Unit 8: Economic Balance Sheet

Balance Sheet Model of the Firm

The assets of the firm must be supported by the firm obtaining financing (borrowing or issue equity). The accounting balance sheet follows the cost principle and records asset and claims at their historic costs when added to the balance sheet. The economic balance sheet also looks at assets and claims, but uses current market values.

bond

A security representing the long-term debt of a company.

bank loan

Indirect financing where the company borrows funds from a bank, which gets those funds from savers. These claims are not traded in the financial markets.

preferred stock

A type of stock whose holders are given certain priority over common shareholders in the payment of dividends. Usually the dividend rate is fixed at the time of issue and no voting rights are given.

common stock

Equity claims held by the "residual owners" of the firm who are the last to receive any distribution of earnings or assets.

Privately held company

A company that raises capital by selling their securities directly to investors rather than the general public.

publicly traded corporations

Corporations who fulfill registration and reporting requirements and are authorized to sell financial securities to the general public.

Primary Market Transaction

Corporations and other organizations, with the assistance of investment banks, create financial securities and issue them to the investing public. This is how companies raise capital.

Initial public offerings (IPO)

the original sale of a company's securities to the public; also called an unseasoned new issue

Seasoned security offering (SEO)

A new public stock issued after the company's stock has been previously issued publically. Also called a seasoned new issue.

rights offer

An offer that gives a current shareholder the opportunity to maintain a proportionate interest in the company before shares are offered to the public.

crowdfunding

Websites in which companies needing capital post information about their company and invite individuals to invest. bypasses the traditional financial intermediaries such as investment banks and commercial banks.

institutional investors

These organizations pool large sums of money and invest those sums in securities, real property securities, and other investment assets. Their role in the economy is to act as highly specialized investors on behalf of others.

secondary market transaction

An investor holding a publicly traded security sells the security to another investor. The company issuing the security is not part of this transaction. Once issued, these securities are traded among investors

direct financing

involves companies issuing financial securities through the financial markets to expand and build their operations.

indirect financing

involves financial institutions that are intermediaries between savers and borrowers.

investment bank

a financial intermediary who provides a variety of services including aiding in the sale of securities, facilitating mergers and other corporate reorganizations, acting as brokers to both individuals and institutional clients, and trading for their own account.

intermediary

institution that acts as a middleman, providing services to those with funds to invest and those who need funds

commercial bank

A financial intermediary that serves as an interface with savers and borrowers. These banks accept deposits from savers that offer safety and a rate of return. They then lend these funds out to individuals and businesses who need to borrow. Banks make a profit by lending out funds at an interest rate that is higher than the rate they pay to their depositors.

financial markets

markets where financial securities, such as stocks and bonds, are bought and sold/issued and traded

exchanges

Organized public markets where companies list their securities for trading by investors. These listed securities must adhere to securities laws and regulations to be traded on these public markets. The exchanges provide a legal platform to ensure that the commitments made by participants are realized. Exchanges are generally organized as profit-seeking companies.

over-the-counter market (OTC)

not centralized trading places but rather systems by which dealers can offer to buy and sell securities among themselves and to their customers

dealer

A market maker that maintains an inventory and stands ready to buy and sell at any time. makes a profit through the spread: by buying an asset at one price and selling the asset at a higher price.

broker

An entity that brings security buyers and sellers together but does not maintain an inventory. They make a profit via a commission paid for services rendered in facilitating the trade.

bootstrapping

involves using personal savings, selling personal assets, borrowing against assets, using credit cards, and taking on personal loans to raise capital.

venture capital

develop businesses into viable, profitable companies through their investment of capital that more traditional investors may not make.

efficient market

A market in which the price of the asset reflects its economic value.

Efficient Market Hypothesis (EMH)

States that prices of securities fully reflect available information. Investors buying bonds and stocks should expect to obtain an equilibrium rate of return. Firms should expect to receive the fair value for the securities they sell.

Technical Analysis

Seeks to predict future price movements by identifying patterns and relationships in historic market information and then using these patterns to predict future prices.

weak-form efficient market

Theory that a market is efficient with respect to historical price information.

public information

Information available to the investing public.

Fundamental Analysis

Evaluates relevant economic, financial, political and other qualitative and quantitative information in order to determine an asset's intrinsic/economic value.

Semi-strong efficient market

Theory that a market is efficient with respect to public information.

private information

Information that is not available to most investors.

insider trading

An insider is anyone with nonpublic, specific information. They cannot use their information to take unfair advantage when trading with outsiders.

strong-form efficient market

Theory that a market is efficient with respect to all available information, public or private.

can an investor consistently beat the market and earn a higher than expected return?

no! the future is unknowable and there's no guarantee

which 2 decisions are connected via the economic balance sheet?

capital budgeting decision that concerns what productive assets the firm should obtain and capital structure decision that involves raising capital from investors

Facebook Initial Public Offering of its securities is an example of..

primary market transaction, company is issuing stock for the first time so there are no existing measures (market prices) to definitively determine the firms market value, investment bank used to estimate price that security should be offered and help with registration of new security with SEC

auction markets (ex:NYSE)

brokers and agents meet at a physical location (the exchange) to buy/sell assets; brokers don't own asset, just serve major function of getting buyers/sellers together and earn commissions (like real estate brokers)

Dealer Markets (NASDAQ)

represent dealers operating in dispersed locales who buy/sell assets themselves, communicating electronically or over the counter; dealers make profit by buying asset from one party(bid price) and selling to another (ask price)

bid-ask spread

the difference between the bid price and the asked price, dealer keeps the difference

explain why a characteristic of an efficient market is that investments in that market have zero NPVs

On average, the only return that is earned is the required return—investors buy assets with returns in excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus causing the return to rise to the required return (zero NPV).

If a market is semistrong form efficient, is it also weak form efficient? Explain.

Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency.

what are the implications of the efficient markets hypothesis for investors who buy and sell stocks in an attempt to beat the market?

Ignoring trading costs, on average, such investors merely earn what the market offers; stock investments all have a zero NPV. If trading costs exist, then these investors lose by the amount of the costs. investors may make a killing in some market periods but will likely be killed in other market periods; also consider survivor bias

difference between stock market and gambling

gambling is zero-sum game, investing can produce an acceptable rate of return and is a positive sum game. Major engine of economic growth and promote efficiency