Periodic receipts of interest by the bondholder from the issuer. These are typically fixed amounts paid at regular intervals throughout the bond's life. | | Coupon Rate | The annual interest rate paid on a bond's face value, expressed as a percentage. This rate is fixed for the life of the bond and determines the amount of the coupon payment. | | Current Yield | The annual coupon payment divided by the bond's current market price. It represents the income return on the bond at its current market value, without considering any capital gains or losses. | | Default Premium | An additional yield that investors demand to compensate for the risk that the bond issuer may default on its payments. This premium is typically higher for bonds with lower credit ratings. | | Dividend Discount Model (DDM)| A method for valuing a stock by discounting all of its expected future dividends back to their present value. The sum of these present values represents the intrinsic value of the stock. | | Dividend Yield | The annual dividend payment per share divided by the stock's current market price. It represents the income return from dividends relative to the stock's price. | | Effective Annual Rate (EAR) | The actual rate of interest earned or paid on an investment or loan over a one-year period, taking into account the effect of compounding. It is calculated as $(1 + \text{periodic rate})^{\text{number of periods}} - 1$. | | Efficient Market Hypothesis (EMH)| A theory stating that security prices fully reflect all available information. This implies that it is impossible to consistently "beat the market" through technical or fundamental analysis. | | Face Value | The par value of a bond, which is the amount the issuer agrees to repay the bondholder at the maturity date. It is also known as the principal amount of the bond. | | Going-Concern Value | The value of a firm as an operating entity, assuming it will continue to exist and operate in the future. This contrasts with liquidation value, which assumes the firm ceases operations. | | Growth Rate | The expected rate at which a company's earnings, dividends, or stock price is anticipated to increase over time. This is a key input in stock valuation models. | | Interest Rate | The cost of borrowing money or the return on lending money, typically expressed as an annual percentage. In bond valuation, it is a key factor influencing bond prices and yields. | | Liquidation Value | The net amount realized from selling all of a firm's assets and paying off all creditors. It represents the value of the firm if it were to be dissolved. | | Market Value | The current price at which a security or asset is trading in the open market. For bonds, it can fluctuate based on interest rates, credit risk, and time to maturity. | | Nominal Interest Rate | The stated interest rate without accounting for inflation. It represents the actual monetary return earned, but does not reflect changes in purchasing power. | | Par Value | The nominal value of a bond or share of stock, which is typically the amount repaid at maturity for a bond or the stated value on a share certificate. Bonds are often issued at par value. | | Plowback Ratio | The proportion of a company's earnings that is reinvested back into the business rather than being paid out as dividends. It is calculated as $(1 - \text{Dividend Payout Ratio})$. | | Present Value (PV) | The current worth of a future sum of money or stream of cash flows, given a specified rate of return. Future cash flows are discounted back to their present value using an appropriate discount rate. | | Price-to-Book (P/B) Ratio | A valuation metric that compares a company's market value of equity to its book value of equity. A P/B ratio greater than 1 suggests investors value the company higher than its accounting net worth. | | Price-to-Earnings (P/E) Ratio| A valuation metric that compares a company's stock price to its earnings per share. It indicates how much investors are willing to pay for each dollar of a company's earnings. | | Real Interest Rate | The nominal interest rate minus the inflation rate. It reflects the actual increase in purchasing power an investor expects to receive from an investment. | | Required Return | The minimum rate of return that an investor expects to receive from an investment to compensate for the perceived risk. It is a crucial component in discounted cash flow valuation models. | | Sustainable Growth Rate | The maximum rate at which a firm can grow its earnings and dividends without increasing its financial leverage or issuing new equity. It is often calculated as Return on Equity multiplied by the plowback ratio. | | Terminal Value | In stock valuation, this represents the value of a stock at the end of a projected period, often assuming a constant growth rate thereafter. It is also the present value of all cash flows beyond the explicit forecast period. | | Yield Curve | A graphical representation of the relationship between the yields of bonds and their respective maturities. It typically plots Treasury yields against time to maturity. | | Yield to Maturity (YTM) | The total return anticipated on a bond if it is held until it matures. YTM is expressed as an annual rate and takes into account the bond's current market price, par value, coupon interest, and time to maturity. | | Capital Rationing | A situation where a firm has more acceptable investment projects than it can finance, forcing it to choose among them based on their relative merits, often leading to missed positive Net Present Value (NPV) opportunities. | | Cost of Capital | The minimum acceptable rate of return that a firm requires for an investment project, reflecting the opportunity cost of investing funds elsewhere, considering the risk associated with the investment. | | Depreciation Tax Shield | The reduction in tax liability that results from the tax-deductible nature of depreciation expense, effectively lowering the taxable income and thus the amount of tax paid by the firm. | | Discount Rate | The rate used to determine the present value of future cash flows. It typically reflects the opportunity cost of capital, incorporating the risk associated with the investment. | | Economic Value Added (EVA) | A measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. It aims to capture the true economic profit. | | Free Cash Flow | The cash flow available to a company after accounting for capital expenditures and changes in working capital. It represents the cash that can be distributed to investors or used for other corporate purposes. | | Hard Capital Rationing | A situation where external market forces, such as a lack of access to sufficient capital from lenders or equity markets, prevent a firm from investing in all positive Net Present Value (NPV) projects. | | Internal Rate of Return (IRR) | The discount rate at which the Net Present Value (NPV) of all the cash flows from a particular project or investment equals zero. It represents the effective rate of return of an investment. | | Investment Appraisal | The process of evaluating potential capital investments to determine their financial viability and potential profitability. It involves analyzing expected cash flows and comparing them to the required rate of return. | | Marketable Securities | Highly liquid financial instruments that can be easily bought or sold in the financial markets, such as short-term government bonds or treasury bills, representing a company's most liquid assets. | | Net Present Value (NPV) | The difference between the present value of cash inflows and the present value of cash outflows over a period of time. A positive NPV indicates that the projected earnings are greater than the anticipated costs, suggesting a financially attractive investment. | | Payback Period | The length of time required for an investment to generate cash flows sufficient to recover its initial cost. It is a simple measure but does not consider the time value of money beyond the payback period. | | Profitability Index (PI) | A ratio of the present value of future cash flows to the initial investment cost. A PI greater than 1 indicates that the project is expected to generate more value than it costs. | | Seasoned Equity Offering (SEO) | The sale of additional shares of stock by a company that has already made an initial public offering (IPO). These offerings occur after the company has been publicly traded for some time. | | Soft Capital Rationing | A situation where a firm's management imposes limits on the amount of capital that can be invested in projects, often due to strategic considerations or a desire to limit the number of projects undertaken. | | Sunk Cost | A cost that has already been incurred and cannot be recovered. Sunk costs are irrelevant to future investment decisions because they do not change the incremental cash flows of a project. | | Working Capital | The difference between a company's current assets and its current liabilities. It represents the capital available for day-to-day operations and can fluctuate throughout a project's life. | | Beta | A measure of a stock's volatility in relation to the overall market. A beta of 1.0 indicates that the stock's price will move with the market, while a beta greater than 1.0 suggests higher volatility and a beta less than 1.0 indicates lower volatility. | | Capital Asset Pricing Model (CAPM) | A financial model used to determine the theoretically appropriate required rate of return for an asset. It posits that the expected return on an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's beta. | | Diversification | The strategy of spreading investments across various asset classes, industries, or geographic regions to reduce overall portfolio risk. By holding a variety of assets, the impact of any single poorly performing investment is lessened. | | Market Risk | The risk inherent to the entire market or market segment, often referred to as systematic risk. This type of risk cannot be eliminated through diversification and is influenced by macroeconomic factors such as interest rates, inflation, and economic recessions. | | Portfolio | A collection of financial investments such as stocks, bonds, commodities, cash, and cash equivalents, including mutual funds and exchange-traded funds. The goal of a portfolio is to balance risk and reward. | | Risk Premium | The excess return an investment is expected to yield over the risk-free rate of return. This extra return compensates investors for taking on additional risk compared to a risk-free investment. | | Specific Risk | The risk associated with a particular company or industry, also known as unsystematic risk. This risk can be reduced or eliminated through diversification, as it is not related to the overall market performance. | | Variance | A statistical measure that quantifies the dispersion of a set of data points around their mean. In finance, variance of returns indicates the degree of volatility or spread of an investment's returns. | | Weighted Average Cost of Capital (WACC) | The average rate of return a company expects to pay to its security holders to finance its assets. WACC is calculated by multiplying the cost of each capital component (debt, preferred stock, common stock) by its respective proportion in the capital structure and summing these values. | | Accounts Payable | The total amount of money a company owes to its suppliers for goods and services purchased on credit, representing a short-term liability. | | Accounts Receivable | The total amount of money owed to a company by its customers for goods and services delivered on credit, representing a short-term asset. | | Aging Schedule | A report that details accounts receivable, categorized by the length of time each invoice has been outstanding, used to assess the collectibility of receivables. | | Carrying Cost of Inventory | The expenses associated with holding inventory, including storage, insurance, obsolescence, spoilage, and the opportunity cost of the capital invested in the inventory. | | Cash Budget | A financial plan that forecasts a company's expected cash inflows and outflows over a specific period, used for short-term financial planning and liquidity management. | | Cash Cycle | The length of time it takes for a company to convert its investments in inventory and other resources into cash flows from sales. | | Credit Analysis | The process of evaluating the creditworthiness of a potential customer to determine whether to extend credit and under what terms. | | Credit Policy | The set of rules and guidelines a firm establishes to determine whether or not to extend credit to customers and the associated terms and conditions. | | Dividends | A distribution of a portion of a company's earnings to its shareholders, typically in the form of cash or stock. | | Economic Order Quantity (EOQ) | A model used to determine the optimal order size for inventory that minimizes the total cost of ordering and carrying inventory. | | EBIT (Earnings Before Interest and Taxes) | A measure of a company's operating profit before accounting for interest expenses and income taxes, often used as an indicator of core business profitability. | | Goodwill | An intangible asset that represents the excess of the purchase price of an acquired company over the fair value of its identifiable net assets, often reflecting brand reputation or customer relationships. | | Income Statement | A financial statement that reports a company's financial performance over a specific accounting period, showing revenues, expenses, and net income or loss. | | Inventory | Goods or materials held by a company for sale or use in production. | | Maturity Matching | A financing strategy where the maturity of a firm's assets is matched with the maturity of its liabilities, aiming to align cash inflows with cash outflows. | | Money Market Instruments | Short-term debt instruments with high liquidity and maturities typically less than one year, such as Treasury bills, commercial paper, and repurchase agreements. | | Net Working Capital (NWC) | The difference between a company's current assets and current liabilities, representing the firm's short-term financial health and operational liquidity. `$NWC = Current Assets - Current Liabilities$` | | Open Account | A credit transaction where goods are sold and delivered to a buyer, and the seller expects payment at a later date without a formal debt instrument. | | Order Costs | Expenses incurred each time a company places an order for inventory, including administrative costs, processing fees, and shipping charges. | | Permanent Working Capital | The minimum level of net working capital that a firm must maintain on a continuous basis to support its operations, often financed from long-term sources. | | Revolving Line of Credit | A flexible loan agreement that allows a company to borrow funds up to a specified limit, repay them, and then borrow again during the term of the agreement. | | Short-Term Financial Planning | The process of forecasting a company's cash needs and developing strategies to manage its short-term assets and liabilities to ensure adequate liquidity. | | Statement of Cash Flows | A financial statement that summarizes the cash inflows and outflows of a company over a specific period, categorized into operating, investing, and financing activities. | | Stretching Payables | A practice where a company deliberately delays payment of its supplier invoices beyond the agreed-upon due date to conserve cash, often incurring a loss of discounts or goodwill. | | Trade Credit | Credit extended by a supplier to a customer, allowing the customer to purchase goods or services and pay for them at a later date. | | Treasury Stock | Shares of a company's own stock that it has repurchased from the open market and holds, which does not represent an asset. | | Working Capital Management | The strategic and operational process of managing a company's current assets and current liabilities to ensure efficient use of resources and sufficient liquidity. | | Asset Turnover Ratio | A financial ratio that measures how efficiently a company uses its assets to generate sales, calculated by dividing sales by total assets. | | Book Value | The value of an asset as recorded on the company's balance sheet, typically the historical cost less accumulated depreciation. | | Capital Budgeting Decisions | Decisions regarding the firm's long-term investments, such as deciding whether to buy a new machine or repair an old one, or whether to invest in a new product line. | | Capital Gains Rate | The rate at which the price of a stock is expected to increase over a specific period. | | Capital Markets | Markets where financial securities such as stocks and bonds are traded, typically for long-term financing. | | Cash Flow from Operations | The cash generated or used by a company's normal business operations during a specific period. | | Collateral Agreements | Provisions in loan agreements that require the borrower to pledge specific assets as security for the loan, which the lender can seize if the borrower defaults. | | Common Stock | A security that represents ownership in a corporation, entitling the shareholder to voting rights and a residual claim on the company's assets and earnings. | | Composite (Consolidated) Financial Statements | Financial statements that combine the financial information of a parent company and its subsidiaries into a single set of reports. | | Compound Interest | Interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. | | Contingency Planning | The process of developing plans to respond to unexpected events or scenarios that could affect a company's operations or financial performance. | | Convertible Bond | A type of bond that can be converted into a predetermined amount of the issuer's common stock at the option of the bondholder. | | Corporate Finance | The area of finance that deals with the financial decisions corporations make and the tools and analysis used to make these decisions, covering capital structure, dividend policy, and investment decisions. | | Corporate Raiders | Individuals or groups who seek to acquire control of a company, often through hostile takeovers, with the aim of restructuring or selling off assets for profit. | | Corporation Taxation | The system of taxes levied on the profits of corporations, which can sometimes lead to "double taxation" when profits are taxed at the corporate level and then again when distributed to shareholders as dividends. | | Coupon Payments | The periodic interest payments made by a bond issuer to the bondholder, typically fixed for the life of the bond. | | Credit Card Receivables | Money owed to a company by customers who have made purchases using credit cards, representing a short-term asset for the company. | | Credit Scoring Systems | Statistical models used to evaluate the creditworthiness of borrowers by analyzing their financial characteristics and payment history. | | Current Assets | Assets that a company expects to convert into cash, sell, or consume within one year or its operating cycle, whichever is longer. | | Current Liabilities | Obligations that a company expects to settle within one year or its operating cycle, whichever is longer. | | Current Ratio | A liquidity ratio that measures a firm's ability to pay off its short-term obligations with its short-term assets, calculated as current assets divided by current liabilities. | | Debt Burden | A measure of a company's ability to meet its debt obligations, often expressed as a ratio of debt to equity or debt to assets. | | Debt Ratio | A financial leverage ratio that measures the proportion of a company's assets financed by debt, calculated as total liabilities divided by total assets. | | Debt-Equity Ratio | A financial leverage ratio that indicates the relative proportions of debt and equity financing used by a company. | | Debt-to-Asset Ratio | A financial leverage ratio that measures the proportion of a company's assets financed by debt, calculated as total debt divided by total assets. | | Depreciation Expense | An accounting charge that allocates the cost of a tangible asset over its useful life, reflecting the asset's gradual wear and tear or obsolescence. | | Derivative Instruments | Financial contracts whose value is derived from an underlying asset, index, or interest rate, such as futures, options, and swaps. | | Derivatives | Financial instruments whose value is derived from the performance of an underlying asset, such as stocks, bonds, commodities, or currencies. | | Direct Merger | A merger where two companies in the same industry combine, often to gain market share or achieve economies of scale. | | Discount Factor | A multiplier used to calculate the present value of future cash flows, representing the present value of one dollar to be received at a specific future date. | | Discounted Cash Flow (DCF) Analysis | A valuation method used to estimate the value of an investment based on its expected future cash flows, discounted back to their present value. | | Dividend Payout Ratio | The proportion of a company's earnings that is paid out to shareholders as dividends. | | Downside Risk | The risk of a negative outcome or loss on an investment, such as a decline in stock price or an increase in interest rates. | | Effective Annual Interest Rate | The actual interest rate earned or paid on an investment or loan over a year, taking into account the effects of compounding. | | Embedded Options | Contractual features within a financial instrument, such as a call or put option, that give the issuer or holder the right, but not the obligation, to take a specific action. | | Equities | Financial instruments representing ownership in a corporation, such as common stock and preferred stock. | | Equity Financing | Raising capital by selling ownership stakes in the company, typically through the issuance of common or preferred stock. | | Equity Holders | Owners of a company's stock who have a claim on the company's residual assets and earnings after all other stakeholders have been paid. | | Eurobond | A bond denominated in a currency other than that of the country in which it is issued, often marketed internationally. | | EVA (Economic Value Added) | A measure of a company's financial performance based on the residual wealth calculated by deducting the cost of capital from its operating profit. | | Exchange Rate | The price of one country's currency in terms of another country's currency, used for international trade and investment. | | Exchange Rate Risk | The risk that changes in exchange rates will affect the value of financial transactions or investments denominated in foreign currencies. | | Executive Stock Options | Options granted to employees, typically executives, that give them the right to purchase the company's stock at a predetermined price, often used as an incentive to increase firm value. | | Expected Return | The anticipated rate of return on an investment, calculated based on historical data, market expectations, or probability distributions of future returns. | | Expenses | Costs incurred by a business in its normal course of operations, such as salaries, rent, and utilities. | | Financial Assets | Intangible assets that represent a claim to income or future benefits, such as stocks, bonds, and bank deposits. | | Financial Distress Costs | The costs incurred by a company when it experiences financial difficulties, such as bankruptcy costs, legal fees, and loss of reputation. | | Financial Future | A standardized contract to buy or sell a specific financial asset at a predetermined price on a future date, traded on an organized exchange. | | Financial Futures Markets | Organized exchanges where financial futures contracts are traded, allowing participants to hedge against or speculate on future price movements of financial assets. | | Financial Planning | The process of setting financial goals and developing strategies to achieve them, often involving forecasting future financial performance and identifying funding needs. | | Financial Ratios | Metrics used to analyze a company's financial performance and condition by comparing different financial statement items, such as liquidity, profitability, and leverage ratios. | | Financial Risk | The risk associated with a firm's use of debt financing, which can increase the variability of earnings and the possibility of financial distress or bankruptcy. | | Financial Statements | Reports that provide a summary of a company's financial performance and position, including the income statement, balance sheet, and cash flow statement. | | Financing Decisions | Decisions regarding how a firm raises the capital needed to fund its operations and investments, including decisions about the mix of debt and equity financing. | | Firm Commitment | An agreement where an underwriter guarantees to purchase a certain number of securities from an issuing firm at a specified price, assuming the risk of reselling them to the public. | | Fixed Assets | Tangible assets that a company uses in its operations for more than one year, such as property, plant, and equipment. | | Fixed Costs | Costs that remain constant regardless of the level of production or sales, such as rent and salaries. | | Floating-Rate Loan | A loan with an interest rate that adjusts periodically based on changes in a benchmark interest rate, such as the prime rate or SOFR. | | Floatation Costs | The costs incurred by a company when issuing new securities, including underwriting fees, legal expenses, and printing costs. | | Foreign Exchange Market | The global market where currencies are traded, allowing for the exchange of one country's currency for another's. | | Forward Contract | A customized agreement between two parties to buy or sell an asset at a specified price on a future date, traded over-the-counter. | | Forward Rate | The exchange rate agreed upon today for a currency transaction that will take place at a specified future date. | | Futures Contract | A standardized contract to buy or sell a specific asset at a predetermined price on a future date, traded on an organized exchange. | | Futures Price | The price at which a futures contract is traded, reflecting the market's expectation of the underlying asset's price at expiration. | | GAAP (Generally Accepted Accounting Principles) | A set of accounting standards and guidelines used in the United States to ensure consistency and comparability in financial reporting. | | General Cash Offer | The sale of securities to the public by a firm that has already made a public offering of securities. | | Going Concern | The assumption that a business will continue to operate indefinitely into the future. | | Gold Standard of Investment Criteria | Refers to the Net Present Value (NPV) rule as the most theoretically sound method for evaluating investment projects. | | Good Will | An intangible asset that represents the excess of the purchase price of an acquired company over the fair market value of its identifiable net assets, often reflecting brand reputation or other unidentifiable assets. | | Government Bonds | Debt securities issued by government entities, typically considered low-risk investments. | | Greenmail Offer | The practice of a company buying back its shares from a potential hostile acquirer at a premium price to prevent a takeover. | | Hedging | The practice of using financial instruments, such as futures or options, to reduce or offset the risk of adverse price movements in an underlying asset. | | Horizontal Merger | A merger between two companies that operate in the same industry and are often competitors. | | House of Cards | A metaphorical term that might describe a financial structure or strategy that is highly unstable and prone to collapse. | | Human Capital | The economic value of a worker's experience and skills, including education, training, judgment, intelligence, and other skills acquired in a lifetime. | | Hybrid Security | A financial instrument that possesses characteristics of both debt and equity securities, such as convertible bonds or preferred stock. | | IFRS (International Financial Reporting Standards) | A set of accounting standards developed by the International Accounting Standards Board (IASB) that are used in many countries around the world. | | Incremental Cash Flows | The additional cash flows generated or consumed by a particular project or investment decision, compared to what would have occurred without the decision. | | Indirect Exchange Rate | An exchange rate quoted as the amount of one currency required to purchase one unit of another currency. | | Inflation Rate | The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. | | Initial Investment | The total cost incurred to start a project or business, including the purchase of assets and initial working capital requirements. | | Insider Trading | The trading of a public company's stock or other securities by individuals with access to non-public information about the company. | | Installment Plan | A payment arrangement where a purchase is paid for in regular, periodic installments over a specified period. | | Insufficient Inventory | A situation where a company does not have enough inventory on hand to meet customer demand or production requirements. | | Intangible Assets | Assets that lack physical substance but have value due to the rights and privileges they confer, such as patents, trademarks, and goodwill. | | Interest Expense | The cost incurred by a company for borrowing money, typically expressed as a percentage of the outstanding loan principal. | | Interest Rate Differential | The difference between interest rates in different countries or for different types of financial instruments. | | Interest Rate Risk | The risk that changes in interest rates will affect the value of financial assets or liabilities, particularly fixed-income securities. | | Internal Growth Rate | The maximum rate at which a company can grow without external financing, relying solely on internally generated funds. | | International Fisher Effect | A theory that predicts that differences in nominal interest rates between countries reflect differences in their expected inflation rates. | | Inventory Turnover Rate | A financial ratio that measures how many times a company's inventory is sold and replaced over a given period, calculated by dividing cost of goods sold by average inventory. | | Investment Decisions | Decisions about how a firm allocates its capital to various projects and assets to maximize shareholder wealth. | | Investment Horizon | The length of time an investor intends to hold an investment before selling it. | | Investment Quality Ratings | Assessments of the creditworthiness of a company or security, typically provided by rating agencies, indicating the likelihood of default. | | Investment Timing Problem | The challenge of deciding the optimal time to make an investment when there is flexibility in when the investment can be undertaken, considering factors like market conditions and future costs. | | Invoice | A commercial document that records a transaction between a buyer and a seller, detailing the goods or services provided, quantities, and agreed prices. | | IPO (Initial Public Offering) | The first sale of stock by a private company to the public, allowing it to raise capital and become a publicly traded entity. | | Irrelevance Proposition (MM Proposition I) | A theorem in corporate finance that states that, in the absence of taxes and other market imperfections, a firm's value is independent of its capital structure. | | J Curve Effect | A phenomenon that describes the short-term worsening of a country's trade balance following a currency depreciation, before improvements occur due to increased export competitiveness. | | Joint Venture | A business arrangement where two or more parties agree to pool their resources for the purpose of accomplishing a specific task. | | Junk Bond | A high-yield bond that pays higher interest rates than average bonds, but with a higher risk of default. | | Junior Debt | Debt that ranks lower in priority than other debt in the event of bankruptcy or liquidation, often carrying higher interest rates due to increased risk. | | Keynesian Economics | A macroeconomic theory that argues that aggregate demand, not supply, is the primary determinant of economic activity, especially during recessions. | | Labor Cost | The expense incurred by a company for employing its workforce, including wages, salaries, benefits, and taxes. | | Large-Scale Efforts | Significant actions or initiatives undertaken by a company, often in response to external pressures or opportunities. | | Law of One Price | A principle that states that identical goods should sell for the same price in different markets when measured in a common currency, assuming no transaction costs or barriers to trade. | | Lease Obligation | A contractual commitment to make periodic payments for the use of an asset over a specified period. | | Leverage Ratio | A financial ratio that measures the extent to which a firm uses debt financing in its capital structure, indicating its financial risk. | | Liabilities | Obligations of a company that are owed to external parties, such as accounts payable, salaries payable, and debt. | | Line of Credit | An agreement between a bank and a customer that provides the customer with the ability to withdraw funds up to a specified amount without having to make a formal application for each withdrawal. | | Limited Liability Company (LLC) | A business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. | | Limited Liability Partnership (LLP) | A partnership structure where some or all partners have limited liability, protecting their personal assets from business debts and lawsuits. | | Liquidity Ratios | Financial ratios that measure a company's ability to meet its short-term obligations, such as the current ratio and the quick ratio. | | Loan Officer | A bank employee responsible for managing customer relationships, approving loans, and ensuring compliance with lending policies. | | Loan-to-Value (LTV) Ratio | A lending risk metric that compares the loan amount to the appraised value of the property, used by lenders to assess the risk of a mortgage loan. | | Long-Term Debt | Obligations of a company that are due more than one year from the date of the balance sheet, such as bonds and long-term bank loans. | | Long-Term Financial Planning | The process of setting financial goals and developing strategies to achieve them over a period longer than one year, often involving sales forecasts, capital budgets, and pro forma financial statements. | | Loss of Premium | A term that might refer to a decrease in the market value of a bond that was initially selling at a premium, often due to rising interest rates. | | Low-Risk Stocks | Stocks of companies that are considered to be less volatile and more stable in terms of earnings and stock price movements, often characterized by lower betas. | | LBO (Leveraged Buyout) | The acquisition of another company using a significant amount of borrowed money (leveraged), with the assets of the acquired company typically used as collateral for the loan. | | Macro Risk | Risks that affect the entire economy or a large segment of it, such as inflation, recession, or changes in interest rates. | | Management Buyout (MBO) | A type of leveraged buyout where the existing management team of a company acquires a controlling stake in the business. | | Margin Account | An account held with a brokerage firm that allows investors to borrow money to purchase securities, requiring a deposit of collateral to cover potential losses. | | Margin Call | A demand from a broker for an investor to deposit additional money or securities into their margin account to cover potential losses from leveraged investments. | | Market Efficiency | The degree to which market prices reflect all available information, influencing the ability of investors to consistently earn abnormal returns. | | Market Index Fund | A type of mutual fund that tracks the performance of a specific market index, such as the S&P 500, by holding a portfolio of securities that mirrors the index's composition. | | Market Risk Premium | The excess return that investors expect to receive for investing in the stock market over and above the risk-free rate, reflecting compensation for bearing systematic risk. | | Market-to-Book Ratio | A valuation ratio that compares a company's market value of equity to its book value of equity, indicating how much investors are willing to pay for each dollar of book value. | | Mark-to-Market | The practice of valuing financial assets and liabilities at their current market prices, with any gains or losses recognized immediately in earnings. | | Matching Maturities Strategy | A financing strategy where the maturity of a firm's assets is matched with the maturity of its liabilities, minimizing the risk of cash shortages or surpluses. | | Maturity Date | The date on which the principal amount of a debt instrument becomes due and payable. | | Means of Financial Planning | The various tools, techniques, and methodologies used in the process of financial planning, such as percentage-of-sales models, pro forma statements, and ratio analysis. | | Mergers | The combination of two or more companies into a single entity, often to achieve economies of scale, market power, or other strategic advantages. | | Minimum Working Capital Strategy | A financing strategy that aims to minimize the investment in working capital by holding the lowest possible levels of current assets and current liabilities. | | Money Market Securities | Short-term, highly liquid debt instruments traded in the money market, typically with maturities of less than one year. | | Monopoly | A market structure where a single firm dominates the market and has significant control over prices and output, often due to lack of competition. | | More Intense Competition | A situation where firms in a particular market face strong rivalry from competitors, leading to pressures on prices, costs, and innovation. | | Mortgage | A loan secured by real property, where the property serves as collateral for the loan. | | Most Likely to Have a Negative Operating Cash Flow | A situation where a company's cash outflows for its operations exceed its cash inflows during a specific period. | | Multinational Corporation | A company that operates in several countries, often engaging in international trade, investment, and financial management. | | Mutual Fund | An investment vehicle that pools money from many investors to purchase a diversified portfolio of securities, managed by a professional fund manager. | | MVA (Market Value Added) | A measure of the total value created by a company for its shareholders, calculated as the difference between the market value of the firm and its book value. | | Net Income | The profit remaining after all expenses, including taxes and interest, have been deducted from a company's total revenues. | | New Equity Issues | The sale of new shares of stock by a company to raise capital from investors. | | Non-Callable Bond | A bond that cannot be redeemed or repurchased by the issuer before its maturity date. | | Non-Recourse Debt | Debt that is secured only by the specific asset financed, meaning the lender cannot pursue the borrower's other assets if the borrower defaults. | | Non-Sunk Cost | Costs that are not irrecoverable and can be avoided if a project is not undertaken. | | Non-Zero NPV | A situation where the net present value of a project is not equal to zero, indicating that the project is expected to generate returns above or below the required rate of return. | | Normal Profit | The minimum level of profit needed to keep a firm in business over the long term; when profits are lower than normal, firms may exit the industry. | | Notes Payable | Short-term debt obligations of a company, typically incurred from borrowing from financial institutions. | | NWC Turnover Ratio | A financial ratio that measures how efficiently a firm uses its net working capital to generate sales, calculated as sales divided by net working capital. | | Obligation to Purchase | A commitment to buy an asset at a specified price and date, as required by certain financial contracts like futures. | | Offer Price | The price at which a seller is willing to sell a security or asset. | | Offsetting Futures Transaction | A transaction that cancels out an existing futures position, effectively closing the contract before its expiration date. | | Open Market Repurchase | A method where a company buys back its own shares on the open market, gradually reducing the number of outstanding shares. | | Operating Cash Flow | The cash generated from a company's normal business operations, excluding cash flows from financing or investing activities. | | Operating Income | Profit generated from a company's core business operations before accounting for interest and taxes. | | Operating Leverage | The extent to which a firm relies on fixed costs in its operations; a high degree of operating leverage means that small changes in sales can lead to large changes in operating income. | | Option | A contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain period. | | Option Buyer | The party who purchases an option contract, paying a premium for the right to exercise the option. | | Option Seller | The party who writes or sells an option contract, receiving a premium in exchange for the obligation to fulfill the contract if exercised. | | Optimal Capital Structure | The mix of debt and equity financing that minimizes a firm's weighted-average cost of capital (WACC) and maximizes its overall value. | | Ordinary Annuity | A series of equal cash payments made at the end of each period for a specified duration. | | OTC Market (Over-the-Counter Market) | A decentralized market where financial securities are traded directly between two parties, without the oversight of a formal exchange. | | Other Current Assets | Assets that do not fit into the categories of cash, marketable securities, accounts receivable, or inventory, and are expected to be converted to cash within one year. | | Outsiders | Individuals or groups not associated with a company's current management or board of directors. | | Over-the-Counter (OTC) Market | A decentralized market where financial securities are traded directly between two parties, without the oversight of a formal exchange. | | Overhead Expenses | Indirect costs incurred by a business that are not directly tied to the production of a specific product or service, such as rent, utilities, and administrative salaries. | | Overpricing | Setting the price of a security or asset higher than its perceived intrinsic value, potentially leading to reduced demand or sales. | | Overvalued | A situation where the market price of a security is higher than its estimated intrinsic value, suggesting it may be a poor investment. | | P/E Ratio (Price-to-Earnings Ratio) | A valuation ratio that compares a company's stock price to its earnings per share, used to assess whether a stock is overvalued or undervalued. | | Paid-in Capital | The total amount of money that shareholders have paid to the corporation in exchange for stock, including par value and any additional paid-in capital. | | Paid-in Surplus | The excess amount paid by investors for shares above their par value, recorded as additional paid-in capital on the balance sheet. | | Partnership | A business owned and operated by two or more individuals who agree to share in the profits and losses of the business. | | Payment Date | The date on which a company actually distributes dividends to its shareholders. | | Peculiar Risks | Risks that are specific to a particular company or industry, and can be diversified away by investing in a broader portfolio of assets. | | Penny Stocks | Stocks that trade for less than $5 per share, often associated with small, unproven companies and carrying high risk. | | Pension Funds | Funds established by employers to provide retirement income for their employees, often investing in a diversified portfolio of securities. | | Perpetual Cash Flows | Cash flows that are expected to continue indefinitely, often used in valuation models for assets like perpetuities or ongoing businesses. | | Perpetual Tax Shield | The ongoing tax savings generated by the deductibility of interest payments on debt, which continues as long as the debt remains outstanding. | | Perpetuity | A series of equal cash payments that continue indefinitely, often used in financial valuation models. | | Personal IOU | A written promise from an individual to repay a loan to another individual, representing a form of informal debt. | | Pharmaceutical Drug | A medicinal substance used to treat or prevent disease. | | P/E Ratio | Price-to-Earnings ratio. | | Piggyback Registration | A procedure where an issuer allows holders of privately placed securities to register their securities for public sale along with the issuer's own public offering. | | Pilot Project | A small-scale preliminary study conducted to evaluate feasibility, time, cost, and potential usefulness of a larger project. | | Planned Investment | Capital expenditures that are part of a company's long-term financial plan, designed to support future growth and operations. | | Planning Model | A framework used in financial planning that outlines the relationships between various financial variables and forecasts future financial outcomes. | | Plant and Equipment | Tangible assets used by a company in its operations, such as machinery, buildings, and land. | | Poison Pill | A defensive tactic used by a company targeted for takeover to make itself less attractive to the acquirer, often by issuing rights that allow existing shareholders to purchase more stock at a discount. | | Political Risk | The risk that political events or actions in a foreign country will negatively affect an investment or business operations. | | Portfolio Beta | A measure of the systematic risk of a portfolio of assets, calculated as the weighted average of the betas of the individual assets in the portfolio. | | Portfolio Diversification | The strategy of holding a variety of investments to reduce overall risk. | | Portfolio Return | The total gain or loss realized on an investment portfolio over a specific period, expressed as a percentage of the initial investment. | | Positive NPV Project | An investment project whose net present value is greater than zero, indicating that it is expected to generate returns exceeding the required rate of return. | | Potential Liquidity Increase | An improvement in a company's ability to meet its short-term obligations, often resulting from an increase in current assets or a decrease in current liabilities. | | Pre-IPO Shares | Shares of a company that are sold privately to investors before the company makes its initial public offering (IPO). | | Preferred Bond | A debt instrument that has priority over common stock but ranks below other debt securities in the event of bankruptcy or liquidation. | | Preferred Stock | A class of stock that typically pays a fixed dividend and has priority over common stock in terms of dividend payments and asset distribution in case of liquidation. | | Premium Bond | A bond that is trading in the market at a price above its par value, typically because its coupon rate is higher than the prevailing market interest rates. | | Present Value | The current value of a future sum of money or stream of cash flows, discounted at a specific rate of return. | | Price Index | A measure of the average change over time in the prices of a basket of goods and services, used to track inflation or deflation. | | Price-to-Book Ratio | A valuation ratio that compares a company's market price per share to its book value per share, indicating how much investors are willing to pay for each dollar of book value. | | Principal | The original amount of a loan or investment, excluding any interest or fees. | | Private Equity Fund | An investment fund that pools capital from accredited investors or institutional investors to invest in the equity of private companies or to acquire public companies. | | Private Placement | The sale of securities directly to a limited number of investors, typically institutional investors, without a public offering. | | Probability of Collection | The likelihood that a customer will pay for goods or services purchased on credit, a key factor in credit decision-making. | | Product Markets | Markets where goods and services are bought and sold, as opposed to financial markets where financial instruments are traded. | | Professional Corporation | A type of corporation specifically designed for licensed professionals, such as doctors, lawyers, or accountants, offering limited liability protection. | | Profit Margin | A profitability ratio that measures how much profit a company generates for every dollar of sales, calculated as net income divided by sales. | | Promissory Note | A written promise from one party (the maker) to pay a specified sum of money to another party (the payee) either on demand or at a specified future date. | | Promoted Rate | An introductory or special interest rate offered on a financial product, such as a credit card or loan, for a limited period. | | Promoters | Individuals who organize and manage the initial stages of a business venture, often involving fundraising and the formation of the legal structure. | | Property Insurance Companies | Insurance companies that provide coverage against losses related to damage or destruction of property, such as fire, theft, or natural disasters. | | Prospectus | A legal document that provides detailed information about a security offering, including the company's business, financial condition, and risks involved, provided to potential investors. | | Protective Covenants | Clauses included in loan agreements or bond indentures that impose restrictions on the borrower's actions to protect the lender's interests, such as limitations on dividend payments or additional debt issuance. | | Proxy Contest | A situation where shareholders solicit proxies (votes) from other shareholders to gain control of the company's board of directors and management. | | Proxy Statement | A document that is required by the Securities and Exchange Commission (SEC) to be sent to shareholders before a shareholder meeting, containing information about matters to be voted upon. | | Purchasing Power Parity (PPP) | An economic theory that suggests exchange rates between currencies will adjust to equalize the prices of identical goods and services in different countries over time. | | Put Option | A contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a specified price within a certain period. | | Quick Ratio | A liquidity ratio that measures a firm's ability to meet its short-term obligations using only its most liquid assets (excluding inventory), calculated as (current assets - inventory) / current liabilities. | | Real Assets | Tangible assets that have intrinsic value due to their physical properties, such as land, buildings, and equipment. | | Real Option | An option embedded within a capital investment decision that provides flexibility to take certain actions in the future, such as expanding, abandoning, or delaying the project, based on changing market conditions. | | Real Rate of Interest | The nominal interest rate adjusted for inflation, reflecting the true return on an investment in terms of purchasing power. | | Receivables Turnover Rate | A financial ratio that measures how efficiently a company collects its outstanding accounts receivable, calculated as credit sales divided by average accounts receivable. | | Recourse | The ability of a lender to pursue the borrower's other assets if the collateral securing a loan is insufficient to cover the outstanding debt. | | Reduction in Share Value | A decrease in the market price of a company's stock, which can occur for various reasons, including negative news, poor financial performance, or dilution from new stock issuance. | | Refinancing | Replacing an existing debt obligation with a new one, often to obtain better terms, such as a lower interest rate or longer maturity. | | Rejected Project | An investment project that is not undertaken because its expected returns do not meet the company's required rate of return or its net present value (NPV) is negative. | | Remaining Costs | Costs that are still outstanding or yet to be incurred for a particular project or transaction. | | Repurchase of Shares | A transaction where a company buys back its own outstanding shares from the open market or through a tender offer, reducing the number of shares outstanding and potentially increasing earnings per share and shareholder value. | | Required Rate of Return | The minimum rate of return that an investor expects to earn on an investment, reflecting the riskiness of the investment and the time value of money. | | Residual Claim | The claim of equity holders on a company's assets and earnings after all other claims, such as debt and preferred stock, have been satisfied. | | Restructuring | The process of making significant changes to a company's financial or operational structure, often to improve efficiency, reduce costs, or enhance shareholder value. | | Retained Earnings | The cumulative profits of a company that have not been distributed to shareholders as dividends but have been reinvested in the business. | | Retention Ratio | The proportion of a company's earnings that is retained and reinvested in the business, rather than paid out as dividends. | | Return on Assets (ROA) | A profitability ratio that measures how efficiently a company uses its assets to generate profits, calculated as net income divided by total assets. | | Return on Equity (ROE) | A profitability ratio that measures how effectively a company uses shareholder equity to generate profits, calculated as net income divided by total equity. | | Revaluation | The process of adjusting the value of an asset on a company's balance sheet to reflect its current market value, rather than its historical cost. | | Rights Issue | An offer to existing shareholders to purchase additional shares in the company, typically at a discount to the current market price, allowing them to maintain their proportional ownership. | | Risk | The possibility that an investment's actual return will differ from its expected return, including the possibility of losing some or all of the original investment. | | Risk Aversion | The tendency of investors to prefer lower returns with known risks over higher returns with unknown risks. | | Risk-Free Rate | The theoretical rate of return of an investment with zero risk, often represented by the yield on government securities like Treasury bills. | | Risk Reduction | Strategies employed to lower the potential for losses on an investment, such as diversification, hedging, or purchasing insurance. | | Roadshows | Presentations given by a company's management to potential investors to promote a new security offering and gauge market demand. | | ROC (Return on Capital) | A measure of a company's profitability that relates its operating profit to the total capital invested in the business. | | Rolling Over Debt | The practice of replacing maturing debt with new debt, often to extend the repayment period or obtain more favorable financing terms. | | Sale of Marketable Securities | The transaction of selling short-term, liquid investments that can be easily converted into cash. | | Sale of Treasury Stock | The reissuance of shares that a company has previously repurchased from the market. | | Salvage Value | The estimated resale or disposal value of an asset at the end of its useful life. | | Savings Account | A deposit account at a financial institution that pays interest on the deposited funds, typically offering lower rates than other investments but with high safety and liquidity. | | Scenario Analysis | A forecasting technique used in capital budgeting to assess the potential impact of different plausible future economic or market conditions on an investment's profitability. | | SEC (Securities and Exchange Commission) | The U.S. government agency responsible for regulating the securities markets and protecting investors. | | Secured Debt | Debt that is backed by specific collateral, such as real estate or equipment, which the lender can seize if the borrower defaults. | | Securities | Financial instruments that represent a claim on the issuer's assets or earnings, such as stocks and bonds. | | Security Market Line (SML) | A graphical representation of the Capital Asset Pricing Model (CAPM), showing the relationship between an asset's expected return and its systematic risk (beta). | | Selling Expenses | Costs incurred in the process of selling goods or services, such as commissions, advertising, and shipping. | | Semi-Strong Form Efficiency | A level of market efficiency where security prices reflect all publicly available information, making it impossible to consistently earn abnormal returns through fundamental or technical analysis. | | Sensitivity Analysis | A capital budgeting technique used to assess how changes in a single input variable affect an investment's outcome, such as its net present value (NPV). | | Separation of Ownership and Control | A characteristic of corporations where the owners (shareholders) are typically separate from the managers who run the company, potentially leading to agency problems. | | September Put | A put option contract that expires in September. | | Servicing Costs | The costs associated with managing and administering financial transactions, such as loan servicing, customer support, and record-keeping. | | Shareholder Wealth Maximization | The primary goal of corporate management, aiming to increase the value of the company's stock to benefit its owners. | | Shark Attractant | A defensive tactic used by a company to make itself less attractive to potential hostile acquirers, often by implementing measures that increase the cost or difficulty of a takeover. | | Shark Repellent | Defensive measures taken by a company to make it more difficult or costly for an unwanted acquirer to gain control, often through changes in the corporate charter or bylaws. | | Short Selling | The practice of selling a security that the investor does not own, with the expectation that the price will fall, allowing the investor to buy it back at a lower price and profit from the difference. | | Short-Term Financial Plan | A plan that outlines a company's expected cash inflows and outflows over a period of one year or less, used for managing liquidity and meeting short-term financial obligations. | | Short-Term Financing | Borrowing funds for a period of one year or less, such as through bank loans, commercial paper, or stretching accounts payable. | | Short-Term Liabilities | Obligations that a company expects to settle within one year or its operating cycle, whichever is longer. | | Signal | Information conveyed by a company's actions or announcements that can influence investor perceptions and stock prices, such as dividend changes or stock repurchases. | | Simple Interest | Interest calculated only on the principal amount of a loan or investment, without taking into account the effects of compounding. | | Sinking Fund | A fund established by a company to gradually retire its debt obligations before their maturity date, often by making periodic payments into the fund. | | Site Selection | The process of identifying and evaluating potential locations for a new business facility or operation, considering factors like cost, logistics, and market access. | | Small-Scale Preliminary Study | A pilot project or feasibility study conducted before undertaking a larger, more resource-intensive initiative. | | Sole Proprietorship | A business owned and operated by a single individual, with no legal distinction between the owner and the business, and unlimited personal liability for business debts. | | SOFR (Secured Overnight Financing Rate) | A benchmark interest rate used in the U.S. financial markets, representing the average rate for overnight collateralized transactions. | | Sources and Uses of Cash Statement | A financial statement that reports the cash inflows (sources) and cash outflows (uses) of a company over a specific period, often part of a financial plan. | | South Sea Company | A British joint-stock company founded in 1711 that was granted a monopoly on trade with Spanish South America, but collapsed spectacularly in 1720 due to speculative excess. | | Span of Control | The number of subordinates a manager can effectively supervise and control. | | Special Dividend | A one-time dividend payment made by a company to its shareholders, often in addition to regular dividends, typically resulting from unexpected profits or asset sales. | | Speculation | The practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of a security or asset. | | Speculators | Investors who engage in speculation, aiming to profit from short-term price movements in financial markets, often by taking on higher levels of risk. | | Spin-off | A corporate restructuring strategy where a company separates a division or subsidiary into a new, independent entity, distributing shares of the new company to existing shareholders. | | Spot Rate | The exchange rate for a currency transaction that takes place immediately or within a very short period (typically two business days). | | Spread | The difference between the bid price and the ask price of a security or asset, representing the profit potential for market makers or dealers. | | S&P 500 | A stock market index that tracks the performance of 500 of the largest publicly traded companies in the United States, often used as a benchmark for the overall stock market. | | Staggered Board | A corporate governance practice where the members of the board of directors are elected for overlapping terms, making it more difficult for shareholders to replace the entire board at once. | | Stand-alone Value | The market value of a company or asset considered independently, without reference to any potential merger or acquisition synergies. | | Stock Dividend | A dividend paid in the form of additional shares of stock, rather than cash, distributed to existing shareholders. | | Stock Repurchase | A transaction where a company buys back its own shares from the open market or through a tender offer, reducing the number of outstanding shares and potentially increasing earnings per share and shareholder value. | | Stock Split | A corporate action where a company divides its existing shares into multiple new shares, increasing the number of shares outstanding but decreasing the price per share proportionally. | | Stockholders' Equity | The residual interest in the assets of an entity after deducting all its liabilities, representing the owners' stake in the company. | | Straight Bond | A debt instrument that does not contain any embedded options, such as call or conversion features, and pays a fixed coupon rate until maturity. | | Strategic Reasons | Motivations for business decisions that are driven by long-term goals and competitive advantages, such as entering new markets or acquiring complementary resources. | | Strike Price | The predetermined price at which the buyer of an option contract has the right to buy (call option) or sell (put option) the underlying asset. Also known as the exercise price. | | Strong-Form Efficiency | The highest level of market efficiency, where security prices reflect all information, both public and private, making it impossible to consistently earn abnormal returns. | | Subordinated Debt | Debt that ranks lower in priority than other debt in the event of bankruptcy or liquidation, often carrying higher interest rates due to increased risk. | | Subsidiary | A company that is owned or controlled by another company, known as the parent company. | | Subsidiary Company | A company controlled by a parent company, which typically owns a majority of the subsidiary's stock. | | Supermajority | A voting requirement that mandates a higher percentage of shareholder or director approval than a simple majority for certain corporate actions, such as mergers or amendments to the charter. | | Suppliers | Businesses or individuals that provide goods or services to other companies. | | Supply Chain Management | The oversight of materials, information, and finances as they move in a process from supplier to manufacturer to wholesaler to retailer to consumer. | | Swap | A derivative contract where two parties exchange financial instruments or cash flows or liabilities from two different financial instruments. | | Swaps | Derivative contracts that involve the exchange of financial instruments or cash flows between two parties, often used to manage interest rate risk or currency risk. | | Symmetrical Information | A situation where all market participants have access to the same information about a security or asset. | | Tax Liability | The total amount of taxes a company or individual owes to the government for a given period. | | Tax Rate | The percentage of income or profits that is paid as taxes to the government. | | Tax Shield | A reduction in taxable income or tax liability resulting from certain deductible expenses, such as interest payments or depreciation. | | Taxable Income | The portion of a company's or individual's income that is subject to taxation. | | Target Firm | The company that is being acquired in a merger or takeover transaction. | | T-Bill (Treasury Bill) | A short-term debt security issued by the U.S. Treasury with maturities of one year or less, considered a risk-free investment. | | Technical Analysis | A method of evaluating securities by analyzing statistical trends gathered from trading activity, such as price movement and volume. | | Tender Offer | A public offer made by a potential acquirer to purchase shares of a target company directly from its shareholders, usually at a premium to the current market price. | | Tenor | The length of time until a loan or debt obligation matures. | | Term Loan | A loan from a bank or other lender that has a specified repayment schedule and maturity date, often used for financing capital expenditures or business acquisitions. | | Terms of Trade Credit | The conditions under which a seller extends credit to a buyer, including the discount offered for early payment, the net payment period, and any penalties for late payment. | | Tertiary Market | A hypothetical market segment that might exist beyond primary and secondary markets, but is not a standard term in finance. | | Theory of Purchasing Power Parity (PPP) | An economic theory that suggests exchange rates between currencies will adjust to equalize the prices of identical goods and services in different countries over time. | | Time Value of Money | The concept that a dollar today is worth more than a dollar in the future, due to its potential earning capacity through investment. | | Times Interest Earned (TIE) Ratio | A profitability ratio that measures a company's ability to meet its interest obligations, calculated as earnings before interest and taxes (EBIT) divided by interest expense. | | Timing Option | A real option that provides the flexibility to delay or accelerate an investment decision based on market conditions or future information. | | Tiresome Information | Information that is widely disseminated and already reflected in market prices, providing no new insights for generating abnormal profits. | | T-Bills (Treasury Bills) | Short-term debt obligations issued by the U.S. Treasury with maturities of one year or less, considered risk-free investments. | | Total Capital Requirements | The total amount of funds a company needs to finance its operations, investments, and growth. | | Total Debt Ratio | A leverage ratio that measures the proportion of a company's assets financed by debt, calculated as total liabilities divided by total assets. | | Total Return | The overall gain or loss on an investment over a period, including income received (e.g., dividends or interest) and capital appreciation or depreciation. | | Trading on Equity | The use of debt financing to increase the potential return on equity, often leading to higher financial risk. | | Transaction Costs | Expenses incurred when buying or selling a financial asset or security, such as brokerage fees, commissions, and taxes. | | Treasury Bonds | Long-term debt securities issued by the U.S. Treasury with maturities of 10 years or more, considered low-risk investments. | | Treasury Bills | Short-term debt instruments issued by the U.S. Treasury with maturities of one year or less, considered risk-free investments. | | Trend Analysis | The examination of financial data over time to identify patterns, trends, and relationships, used in financial planning and forecasting. | | Tri-C Corp | A hypothetical company mentioned in the context of financial ratio analysis. | | Trigger Point | A specific condition or event that initiates a particular action or decision, such as a trigger for exercising an option or defaulting on a loan. | | T-Shirt Inventory | A colloquial term referring to inventory that is likely to be easily sold or have high turnover. | | T-Shirt Wins of the Super Bowl | Refers to inventory of merchandise related to a specific sporting event, which may have a limited or seasonal demand. | | T-accounts | Simplified representations of financial transactions used in accounting to track changes in specific accounts. | | T-bill Rate | The interest rate on Treasury bills, often used as a proxy for the risk-free rate. | | Two-Stock Portfolio | A portfolio consisting of only two different stocks, used in examples to illustrate portfolio diversification and risk calculations. | | Umbrella Company | A large, diversified corporation that operates in multiple industries and geographic locations, often with a complex organizational structure. | | Underpriced | A situation where the market price of a security is lower than its perceived intrinsic value, suggesting it may be a good investment opportunity. | | Underpricing of New Issues | The practice of selling new securities at a price below their expected market value, often done to ensure successful distribution and attract investors. | | Underwriter | An investment bank or financial institution that helps companies raise capital by purchasing newly issued securities and reselling them to the public. | | Underwriting Spread | The difference between the price at which an underwriter buys securities from an issuer and the price at which they are resold to the public, representing the underwriter's fee. | | Underwriting Terms | The conditions and agreements set forth by an underwriter for the issuance and sale of securities, including pricing, fees, and marketing strategies. | | Underlying Asset | The asset on which a derivative contract, such as an option or futures contract, is based. | | Underperform | When the return on an investment or asset is lower than expected or lower than that of a benchmark index. | | Undervalued | A situation where the market price of a security is lower than its estimated intrinsic value, suggesting it may be a good investment opportunity. | | Unlimited Personal Liability | A characteristic of sole proprietorships and general partnerships where the owners are personally responsible for all business debts and obligations, potentially risking their personal assets. | | Unlevered Firm | A company that has no debt in its capital structure, financed entirely by equity. | | Unprofitable Entities | Businesses that are consistently losing money and are unable to generate sufficient revenue to cover their expenses. | | Unsecured Debt | Debt that is not backed by specific collateral, meaning the lender's claim on the borrower's assets is general rather than specific. | | Up-front Price | The initial payment made for a financial contract or asset at the time of purchase. | | Upward-Sloping Yield Curve | A yield curve where longer-maturity bonds offer higher yields than shorter-maturity bonds, typically indicating expectations of rising interest rates or economic growth. | | U.S. Treasury Bonds | Long-term debt securities issued by the U.S. Treasury with maturities of 10 years or more, considered low-risk investments. | | U.S. Treasury Bills | Short-term debt instruments issued by the U.S. Treasury with maturities of one year or less, considered risk-free investments. | | Valuation | The process of estimating the economic worth of a company, security, or asset based on various financial and market factors. | | Variable Costs | Costs that change in proportion to the level of production or sales, such as raw materials and direct labor. | | Vertical Merger | A merger between two companies that operate at different stages of the same industry's supply chain, such as a manufacturer acquiring a supplier or distributor. | | Visa Inc. | A multinational financial services corporation that facilitates electronic funds transfers throughout the world, most commonly through Visa-branded credit cards, debit cards and prepaid cards. | | Volatility | A measure of the dispersion or fluctuation of returns for a given security or market index, indicating the degree of risk associated with the investment. | | Volatility of Stock Price | The degree to which a stock's price fluctuates over a period, reflecting market risk and company-specific factors. | | Voting Power | The rights granted to shareholders to influence corporate decisions by casting votes on matters such as the election of directors and major corporate actions. | | WACC (Weighted-Average Cost of Capital) | The average rate of return a company expects to pay to all its security holders to finance its assets, calculated by weighing the cost of each component of capital (debt, preferred stock, and common equity) by its proportion in the capital structure. | | Warrants | Securities that give the holder the right to purchase a company's stock at a predetermined price within a specified period, often attached to bonds or preferred stock as a "sweetener" to increase their attractiveness. | | Weak-Form Efficiency | The lowest level of market efficiency, where security prices reflect all past market information, making it impossible to consistently earn abnormal returns through technical analysis alone. | | Wheat Farmer | An agricultural producer who cultivates and sells wheat, often involved in hedging strategies using futures contracts. | | When-Issued Trading | Trading of a security that has been authorized but not yet issued. | | Work-in-Progress Inventory | Goods that are currently in the production process but have not yet been completed. | | Zero-Coupon Bond | A bond that does not pay periodic interest payments (coupons) but is sold at a discount to its face value and pays the full face value at maturity. | | Zero-Sum Game | A situation where the total gains of the participants are exactly equal to the total losses, meaning one party's profit comes at the expense of another's. | | Call Option | A financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price (the exercise price) on or before a certain date. | | Exercise Price | The predetermined price at which the holder of an option can buy (for a call option) or sell (for a put option) the underlying asset. | | Speculator | An individual or entity that trades in financial markets with the hope of profiting from short-term price fluctuations, thereby assuming a higher level of risk. | | Callable Bond | A bond that the issuer has the right to redeem, or call, before its maturity date at a specified price. | | Warrant | A security issued by a company that gives the holder the right to purchase a certain number of shares of the company's stock at a specified price for a specified period of time. It is often attached to bonds as a "sweetener." | | Currency Swap | An agreement between two parties to exchange principal and interest payments on a loan in one currency for equivalent payments in another currency. | | Interest Rate Swap | An agreement between two parties to exchange interest rate payments over a specified period. Typically, one party exchanges fixed-rate payments for floating-rate payments, or vice versa. | | Operational Hedging | A strategy that involves adjusting a company's operations to reduce exposure to financial risks, such as manufacturing goods in the country where they will be sold. | | Put-Call Parity | A principle that defines the relationship between the price of a European call option, a European put option, the underlying asset, and a risk-free bond. The relationship is $C + PV(X) = P + S$, where C is the call price, P is the put price, PV(X) is the present value of the exercise price, and S is the stock price. | | Time to Expiration | The period remaining until an option contract expires. All else being equal, options with more time to expiration generally have higher values. | | Embedded Option | An option that is part of a larger financial instrument, such as the call option in a callable bond or the conversion option in a convertible bond. | | Flexibility Option | A type of real option that provides the holder with the discretion to adjust operations or investments in response to changing market conditions. | | Amortizing Loan | A loan where each payment reduces both the principal balance and the accrued interest, leading to a diminishing principal over time. | | Annuity | A series of equal cash payments made at regular intervals for a specified period of time. | | Annuity Due | A type of annuity where payments are made at the beginning of each period, rather than at the end. | | Future Value | The value of a current asset at a specified future date, based on an assumed rate of growth or interest. |