• The process of planning and managing a firm's long-term investments
• What long-term investments should we take?

• The mixture of debt and equity maintained by a firm.
• Where will the company get the long-term capital for its investments?

• A firm's short-term assets and liabilities.
• How should we manage our day to day financial activities?

• Advantages
  • easy to raise capital
  • easy to transfer ownership
  • limited liability for the owners
• Disadvantages
  • double taxation
  • more difficult to start than other types of businesses
• Bylaws
  • The rules describing how the corporation regulates its own existence.

• Maximize the current value per share of the existing stock.
• Increase the market value of shareholder equity.

• Primary market
  • Refers to the original sale of securities by governments and corporations.
• Secondary market
  • Those in which securities already sold on the primary market are bought and sold after the original sale.
  • Secondary markets can either be:
    • Dealer market
      • A type of secondary market called-over-the counter markets (OTC) where stocks and long-term debt are bought and sold and transactions are handled by a dealer.
    • Auction market
      • A  type of secondary market that has a physical location, like Wall Street, and the market itself brings buyers and sellers together with little role of a dealer.

• Financial statement showing a firm's accounting value on a particular date.
• Example Balance Sheet
• Balance Sheet Model Diagram

• An asset with a relatively long life that is either tangible or intangible.
  • Buildings and equipment are some example of long term assets.
    • Tangible asset
      • An asset that has physical shape and form like a truck or a computer.
    • Intangible asset
      • An asset that has no physical shape and form like a trademark or patent.

• An asset that has a life of less than one year.
  • Cash, accounts receivable and inventory are usually listed as a current asset.
  • Current assets are more liquid than long term assets and are listed first on the balance sheet.
    • Account recievable
      • A current asset, which is money owed to the firm by customers who purchased on credit.

• Liabilities or debt with a relatively long life.

• A liability or debt with a life less than one year. They must be paid within the year.
  • Accounts payable and short term bonds or interest payments on bonds are such current liabilities.
    • Account payable
      • A current liability, which is money the firm owes to its supplier.

• A type of long-term debt.
  • Bonds are issued by corporations to raise additional capital on top of the capital raised from the sale of stock usually for different purposes and for a fixed time period with a relatively fixed interest rate.

• A type of long term creditor.
  • People buy bonds from the corporation because they expect the corporation to pay the promised interest rate each year.

• The difference between the total value of current and fixed assets and the total value of current and long-term liabilities.

• Assets = Liabilities + Shareholders' Equity

• Current assets less current liabilities.

• The speed and ease with which an asset can be converted to cash.

• Shareholders' equity = Assets - Liabilities

• The use of debt in a firm's capital structure. The more debt a firm has as a percentage of assets, the greater is its degree of financial leverage.

• The common set of standards and procedures by which audited financial statements are prepared.

• The value of assets according to cost of assets and may not be what the assets are actually worth.

• The value of  assets according to the market price of the assets if sold today.
  • The goal of the financial manager is to maximize the market value of the stock.
  • It's important not to confuse book value and market value.

• Financial statement summarizing a firm's performance over a period of time.
  • Income statement equation
    • Revenues - Expenses = Income
• Example Income Statement

• Expenses charged against revenues that do not directly affect cash flow, such as depreciation.

• Total taxes paid divided by total taxable income.

• Amount of tax payable on the next dollar earned.
  • It's the marginal tax rate that is relevant for most financial decisions because it's that new marginal rate that will apply to new future cash flows.
  • The marginal tax rate paid by corporations with the largest incomes is 35 percent in the United States.
  • Tax Table Example
  • Tax Calculation Example

• The difference between the number of dollars that came in and the number that went out.
  • Net income computed on the balance sheet is not cash flow because depreciation which is a noncash expense is deducted when net income is computed.
  • It's important not to confuse accounting net income and cash flow.

• A cash flow identity saying that the cash flow from assets is the total cash flow to creditors and cash flow to stockholders, consisting of: operating cash flow, capital spending, and change in net working capital.
• Example Image

• Cash generated from a firm's normal business activities.
• Example Image

• Money spent on fixed assets less money received from the sale of fixed assets.
• Example Image

• A firm's interest payments to creditors less net new borrowings.

• Dividends paid out by a firm less net new equity raised.

• It's important not to confuse operating costs with financing costs. Accountants and financial managers may tend to have different views and we should therefore pay close attention to things like how noncash items such as deprectiation are calculated on the income statements and how cash expenses such as taxes are calculated.

• A firm's activities that generate cash.
• A decrease in an asset account, the firm sold some assets. (left side)
• An increase in a liability or equity account, the firm obtained cash. (right side)
  • Selling a product
  • Selling an asset
  • Selling a security
    • Borring - bonds
    • Selling an equity interest - stock

• A firm's activities in which cash is spent. Also called applications of cash.
• An incease in an asset account the firm bought some assets. (left side)
• A decrease in a liability account, the firm made a payment. (right side)
  • Paying for labor
  • Paying for materials for production
  • Buying an asset
    • Buying a fixed asset
    • Buying a current asset
      • ie. inventory
  • Payments to creditors
  • Payments to shareholders

• A firm's financial statement that summarizes its sources and uses of cash over a specified period.

• The difference between the sources and uses of cash.

• Similar to the statement of cash flows except it's arranged by souces of cash and uses of cash.

• A standardized financial statement presenting all items in percentage terms. Balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales.

• A standardized financial statement presenting all items relative to a certain base-year amount.

• Relationships determined from a firm's financial information and used for comparison purposes.

• Measures intended to provide information about a firm's liquidity, and these ratios are sometimes called liquidity measures.
• These ratios tell you about how well the company can pay it's bills over a short run. They focus on current assets and current liabilities mostly.
• Short term lenders, creditors including suppliers and banks are interested in such short term ratios.
• Advantage: Current assets market prices and book prices are often more similar than longer term ratios.
• Disadvantage: Current assets and liabilities change rapidly so the value today may not be the same tomorrow.
  • Current ratio
    • Current assets divided by Current liabilities.
    • It tells you how many dollars of assets for each dollar of liabilities or we could say the value is how many times liabilities are covered.
    • A high current ratio implies liquidity however it might also indicate an inefficient use of cash and other short term assets.
    • We assume to see a current ratio of at least 1 because a current ratio would imply a negative net working capital which is not usual for a healthy firm.
    • A low current ratio doesn't necessarily imply a bad company if the company is not borrowing a lot presently.
    • It's important to see how the various transaction could increase or decrease the current ratio. For example, if the firm issued long term debt notes or bonds, the long term liabilities would be affected and would not affect the short term liabilities while affecting the short term assets which would cause the current ratio to rise.
  • Quick Ratio (Acid Test)
    • The acid test ratio is Current assets minus inventory divided by current liabilities.
    • Another liquidity measure with only the most liquid items. For most firms inventory moves slower than other items listed in current assets such as accounts payable and or course cash itself.
    • Basically this is the current ratio without the inventory included because sometimes inventory may be slow moving, obsolete, or damaged. In some cases we want to see how the rest of the current side is doing because sometimes firms have a great deal of capital tied up in inventory.
  • Cash ratio
    • The Cash ratio is Cash divided by Current liabilities.
    • Very short term creditors are most often interested in the cash ratio.
    • This will give you a 'times' factor for cash and liabilities to see how they compare. A firm with too little available cash compared to it's current liabilities may not be able to take further short term loans for example.
  • Net working capital (NWC)
    • The amount of short-term liquidity a firm has
    • Net working capital to total assets
      • Net working capital to total assets is Net Working Capital divided by Total assets. This shows us how much short-term liquidity a firm has.
      • A relatively low level might indicate a low liquidity level as a percent
  • Internal measure
    • Internal measure is Current assets divided by Average daily operating costs. This can show us how long the business can keep running from today with cash inflow instability.
      • Average daily costs are (total costs - depreciation - interest) divided by 365 days.
    • Interval measure when calculated will give you a number in 'days' that the firm could operate on current assets without any addition to current assets, sales, or other means of income.

• Are intended to address the firm's long-run ability to meet its obligations, or, more generally, it's financial leverage.
  • Total debt ratio

    • Total debt ratio is Total assets minis Total equity divided by Total assets. A long-term solvency measure.

    • This will give you a percentage of debt. You can think of it for example as a percentage, like 30% debt. Or you can think of it as compared to $1.00 so $0.30 for every dollar of assets. Or you can think of it terms of the remaineder where you have $0.70 (1.00 - 0.30) equity for every $0.30 of debt.

    • What percent of long term debt is the firm currently operating under? How much debt does the firm have compared to assets?

  • Debt equity ratio

    • Debt equity ratio is Total debt divided by Total equity. A long-term solvency measure.

    • A variation on the total debt ratio

  • Equity multiplier
    • Equity multiplier is Total assets divided by Total equity. A long-term solvency measure.
    • a variation on the total debt ratio
    • 1 plus the debt equity ratio
  • Long-term debt ratio
    • Long-term debt ratio is Long-term debt divided by Long-term debt plus Total equity.  A long-term solvency measure.
    • Frequently a financial analyst might be interested more in the firms long term debt as opposed to current liabilities because the current liabilites is always changing.
  • Times interest earned ratio (TIE)
    • Times interest earned ratio is EBIT divided by interest. This ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio.
  • Cash coverage ratio
    • Cash coverage ratio is EBIT + Depreciation divided by interest. The numerator is often abbreviated as EBDIT (earnings before depreciation, interest, and taxes) It is a basic measure of the firm's ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations.

• The specific ratios can be interpreted as measures of turnover. They are intended to describe how efficiently or intensively a firm uses its assets to generate sales.
  • Inventory turnover
    • Inventory turnover equals Costs of goods sold divided by Inventory. The higher this ratio the more efficiently we are managing inventory.
    • This tells how many times we sold our inventory for the period.

  • Days' sales in inventory

    • Days' sales in inventory is 365 divided by Inventory turnover. This tells us how many days it will take to sell our inventory and how fast we sell our inventory.
  • Receivables turnover
    • Receivables turnover is Sales divided by Accounts receivable. This shows how fast we collect on our sales.
  • Days' sales in receivables
    • Days' sales in receivables is 365 days divided by Receivables turnover.  This tells us how often we collect on our credit sales.
  • Asset Turnover Ratios
    • Asset turnover ratios are big picture ratios.
  • NWC Turnover
    • NWC Turnover is Sales divided by NWC. This ratio measures how much 'work' we get out of our working capital.
  • Fixed asset turnover
    • Fixed asset turnover is sales divided by net fixed assets. For every dollar in fixed assets.
    • This tells us for every dollar in fixed assets, we are making x amount of money.
  • Total asset turnover
    • Total asset turnover is sales divided by total assets. For every dollar in assets.
    • This tells us overall for every dollar in assets, we are making x amount of money.
  • Total asset time
    • If we want to know how long it takes to turn over our total assets we can just use the number from total asset turnover and divide into 1. (1/x = y)
    • Example: we are making 0.40 for every dollar in assets. 1/.40 = 2.5. Therefore it would take us 2.5 years to completely turn over our assets.

• Are intended to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations.
  • Profit Margin
    • Profit margin is net income divided by sales. This can be thought of as how much money per dollar in sales or in a full percent overall. Relatively high profit margin and low expense ratios relative to sales is desirable however as margins go down volume goes up so you could make up the difference that way as well.
  • Return on Assets (ROA)
    • Is a measure of profit per dollar of assets. It is most commonly defined as Return on Assets equals Net income divided by Total assets. 
    • It can be listed as a percent, or as cents.

  • Return on Equity (ROE)

    • Is a measure of how stockholders did during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually Return on Equity equals Net income divided by Total equity. For every dollar in equity, a certain percent, or cents was earned in accounting terms.
    • It can be listed as % or $0.01 (cents)

5. Market value measures

• Market value measures are based in part on information not necessarily contained in financial statements - the market price per share of the stock. 

  • Earnings per shares (EPS)

    • Earnings per share is Net income divided by Shares outstanding.
  • Price Earnings Ratio (PE)
    • Is Price per share divided by Earnings per share. This gives us a number. The number tells us how many times higher than earnings the shares sell for. The PE ratio measures how much investors are willing to pay per dollar of current earnings, higher PEs are often taken to mean the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its PE would probably be quite large as well.

  • Market-To-Book Ratio

    • Is Market value per share divided by Book value per share. Because book value per share is an accounting number, it reflects historical costs. The market-to-book ratio sort of compares the market value of the firm's investments to their cost. A value less than 1 could mean that the firm has not been successful overall in creating value for its stockholders. A number above 1 can be seen as 1 times.. 2 times.. etc.

• Earnings before interest and tax

• Popular expression breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage. 
  • 1. Operating efficiency (as measured by profit margin)
  • 2. Asset use efficiency (as measured by total asset turnover)
  • 3. Financial leverage (as measured by the equity multiplier)
    • Weakness in either operating or asset use efficiency, or both, will show up in a diminished return on assets, which will translate into a lower ROE. 
  • ROE = Profit Margin X Total Asset Turnover X Equity Multiplyer

• performance evaluation
  • for management compensation
    • profit margin
    • return on equity
• projection planning

• external long-term creditors
• external short-term creditors
• investors
• supplier evaluation
• evaluation by suppliers for credit terms
• credit rating agencies
• competitor evaluation
• acquisitions

• Time-trend analysis
  • historical changes in the firm based on financial ratios
• Peer group evaluation
  • SIC Code based peers
  • www.naics.com
  • ex: comparing current ratios or other ratios across all SIC based peers.

• mixed operation firms - conglomerates
  • if the firm is a conglomerate it's difficult for find the right peer.
• global operations
  • since operations exist around the globe they may or may not have the same accounting standards.
  • They operate under different rules and regulations
• If they a monopoly in their region they don't really compete with the peer counterpart.
• Firms with seasonal business are often difficult to compare
• Firms the end their fiscal year at different times might be difficult to compare.
• Unusual events such as selling assets one time may change the comparison outcome.

• Internal
  • Performance evaluation
  • Future planning
• External
  • Short-term and long-term creditors use the information to evaluate for loans
  • Potential investors use the information to evaluate whether or not it's a good investment.
  • We use the information to evaluate suppliers.
  • Suppliers use statements before deciding to extend credit.
  • Large customers use the statements to decide if we are likely to be around in the future.
  • Credit rating agencies rely on financial statements in assessing a firm's overall creditworthiness.
  • Financial statements are a prime source of information about a firm's financial health.

• A U.S. Government code used to classify a firm by its type of business operations.

• The long-range time period on which the financial planning process focuses, usually the next two to five years.

• The process by which smaller investment proposals of each of a firm's operational units are added up and treated as one big project.

• Examining Interactions
• Exploring options
• Avoiding Surprises
• Ensuring feasibility and internal consistency

• 1. The firm’s needed investment in new assets. This will arise from the investment opportunities the firm chooses to undertake, and it is the result of the firm’s capital budgeting decisions.
• 2. The degree of financial leverage the firm chooses to employ. This will determine the amount of borrowing the firm will use to finance its investments in real assets. This is the firm’s capital structure policy.
• 3. The amount of cash the firm thinks is necessary and appropriate to pay shareholders. This is the firm’s dividend policy.
• 4. The amount of liquidity and working capital the firm needs on an ongoing basis. This is the firm’s net working capital decision.

• 1. A worst case. 
  • This plan would require making relatively pessimistic assumptions about the company’s products and the state of the economy. This kind of disaster planning would emphasize a division’s ability to withstand significant economic adversity, and it would require details concerning cost cutting, and even divestiture and liquidation.
• 2. A normal case. 
  • This plan would require making the most likely assumptions about the company and the economy.
• 3. A best case. 
  • Each division would be required to work out a case based on optimistic assumptions. It could involve new products and expansion and would then detail the financing needed to fund the expansion.

• The sales forecast is the 'driver', meaning that the user of the planning model will supply this value, and most other values will be calculated on it. Planning focuses on projected future sales and the assets and financing needed to support those sales. Frequently the sales forecast will be given as the growth rate in sales rather than explicit sales figures. Perfect sales forecasts are not possible, of course, because sales depend on the uncertain future state of the economy. 

• A forecasted (future predicted) balance sheet, income statement, and statement of cash flows. These are used to summarize the different events projected for the future. 

• A financial planning method in which accounts varied depending on a firm's predicted sales level. Each applicable item is calculated as a percentage of sales. For example, we take the percentage of items on the income statement and compare it directly as a percentage of sales, then if sales were to increase in our pro forma for the next year we would increase the sales but keep the proportional relation the same between the items. Some things that do not vary with sales, like long term debt, or retained earnings may not be increased using this method so they would stay the same until we calculated the rest of the balance sheet and income statement and statement of cash flow.

• The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance. If we were to forcast based on the percentage of sales and left short term and long term debt as it was previously we would have an unbalanced balance sheet because increases in short term liabilites and current assets would cause the balance sheet to unbalance. We can use the plug to determine how we will finance our activities and bring the balance sheet back into balance.

• The amount of cash paid out to shareholders (cash dividend) divided by net income. 
• Example image

• The addition to retained earnings divided by net income. Also called the plowback ratio.  
• Also 'retention ratio' or 'plowback ratio', and it is equal to 1 minus the dividend payout ratio because everything not paid out is retained.
• labeled 'b' in our equations
• Example image

• A firm's total assets divided by its sales, or the amount of assets needed to generate $1 in sales. If the answer is 4 for example, it means you need $4 in assets to generate $1 in sales, or it means if you want to increase sales to $2 you'll require 2 * 4 = 8 in assets. 4 is for example only and is quite 'capital intense'.
• Example image

• In regards to forecasting and assets required please be sure to calculate full capacity sales if not running at full capacity. If unknown then take it as a full capacity calculation.
• Example image

• If current assets are lower than current liabilites you may want to include current liabilites (short term notes) before considering long term debt, or using long term debt to make up the difference.
• Example image

• When we calculate pro forma statements we will have a need for 'new assets' and a 'projected addition to retained earnings'. So we would subtract 'new assets needed' from 'projected addition to retained earnings' and get the EFN. After calculating the proforma balance sheet you can see the assets and liabilities sides do not balance. Just subtract the 2 and get EFN.
• Example image

• Is ROA times b (plowback ratio) divided by 1 minus ROA times b and is the maximum growth rate a firm can achieve without external financing of any kind.
• Example image

• Is ROE times b (plowback ratio) divided by 1 minus ROE times b and is the maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio.

• 1. Profit margin. 
  • An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth.
• 2. Dividend policy. 
  • A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and therefore increases sustainable growth.
• 3. Financial policy. 
  • An increase in the debt-equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate.
• 4. Total asset turnover. 
  • An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity.

• If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover are all fixed, then there is only one possible growth rate.

• The amount an investment is worth after one or more periods.
  • Investing in one period
    • (C + r)
  • Investing in more than one period
    • C = (1 + r)^t
      • C = cash
      • r = rate of interest
      • t = time periods
  • (1 + r)^t = future value factor
  • FVIF(r,t) = future value factor abbreviation
  • FV_t = future value after time

• The process of accumulating interest in an investment over time to earn more interest.

• Interest earned on the reinvestment of previous interest payments.

• Interest earned on both the initial principal and the interest reinvested from prior periods.

• Interest earned only on the original principal amount invested.

• The current value of future cash flows discounted at the appropriate discount rate.
  • PV = Present Value
  • PV = FV_t /(1 + r)^t = basic present value equation

• Calculate the present value of some future amount to determin what it's worth today. 

• The rate used to calculate the present value of future cash flows.
  • PVIF(r, t) = discount rate abbreviation (future value interest factor)
  • 1/(1 + r)^t  = discount factor , discount rate, return rate

• Calculating the present value of a future cash flow to determine its value today.

• If I invest $1 for 1 year at 10% interest what will my $1 be in one year?
  • (1 + r)
  • 1 + .10 = 1.10
• If I invest $1 for 3 years at 10% interest what will my $1 be in three years?
  • C = (1 + r)^t
  • C X (1 +.10)^t
  • 1 X (1 +.10)³ = $1.33
• How much money do I have to invest today to get $1 in a year based on a 10% interest rate?
  • PV = FV_t /(1 + r)^t
  • PV × 1.1 = $1
  • PV = $1/1.1 = $.909
  • check - $.909 X 1.1 = $1
• How much money do I have to invest today to get $1000 in two years based on a 10% interest rate?
  • PV = FV_t /(1 + r)^t
  • PV = $1 X [1/(1 + r)^t] = $1/(1 + r)^t
  • Present value = $1,000/1.21 = $826.45
• Calculating the discount factor only. We want to have $1000 in 3 years and we will get 15% interest, how much do we have to invest today?
  • 1/(1 + r)^t = 1/(1 + .15)^{t =} 1/1.5209 = .6575
  • Discount factor = .6575
  • FV / 1 / (1 + r)^t
  • $1,000 × .6575 = $657.50
  • We must invest $657.50 today to get $1000 in three years if the interest rate it 15%
• We have an investment that will cost us $100 and will double our money in 8 years. We want to know what the discount rate is. The discount rate is also known as the rate of return.
  • PV = FVt / (1 + r)^t
  • 100 = 200 / (1 + r )⁸
  • (1 + r)^t = FV/PV
  • (1 + r)⁸ = 200/100 = 2
  • We can now look at a future value table, find a future value factor that equals 2 after 8 years and we'll see the return is 9%
  • OR
  • We can use the rule of 72
  • OR
  • We can solve the equation mathmatically using the 8th root of both sides
  • (FV / PV)^(1/t) - 1
  • OR
  • We can use a calculator
• Rule of 72
  • For any estimated rate between 5% and 20% we can use 72/r% = t to see what rate we can double our money in t years. So if we want to double our money in 8 years like the previous example we can use
    • 72/r% = 8
    • 72/9% = 8 There for our estimated rate of return, or discount rate is 9%
  • We could also use the rule of 72 to figure out how long it will take to double our money if given the interest rate.
    • 72/9 = t
    • 72/9 = 8
    • Therefore it will take us 8 years to double our money if our interest rate is 9%
  • We can also use the rule of 72 to see how other investments compare.
• We currently have $25,000. If we can earn 12 percent on this $25,000, how long until we have the $50,000?
  • $25,000 = $50,000/1.12^t
  • $50,000/$25,000 = 1.12^t = 2
  • future value factor = 2
  • We now look at a discount factor table table where future value factor = 2 and interest rate = 12% and we should find a future value factor of 1.9738 occurs at 6 periods so it will take us 6 years
  • To solve for t explicitly you can use the Log function on a calculator or use a financial calculator or use a calculator online
  • log(FV/PV) / log(1 + r)

• A level stream of cash flows for a fixed period of time.

• Present value factor = 1/(1+r)^t
• Annuity present value factor = (1-Present value factor)/r
• Annuity present value = C × ((1-Present value factor)/r

• Future value factor = (1 + r)
• Annuity FV factor = (Future value factor - 1)/r
• Annuity future value = C × Annuity FV factor
• [2000×(1.08^30-1)/.08]

• An annuity for which the cash flows occur at the beginning of the period.
• Annuity due value = Ordinary annuity value × (1 + r)

• An annuity in which the cash flows continue forever.
• PV for perpetuity = C/r

• A type of perpetuity.

• The interest rate expressed in terms of the interest payment made each period. Also, quoted interest rate.

• The interest rate expressed as if it were compounded once per year.
  • m = number of times interest is paid per period (yr)
  • EAR = (1 + (Quoted rate)/m))^m-1
  • EAR = (1 + (APR/m))^m-1

• The interest rate charged per period multiplied by the number of periods per year.
  • r × m = APR
  • 1.2% × 12 = 14.4%

• the borrower receives money today and repays a single lump sum at some time in the future
  • FV = borrowed capital × (1 + r) ^ t
• or if the borrower can pay a certain amount in the future we would discount it back.
  • PV = Future Payment/ (1 + r) ^ t

• the borrower pays interest each period and repays the entire principal at some point in the future
  • PMT = Amount borrowed × r
• The borrower pays each PMT then repays the Amount borrowed at the end of the term.

• the borrower repays parts of the loan over time making regular principle reductions: regular payments
  • Declining payments - fixed principal:
    • (Balance × r) + fixed principal payment
  • Fixed payments (common mortgage):
    • Payment = Principal / ((1 - (1/(1 + r)^t))/r)

• The stated interest rate payment made on a bond.

• The principal amount of a bond that is repaid at the end of the term. Also, par value.

• The annual coupon divided by the face value of a bond.

• Specified date on which the principal amount of a bond is paid.

• The rate required in the market on a bond.

• 1. PV of Face value = Face Value / (1 + r)^t
• 2. Annuity Present Value of coupon = (Coupon * Face Value) × (1-1/(1+r)^t)/r
• Bond Value = 1 + 2

• change the r value to the higher or lower rate

• Yield to maturity

• Given a bond value, coupon, time to maturity, and face value, it is possible to find the implicit discount rate, or yield to maturity, by trial and error or computer assistance. To do this, try different discount rates until the calculated bond value equals the given value. Remember that increasing the rate decreases the bond value.

• The written agreement between the corporation and the lender detailing the terms of the debt issue.
• An indenture usually includes:
  • 1. The basic terms of the bonds
  • 2. The total amount of bonds issued
  • 3. A description of property used as security
  • 4. The repayment arrangements
  • 5. The call provisions
  • 6. Details of the protective covenants

• The form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record.

• The form of bond issue in which the bond is issued without record of the owner's name; payment is made to whoever holds the bond. 

• An unsecured debt, usually with a maturity of 10 years or more.

• An unsecured debt, usually with a maturity under 10 years.

• An account managed by the bond trustee for early bond redemption.
  • 1. Some sinking funds start about 10 years after the initial issuance.
  • 2. Some sinking funds establish equal payments over the life of the bond.
  • 3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there's the possibility of a large 'balloon payment' at maturity. 

• An agreement giving the corporation the option to repurchase the bond at a specified price prior to maturity.

• The amount by which the call price exceeds the par value of the bond.

• A call provision prohibiting the company from redeeming the bond prior to a certain date.

• A bond that, during a certain period, cannot be redeemed by the issuer.

• A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest.
• thou shall not (examples)
  • 1. The firm must limit the amount of dividends it pays according to some formula.
  • 2. The firm cannot pledge any assets to other lenders.
  • 3. The firm cannot merge with another firm.
  • 4. The firm cannot sell or lease any major assets without approval by the lender.
  • 5. The firm cannot issue additional long-term debt.
• thou shall (examples)
  • 1. The company must maintain its working capital at or above some specified minimum level.
  • 2. The company must periodically furnish audited financial statements to the lender.
  • 3. The firm must maintain any collateral or security in good condition.

• Aaa or AAA has the highest rating. Capacity to pay interest and principal is extremely strong.
• Aa or AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group makes up the high-grade bond class.
• A or A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in high-rated categories
• Baa or BBB is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakend capacity to pay interest and repay principal for debt in this category than in higher rated categories. These bonds are medium grade obligations.
• Ba;B or BB;B is regarded, on balance, as predominantly speculative.
• Caa, Ca or CCC, CC with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB and Ba indicate the lowest degree of speculation, and CC and Ca the highest degree of speculation. Although such debt is likely to have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions. Some issues may be in default.
• C or C is reserved for income bonds on which no interest is being paid.
• D or D is in default, and payment of interest and/or repayment of principal is in arrears.

• Federal Treasury Notes and bonds
  • Most are ordinary coupon bonds.
  • no default risk
  • exempt from state income taxes but not federal income taxes
• State and local municipal notes and bonds - munis
  • a degree of default risk
  • always callable
  • exempt from federal income taxes but not state or local taxes
• lower yields than taxable bonds
  • Calculating

• A bond that makes no coupon payments, thus initially priced at a deep discount.

• A bond's coupon payment divided by its closing price.

• The price a dealer is willing to pay for a security.

• The price a dealer is willing to take for a security.

• The difference between the bid price and the asked price.

• Interest rates or rates of return that have not been adjusted for inflation.

• Interest rates or rates of return that have been adjusted for inflation.

• The relationship between nominal returns, real returns, and inflation.

• The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money.

• The portion of a nominal interest rate that represents compensation for expected future inflation.

• The compensation investors demand for bearing interest rate risk
• 1. The longer the time to maturity, the greater the interest rate risk.
• 2. The lower the coupon rate, the greater the interest rate risk.

• A plot of the yields on Treasury notes and bonds relative to maturity.
  • it increases at a decreasing rate

• The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default.

• The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

• The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

• The difference between an investment's market value and its cost.

• The process of valuing an investment by discounting its future cash flows.

• The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

• An investment's average net income divided by its average book value.

• The discount rate that makes the NPV of an investment zero.

• A graphical representation of the relationship between an investment's NPVs and various discount rates.

• The possibility that more than one discount rate will make the NPV of an investment zero.

• A situation in which taking one investment prevents the taking of another.

• The present value of an investment's future cash flows divided by its initial cost. Also, benefit-cost ratio.

• The difference between a firm's future cash flows with a project and those without a project.

• The assumption that evaluation of a project may be based on the project's incremental cash flows.

• A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

• The most valuable alternative that is given up if a particular investment is undertaken.

• The cash flows of a new project that come at the expense of a firm's existing projects.

• Financial statements projecting future years' operations

• A depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

• The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

• The present value of a project's costs calculated on an annual basis.

• The possibility that errors in projected cash flows will lead to incorrect decisions. Also, estimation risk.

• The determination of what happens to NPV estimates when we ask what-if questions.

• Investigation of what happens to NPV when only one variable is changed.

• A combination of scenario and sensitivity analysis.

• Costs that change when he quantity of output changes.

• Costs that do not change when the quantity of output changes during a particular time period.

• The change in costs that occurs when there is a small change in output.

• The change in revenue that occurs when there is a small change in output.

• The sales level that results in zero project net income.

• The sales level that results in a zero operating cash flow.

• The sales level that results in a zero NPV.

• The degree to which a firm or project relies on fixed costs.

• The percentage change in operating cash flow relative to the percentage change in quantity sold.

• Opportunities that managers can exploit if certain things happen in the future.

• Taking into account the managerial options implicit in a project.

• Options for the future, related business products or strategies.

• The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

• The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.

• The situation that occurs when a business cannot raise financing for a project under any circumstances.

• The excess return required from an investment in a risky asset over that required from a risk-free investment.

• The average squared difference between the actual return and the average return.

• The positive square root of the variance.

• A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation.

• A market in which security prices reflect available information.

• The hypothesis that actual capital markets, such as the NYSE, are efficient.

• The return on a risky asset expected in the future.

• A group of assets such as stocks and bonds held by an investor.

• A percentage of a portfolio's total value that is in a particular asset.

• A risk that influences a large number of assets. Also market risk.

• A risk that affects at most a small number of assets. Also, unique or asset-specific risk.

• Spreading an investment across a number of assets will eliminate some, but not all, of the risk.

• The expected return on a risky asset depends only on that asset's systematic risk.

• The amount of systematic risk present in a particular risky asset relative to that in an average risky asset.

• A positively sloped straight line displaying the relationship between expected return and beta.

• The slope of the SMI, the difference between the expected return on a market portfolio and the risk-free rate.

• The equation of the SML showing the relationship between expected return and beta.

• The minimum required return on a new investment.

• The return that equity investors require on their investment in the firm.

• The return that lenders require on the firm's debt.

• The weighted average of the cost of equity and the aftertax cost of debt.

• The use of a WACC that is unique to a particular project, based on companies in similar lines of business.

• Financing for new, often high-risk ventures.

• A statement filed with the SEC that discloses all material information concerning the corporation making a public offering.

• An SEC regulation that exempts public issues of less than $1.5 million from most registration requirements.

• A legal document describing details of the issuing corporation and the proposed offering to potential investors.

• A preliminary prospectus distributed to prospective investors in a new issue of securities.

• An advertisement announcing a public offering.

• An issue of securities offered for sale to the general public on a cash basis.

• A public issue of securities in which securities are first offered to existing shareholders. Also called a rights offering.

• A company's first equity issue made available to the public. Also called an unseasoned new issue or an IPO.

• A new equity issue of securities by a company that has previously issued securities to the public.

• Investment firms that act as intermediaries between a company selling securities and the investing public.

• A group of underwriters formed to share the risk and to help sell an issue.

• Compensation to the underwriter, determined by the difference between the underwriters' buying price and offering price.

• The type of underwriting in which the underwriter buys the entire issue, assuming full financial responsibility for any unsold shares.

• The type of underwriting in which the underwriter sells as much of the issues as possible, but can return any unsold shares to the issuer without financial responsibility.

• A contract provision giving the underwriter the option to purchase additional shares from the issuer at the offering price. Also called the overallotment option.

• The beginning of the period when stock is sold without a recently declared right, normally two trading days before the holder-of-record date.

• The date on which existing shareholders on company records are designated as the recipients of stock rights. Also, the date of record.

• The type of underwriting in which the underwriter agrees to purchase the unsubscribed portion of the issue.

• An amount paid to an underwriter participating in a standby underwriting agreement.

• A privilege that allows shareholders to purchase unsubscribed shares in a rights offering at the subscription price.

• Loss in existing shareholders' value, in terms of either ownership, market value, book value, or EPS.

• Direct business loans of, typically, one to five years.

• Loans, usually long-term in nature, provided directly by a limited number of investors.

• Registration permitted by SEC Rule 415, which allows a company to register all issues it expects to sell within two years at one time, with subsequent sales at any time within those two years.

• The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

• The proposition that the value of the firm is independent of the firm's capital structure.

• The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure.

• The equity risk that comes from the nature of the firm's operating activities.

• The equity risk that comes from the financial policy (i.e., capital structure) of the firm.

•  The tax saving attained by a firm from interest expense.

• The cost of capital of a firm that has no debt.

• The costs that are directly associated with bankruptcy, such as legal and administrative expenses.

• The costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

• The direct and indirect costs associated with going bankrupt or experiencing financial distress.

• The theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

• A legal proceeding for liquidating or reorganizing a business.

• Termination of the firm as a going concern.

• Financial restructuring of a failing firm to attempt to continue operations as a going concern.

• The rule establishing priority of claims in liquidation.

• A payment made out of a firm's earnings to its owners, in the form of either cash or stock.

• A payment made by a firm to its owners from sources other than current or accumulated retained earnings.

• A cash payment made by a firm to its owners in the normal course of business, usually made four times a year.

• The date on which the board of directors passes a resolution to pay a dividend.

• The date two business days before the date of record, establishing those individuals entitled to a dividend.

• The date by which a holder must be on record in order to be designated to receive a dividend.

• The date that the dividend checks are mailed.

• The tailored dividend policy created by individual investors who undo corporate dividend policy by reinvesting dividends or selling shares of stock.

• The market's reaction to a change in corporate dividend payout.

• The observable fact that stocks attract particular groups based on dividend yield and the resulting tax effects.

• A policy under which a firm pays dividends only after meeting its investment needs while maintaining a desired debt-equity ratio.

• A firm's long-term desired dividend-to-earnings ratio.

• Another method used to pay out a firm's earnings to its owners, which provides more preferable tax treatment than dividends.

• A payment made by a firm to its owners in the form of stock, diluting the value of each share outstanding.

• An increase in a firm's shares outstanding without any change in owners' equity.

• The price range between the highest and lowest prices at which a stock is traded.

• A stock split in which a firm's number of shares outstanding is reduced.

• The time period between the acquisition of inventory and the collection of cash from receivables.

• The time it takes to acquire and sell inventory.

• The time between sale of inventory and collection of the receivable.

• The time between receipt of inventory and payment for it.

• The time between cash disbursement and cash collection.

• A graphical representation of the operating cycle and cash cycle.

• Costs that rise with increases in the level of investment in current assets.

• Costs that fall with increases in the level of investment in current assets.

• A forecast of cash receipts and disbursements for the next planning period.

• A formal (committed) or informal (noncommitted) prearranged, short-term bank loan.

• Money kept by the firm with a bank in low-interest or non-interest-bearing accounts as part of a loan agreement.

• A secured short-term loan that involves either the assignment or the factoring of receivables.

• A secured short-term loan to purchase inventory.

• The need to hold cash to take advantage of additional investment opportunities, such as bargain purchases.

• The need to hold cash as a safety margin to act as a financial reserve.

• The need to hold cash to satisfy normal disbursement and collection activities associated with a firm's ongoing operations.

• The difference between book cash and bank cash, representing the net effect of checks in the process of clearing.

• Special post office boxes set up to intercept and speed up accounts receivable payments.

• The practice of and procedures for moving cash from multiple banks into the firm's main accounts.

• A disbursement account in which the firm maintains a zero balance, transferring funds in from a master account only as needed to cover checks presented for payment.

• A disbursement account to which the firm transfers an amount that is sufficient to cover demands for payment.

• A firm's desired cash level as determined by the trade-off between carrying costs and shortage costs.

• The costs associated with holding too little cash. Also, shortage costs.

• The conditions under which a firm sells its goods and services for cash or credit.

• The process of determining the probability that customers will not pay.

• The procedures followed by a firm in collecting accounts receivable.

• The length of time for which credit is granted.

• A bill for goods or services provided by the seller to the purchaser.

• A discount given to induce prompt payment. Also, sales discount.

• The evidence of indebtedness.

• A graphical representation of the sum of the carrying costs and the opportunity costs of a credit policy.

• A wholly owned subsidiary that handles the credit function for the parent company.

• The five basic credit factors to be evaluated; character, capacity, capital, collateral, and conditions.

• The process of quantifying the probability of default when granting consumer credit.

• A compilation of accounts receivable by the age of each account.

• The restocking quantity that minimizes the total inventory costs.

• A set of procedures used to determine inventory levels for demand-dependent inventory types such as work-in-progress and raw materials.

• A system for managing demand-dependent inventories that minimizes inventory holdings.

• A security issued in the United States representing shares of a foreign stock and allowing that stock to be traded in the United States.

• The implicit exchange rate between two currencies (usually quoted non-U.S.) quoted in some third currency (Usually the U.S. dollar).

• An index of 10 European currencies intended to serve as monetary unit for the European Monetary System (EMS).

• International bonds issued in multiple countries but denominated in a single currency (usually the issuer's currency).

• Money deposited in a financial center outside of the country whose currency is involved.

• International bonds issued in a single country, usually denominated in that country's currency.

• British and Irish government securities.

• The rate most international banks charge one another for overnight Eurodollar loans.

• Agreements to exchange two securities or currencies.

• The market in which one country's currency is traded for another's.

• The price of one country's currency expressed in terms of another country's currency.

• An agreement to trade currencies based on the exchange rate today for settlement within two business days.

• The exchange rate on a spot trade.

• An agreement to exchange currency at some time in the future.

• The agreed-upon exchange rate to be used in a forward trade.

• The idea that the exchange rate adjusts to keep purchasing power constant among currencies.

• The condition stating that the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.

• The condition stating that the current forward rate is an unbiased predictor of the future spot exchange rate.

• The condition stating that the expected percentage change in the exchange rate is equal to the difference in interest rates.

• The theory that real interest rates are equal across countries.

• The risk related to having international operations in a world where relative currency values vary.

• Risk related to changes in value that arise because of political actions.