Finance notes chap 1-6

Sole Proprietorships

Sole Proprietorships

A business owned and run by one person, with no legal separation between the owner and the business, leading to personal responsibility for all business debts.

Partnerships

Businesses with multiple owners who share responsibilities and debts, with the partnership ending if a partner leaves or dies.

Limited Liability Companies (LLCs)

Businesses where all owners have limited liability, similar to limited partnerships but without a general partner.

Corporations

Separate legal entities from owners, responsible for their obligations, with ownership through shares of stock and the ability to enter contracts and acquire assets.

Boards of Directors

Responsible for monitoring managerial actions and ensuring they act in the best interests of shareholders.

Market for Corporate Control

Involves hostile takeovers of poorly performing companies by entities aiming to replace the board and management.

Shareholder Activism

Shareholders influencing managerial decisions through voting and proposals to replace underperforming executives.

Stakeholder Capitalism

Managers considering interests of stakeholders beyond shareholders in decision-making to impact shareholder value.

Primary Market

Where corporations issue new shares directly to investors to raise capital.

Secondary Market

Where already issued securities are traded among investors without the involvement of the issuing company.

Stock Market Liquidity

Provides flexibility for investors to buy and sell shares quickly and easily.

Market Price Determination

Stock prices fluctuate based on supply and demand, reflecting investors' perceptions of a company's value.

Feedback Mechanism

Share prices provide continuous feedback to managers about investors' views on their decisions.

High-Frequency Traders (HFTs)

Use computer algorithms for rapid trading, profiting from liquidity provision and exploiting outdated orders.

GAAP

Generally Accepted Accounting Principles that financial statements must adhere to for accuracy and comparability.

IFRS

International Financial Reporting Standards aiming for global harmonization of accounting standards.

Balance Sheet

Lists a company's assets and liabilities at a specific point in time.

Assets

Resources owned by a company providing future economic benefits, classified into current and long-term assets.

Liabilities

Company's obligations to other parties, classified into current and long-term liabilities.

Stockholders' Equity

Residual interest in a company's assets after deducting liabilities, reflecting shareholders' ownership stake.

Market Value vs

Market value reflects current market price, while book value is based on historical cost.

Enterprise Value

Total cost to buy a company, including stock value, debt, and minus cash.

Income Statement

Lists a company's revenues and expenses over a period, calculating profitability.

Gross Profit vs

Gross profit considers direct costs, while net income accounts for all expenses.

Diluted EPS

Earnings per share considering the impact of dilutive securities, providing a conservative measure.

Statement of Cash Flows

It shows the cash generated or used in core operations, reflecting the company's cash flow from primary business activities.

Adjusting for Non-Cash Items

Non-cash items like depreciation are added back to net income as they are not actual cash outflows.

Adjusting for Changes in Working Capital

Changes in accounts receivable, payable, and inventory impact cash flow from operating activities.

Investment Activities

Reflects cash used for investments like capital expenditures and other long-term investments.

Financing Activities

Shows cash flow between the company and investors, including dividends, stock issuance, and changes in borrowing.

Dividends Paid

Cash outflow from the company to shareholders as a return on their investment.

Retained Earnings

Portion of net income not paid as dividends, reinvested back into the company.

Stock Issuance or Repurchase

Cash received from issuing new shares or spent on repurchasing existing shares.

Changes in Borrowing

Reflects cash inflows or outflows from changes in short-term and long-term borrowing.

DuPont Identity

Analytical tool breaking down ROE into net profit margin, asset turnover, and equity multiplier components.

Cash Value

The monetary worth of an asset determined by its market price, essential for comparing different assets accurately.

Valuation Principle

The concept that an asset's value is established by its competitive market price, guiding decision-making based on costs and benefits.

Time Value of Money

The principle that money received today is more valuable than money received in the future due to its potential for investment and interest accrual.

Interest Rate

The rate at which money can be exchanged from one time period to another, representing the market price of money in the future.

Discount Factor

The factor, 1/(1+r), where r is the interest rate, used to discount future cash flows to their present value, reflecting the time value of money.

Net Present Value (NPV)

The difference between the present value of benefits and costs associated with a project, helping determine the project's value and feasibility.

NPV Decision Rule

The NPV Decision Rule states that when faced with investment options, choose the one with the highest NPV, as it adds value to the firm akin to receiving that NPV amount in cash today.

Positive NPV

Projects with positive NPV should be accepted as they increase wealth, representing the cash received today if that option is chosen.

Negative NPV

Projects with negative NPV should be rejected to avoid reducing wealth, incurring no cost by not pursuing them.

Zero NPV

Projects with zero NPV neither increase nor decrease wealth, not adding value but not being detrimental either.

Arbitrage Opportunity

Arbitrage is the act of buying and selling the same item in different markets to profit from price differences, involving no risk or investment.

Law of One Price

The Law of One Price states that equivalent investment opportunities should have the same price across different markets, ensuring price uniformity.

No-Arbitrage Price of a Security

The No-Arbitrage Price of a Security is determined by the present value of all cash flows paid by the security, indicating the absence of arbitrage opportunities when the market price matches this value.

Determining Interest Rate from Bond Prices

Involves using the present value formula to calculate the interest rate based on the bond's price and the cash flow it will pay, commonly used to derive current interest rates from bond prices in the market.

Arbitrage Opportunities

Discrepancies in prices that arise when a security's return differs from the risk-free interest rate, allowing investors to exploit these differences until prices reach equilibrium.

No-Arbitrage Price

The fair price of a security in a market without arbitrage opportunities, calculated as the present value of its cash flows, ensuring that buying or selling the security does not create or destroy value.

Separation Principle

The concept that investment decisions should be evaluated independently from financing decisions or other security transactions, emphasizing that value creation comes from real investment projects rather than just financial transactions.

Value Additivity

The principle that the price of a portfolio or security mirroring the cash flows of other securities must equal the sum of the prices of those individual securities, ensuring no arbitrage opportunities exist.

Net Present Value (NPV)

A key metric in project evaluation representing the net benefit of a project in terms of cash today, obtained by converting all cash flows to a common time point for comparison.

Timeline

A fundamental tool in financial management representing the timing of expected cash flows, aiding in decision-making by visually organizing cash flows occurring at different points in time.

Future Value

The value of a cash flow at a future time point after compounding it forward by an interest rate factor, showcasing the growth potential of money over time due to compound interest.

Future Value

The value of an investment at a specified date in the future, calculated based on a specific interest rate and time period.

Discounting

The process of determining the present value of a future cash flow by dividing it by the interest rate factor.

Present Value

The current value of a future cash flow, obtained by discounting it back to the present time.

General Formula

A formula used to calculate the present value of a cash flow moved back n periods by discounting it with the intervening interest rate factors.

Net Present Value (NPV)

The result of subtracting the present value of costs from the present value of benefits in an investment decision.

Perpetuities

Streams of equal cash flows that occur at regular intervals and last indefinitely.

Annuities

A series of equal cash flows paid at regular intervals, with a formula to calculate their present value.

Present Value of Annuity

The current value of a series of equal cash flows to be received or paid at regular intervals over a specific period, discounted back to the present at an appropriate interest rate.

Effective Annual Rate (EAR)

The total amount of interest that will be earned at the end of one year, considering the effect of compounding.

Annual Percentage Rate (APR)

The amount of interest earned in one year without considering compounding effects, often used as a quoted rate by banks.

Amortizing Loans

Loans where the borrower makes regular payments that include both interest and a portion of the principal, leading to the full repayment of the loan over time.

Real Interest Rate

The rate of growth of purchasing power after adjusting for inflation, calculated as the nominal interest rate minus the inflation rate.

Interest Rate Expectations

Investors' beliefs about future interest rate changes influencing their lending and borrowing decisions, affecting the yield curve.

Risk and Interest Rates

Interest rates vary based on investment horizon and borrower identity, with US Treasuries considered risk-free and other borrowers facing default risk.

After-Tax Interest Rates

Reflects the interest an investor retains after deducting taxes, impacting the effective return on investments or loans.

Opportunity Cost of Capital

The best expected return available in the market for an investment of similar risk and term, guiding investment evaluation and capital allocation decisions.

Bond Terminology

Definitions including maturity date, term, face value, coupon rate, and coupons for understanding bond cash flows, prices, and yields.

Zero-Coupon Bonds

Bonds making a single payment at maturity without periodic coupons, such as Treasury bills, traded at a discount to face value.

Yield to Maturity (YTM)

The discount rate equating the present value of bond payments to its market price, representing the return if held to maturity without default.

Risk-Free Interest Rates

The interest rate for risk-free cash flows, often equated to the yield to maturity on default-free zero-coupon bonds of the same maturity.

Zero-Coupon Yield Curve

A plot of risk-free zero-coupon bond yields against maturity dates, providing insights into the yield curve and interest rate expectations.

Coupon Bonds

Bonds making regular coupon interest payments until maturity, including Treasury notes with maturities ranging from one to ten years.

Treasury bonds

US Treasury coupon securities with original maturities exceeding 10 years.

Yield to maturity (YTM)

The internal rate of return (IRR) of investing in a bond until maturity, equating the present value of cash flows to its current price.

Premium

The price at which coupon bonds trade above their face value.

Par

The price at which coupon bonds trade equal to their face value.

Duration

The sensitivity of a bond's price to changes in interest rates, representing the value-weighted average maturity of its cash flows.

Dirty price

The actual cash price of a bond, including accrued interest.

Clean price

The cash price of a bond minus accrued interest, eliminating the sawtooth pattern around coupon payments.

Arbitrage

Exploiting price differences to earn a profit, such as selling a high-priced bond and buying a portfolio of zero-coupon bonds.

Coupon bond yields

The YTM of a coupon bond, a weighted average of zero-coupon bond yields based on cash flow timings.

On-the-run bonds

The most recently issued treasury security of a specific original maturity.

Credit risk

The risk of default by the issuer of a bond that is not default-free, indicating uncertain cash flows.

Debt-ceiling

A limit set by the US Congress on the total debt the government can incur.

Investment-grade bonds

Bonds in the top 4 creditworthiness categories with low default risk.

Speculative bonds

Bonds in the bottom 5 creditworthiness categories with a high risk of default.

Sovereign bonds

Bonds issued by national governments, like US Treasury securities.

Default spread

The difference between the risk-free interest rate on US Treasury notes and interest rates on other loans.