C214 WGU Study Guide0

Financial Securities (3 types)

1. Gov Securities(treasury bonds)- gov invest in natl defense to freeways. Loans provide by the public to gov. When tax revs fall short to cover expenditures, gov issues bonds from 60 days-30yrs.

2. Corporate Bonds- Google might be looking to invest another $50 billion in low-orbiting satellites; however, because of its size, the company cannot walk into a local bank hoping for a $50-billion loan. Instead, Google will likely issue bonds with a face value of $1,000 that make one or two annual coupon payments a year and might be paid back over a 20-year period.

Corporate finance is NOT devoted to understanding various types of financial instruments; investments are. *Corporate finance focuses on the decision making by the management of the firm.

3. Stocks- share of ownership in a co. If Google did not want to borrow money from bondholders to finance the $50-billion low-orbiting satellite project, Google could sell shares of ownership in the company.

Syndicate

is a group that is temporarily formed to handle a bond or stock issue. Syndicates are generally made up of large investment banks or other types of institutional investors. These large investment banks that make up a syndicate might also be the underwriters of the security issue. An underwriter has the responsibility of determining the value of the security and then, in some cases, the underwriter will purchase all of the securities from the issuer and then sell them to other investors.

Two ways a firm issuing a bond can place the bonds with a syndicate:

1. Competitive Sale- Those wishing to underwrite the bond issue will submit bids (on bond's prices and interest rate) to the issuing firm. Firm will then select the underwriter that offered the highest price and lowest interest rate. Underwriter will sell bonds to various investors at (hopefully) a slightly higher price than purchase price.

2. Negotiated Sale- like the competitive sale, a negotiated sale is the process of underwriters submitting proposals including bids. However, this latter type of sale involves a more thorough interview process with the underwriters. Further, the issuing firm will carefully select the management team that will place these bonds.

Primary Markets (Stocks & Bonds)

The primary market for stock issuance works in a similar way to the bond primary market. However, some terminology is different. A firm that is going public (or selling shares of ownership for the first time) is going to perform an initial public offering (IPO). These IPOs are sometimes called new equity offerings. However, much of the underwriting occurs in a similar manner, which we have discussed above.

Secondary Markets (2 types)

1. Auction Market- an auction financial market has a physical location and prices are determined by the highest price an investor is willing to pay. The New York Stock Exchange (NYSE), the world's largest secondary financial market. NYSE has a single dealer that provides liquidity.

*Some high frequency traders provide liquidity to the rest of the market.

*If providing liquidity becomes more risky, then dealers will increase the spread.

*If the price of a particular stock begins to heavily fluctuate, then the specialist will INCREASE the spread.

2. Dealer market- does not require a physical location. Securities are bought and sold through a network of dealers that trade for themselves. a dealer might hold inventory for particular stock and willing to sell to those that demand the stock and buy from those that will supply the stock. NASDAQ, (second-largest secondary market worldly), is example of a dealer market. Most stocks that are listed on NASDAQ have multiple dealers for each. The idea behind having multiple dealers providing liquidity to investors is that the dealers must compete with one another, thus lowering the cost of transacting.

Spread

The difference between the bid price and the ask price.

If the price of a particular stock begins to heavily fluctuate, then the specialist will INCREASE the spread.

Stock Orders (2 types)

Market orders- are time sensitive and would execute at the current ask price.

Limit orders-

-Buy Limit Order can only be executed at the limit price or lower

-Sell Limit Order can only be executed at the limit price or higher.

Market Prices

-Convey info to consumers. Perhaps the newly priced milk is of lower quality or the grocer has excess inventory.

-Affect incentives. For instance, a sophisticated consumer might not be in the market for a brand new car at its current price. However, the dealership could incentivize the consumer by dramatically lowering the price.

-Affect the distribution of income. Nearly all students would agree that the price of garbage collection is lower than the price of health care.

Calculating Security Returns

two types:

1. Dollar returns- are calculated by taking the difference between the previous price and current price, plus any additional cash flow that came from the security. (EX: bonds pay a coupon (or interest) payment 1 or 2 times yearly; stocks pay a dividend. Mathematically, dollar returns are calculated in the following way.

Pt - Pt-1 + CFt

In this equation, Pt is the sold price, Pt-1 is the bought price, and CFt is the cash flow (coupons for bonds; dividends for stocks).

2. Percentage returns- Percentage returns are calculated by simply dividing the dollar returns by the price of the security at time t-1, or the previous time period.

Pt-Pt-1/Pt-1 + CFt/Pt-1

Maximizing Shareholder Value

There are two issues:

1. Agency costs- are real costs and the way that most firms mitigate some of these costs is by aligning managers' interests with shareholders' interests; they are costs by management not acting in the best interests of the shareholders; asymmetrical costs. Most commonly, management might be compensated with shares of ownership in the company or take on projects just because they want to.

2. Focusing solely on profits- (unethical maximization), in some cases, (Enron 2001), the pursuit of profit has led to unethical behavior. However, profitable businesses are employing other workers and are providing their employees the means to consume goods and services from other businesses in the economy.

Finance v Accounting

Accounting- is backward-looking and risk free.

Finance- is forward-looking and involves massive uncertainty.

Accrual Accounting & Matching Principle

(regardless of when a company incurs cost or revenue, it is reported only when the associated cost or revenue is recognized. Neither COGS not revenue represents actual cash.)

allows managers to decide what is "recognized" on the financial statements. Accrual accounting: Revenues are recognized when the earnings process is complete; expenses are "matched" to recognized revenues.

*The accrual system also employs the matching principle.

The matching principle requires that revenue recognized must be matched with the expenses incurred to generate the revenue.

*So, while both accrual and cash systems report $0 in revenue during 20x1, an accrual firm matches $0 revenues with $0 expenses. No revenues, no expenses! Likewise, the revenue from the two systems will be the same in 20x2. However, the accrual system "matches" the $100,000 in revenue with the $75,000 in expenses incurred to generate the revenue.

Cash syst: yr 2001=Exp $75K (NI=$0, thus $75K loss); yr 2002 = Rev @ $100K (thus, 100K Net Inc)

Accr syst: yr 2001=Exp $0 ($0 net income); yr 2002 = Rev $100K and Exp $75K ($25K Net Inc)

Cash based accounting

cash in = revenue; cash out = expense

Cash v Accrual

Cash syst: yr 2001=Exp $75K (NI=$0, thus $75K loss); yr 2002 = Rev @ $100K (thus, 100K Net Inc)

Accr syst: yr 2001=Exp $0 ($0 net income); yr 2002 = Rev $100K and Exp $75K ($25K Net Inc)

Cash Flow

Cash flow is a fact; net income is an opinion.

Income

when thinking about net income, remember the following:

Cash-based income

While not a formal metric, cash income is based on cash in and cash out of the firm. Many think net cash from operations as "profit." Intuitively, cash-based income is similar to what we call Cash Flow from Operations (i.e., CFO).

Income for tax purposes

government has its own system for calculating income. not simple like cash-based income, "income for tax purposes is more straightforward than accounting income." This is the income used to determine the amt of tax a firm must pay. Income for tax purposes generally involves fewer managerial choices than accounting income.

Accounting income

"is reported on the firm's income statement as net income." Calculation of net income requires managers to make many choices. Every line itemin an income statement involves significant discretion about what is reported. Hence, the interpretation of net income requires a solid understanding of the accrual accounting process (GAAP).

*Accounting income is the best metric for understanding the operations of the firm. Unfortunately, it is also the most complicated.

*Best case, we must know what principles management is using as they compile the income statement. Worst case, management uses their discretion to "manage" the reported results. Either way, we must be a skeptic!

Income Statement (simple)

Basic equation Rev-Exp(all)=NI

Rev-Exp[COGS(DM&DL)]= GP

GP - Operating Exp= EBIT(op profit)

EBIT - Int Exp= EBT

EBT- Tax Exp= NI(earnings)

Note: Tax expense as reported on the income statement may have little resemblance to taxes actually paid.

Historical Cost Principle & Fair Value

Historical Cost Principle

most of the line items on the balance sheet are stated at historical cost meaning that when an asset is purchased (or liability incurred) it is recorded at cost.

*Accrual accounting makes no adjustment for changes in the market value of assets reported at historical cost.

Fair Value

most analysts are interested in fair, or market, value.

Balance Sheet

Assets= Liabilities -Eq (or)

Equity = Assets - Liabilities

Assets = Eq (If liab is 0)

Retained Earnings (RE)

The only two options for net income is to pay it(dividends) out or plow it back(RE). Expressed as follows:

...Net Income = Dividends + Change in RE

New RE equals the sum of last year's RE balance plus the change in RE from the current year, or

...New RE = Old RE(last yr) + Change in RE(NI-Div...cur yr)

Solving this equation for the change in RE and substituting into the net income equation yields:

...New RE = Old RE + Net Income - Dividends

Operating Income

AKA: EBIT (earnings before Interest and taxes)

EBIT

Earnings Before Interest & Taxes (AKA: Operating income)

Cashflows (SCF-statement of cashflows)

(3 subdivisions)

Operations, investing, and financing refer to the three types of decisions made by managers:

1. Operational decisions- (CFO-cash from ops), include what to produce, how to produce it, whom to sell it to, whom to use for suppliers, etc. CFO measures the net cash impact of operating decisions.

2. Investing activities- (CFI-cash from investing, acquisitions, and PP&E) involve decisions concerning the purchase and sale of long-term assets, such as conveyor belts or the construction of new production facilities. CFI measures the net cash impact of investing decisions.

3. Financing decisions- (CFF-cash from financing) deal with the issuance of debt and equity, the repayment of debts or repurchase of stock, and the payment of dividends. CFF measures the net cash impact of financing decisions.

Cashflows

The sum of CFO + CFI + CFF is equal to the change in cash during the period.

catagorization of cash flow is flexible and is impacted by the firm's operating environment in several ways:

1. Core activities - will impact the way cash flows are catagorized. For instance, two firms can purchase similar lathes and catagorize the cash outflow differently. For a machine shop, the lathe is likely a long-term asset and the cash flow will be part of CFI; for a equipment vendor, the lathe is likely inventory and included in CFO.

2. Cash flow management - some managers will "manage" (i.e., increase or decrease) reporting of cash flows. For instance, a manager whose bonus is impacted by CFO may be tempted to recatagorize some items to make CFO appear larger. *While most of the techniques to recatagorize cash flows are beyond the scope of this course, it is relatively easy to do for a year or two without violating the rules of GAAP accounting.

3. Market pressure - even if a manager's personal income is not impacted, there are other pressures to manipulate cash flow categorization in the market place. For instance, a firm that is in the process of raising capital does NOT want to show a decrease in CFO. Hence, managers may be willing to use their discretion over accounting choices to increase the reported level of CFO.

**(As with the income statement and balance sheet, the moral here is to be careful when interpreting the SCF. While gross cash flows are difficult to alter, it is relatively easy to increase one category by decreasing another.)

CFO(Cash Flows from Operations)

CFO includes all cash flows related to producing and selling the firm's product, such as cash coming in from customers, cash flowing out for raw materials and operating expenses, and cash flowing out for taxes. While this may appear to be the same way net income is calculated, don't be fooled. Net income is an accounting concept—it is not CFO.

CFO = Net Income + depreciation expense

+/- changes in operating assets (Note: add decreases and subtract increases)

-/+ changes in operating liability accounts (Note: add increases and subtract decreases)

CFO vs. Net Income

Reasons why net income will differ from CFO:

1. Revenue (used to calculate net income)

is not the same as cash collected from sales because of changes in accounts receivable (AR). If AR increases, then firm recognizes sales-an increased AR as revenue but has not yet collected the cash. To determine cash rec'd, we need to subtract the increase in AR or add a decrease in AR. *(Remember, revenue does not equal cash collected!)

2. A gain/loss from sale of PP&E

equip sold for more/ less than book value (Note: Gain/loss on Sale = Sale Price - Book Value). The gain(/loss is included in net income. However, a gain/loss on sale of PP&E is not attributable to CFO, but is to CFI. In a CFS(indirect method, under CFO), a gain from the sale would be subtracted; a loss would be added. B/c the gain on the sale of PP&E is included in net income but is not part of CFO; therefore, it is treated in reverse.

3. Depreciation expense

a significant source difference between net income and CFO. Depreciation expense is included in the calculation of net income but it does not represent an outflow of cash. It is a non-cash expense created for tax purposes. we must add depreciation expense back to net income to adjust net income to reflect actual cash flow.

*(Net income a useful concept, but doesn't represent cash. CFO is more important to financial analysts than net income in many situations.)

*Warning! "NOTES PAYABLE"- notes payable is frequently included in the current liabilities section of the balance sheet but for the purposes of the SCF is considered a financing account (i.e., part of CFF). When calculating CFO, be sure to not adjust net income for changes in notes payable.

CFI (Cash Flows from Investments)

(An increase in gross PP&E from one year to the next represents a use of cash (we had to use cash to purchase more fixed assets-cash outflow. an increase in assets represents an OUTFLOW of cash.)

Formulas:

CFI = Gross PP&E (end) - Gross PP&E (begin)

or

CFI = Change in Net PPE + depreciation expense.

_____________________________________________________

(no assets sold) assume a firm has depreciation expense for 20x2 of $250, and reports net PP&E as

20X1

$1,100

20X2

$1,300

Net PP&E:

= 1,300-1,100=200

(Change in NPPE)200 + (depr exp for X2) 250= 450

CFI=450

------------------------------------

*Change in Gross PP&E

Gross PP&E (X1=3300; X2=3500) so Gross PPE = $200

*Changes in Net PPE (if gross PPE not given)

EX 1:

Net PP&E = Gross PP&E - Accumulated Depreciation; (so add depr to NetPPE to get gross)

$1,100 = Gross PP&E - $500 or (1,100+500=1600)

Gross PP&E = $1,600

EX 2:

X1: NetPPE=900

accum depr=2,400

X2: NetPPE=1,000

acumdepr: 2500

1,000-900=100; 2500-2400=100

CFI=(change in NPPE)=100 + (Change in accum depr AKA: depc exp)=100

So CFI= 100+100= $200

CFF (Cash flows from Financing)

is the net cash impact from financing and includes cash flows from increased borrowing, debt repayment, stock issuance, stock repurchase, or dividend payment. (Increase in financing signals a CASH INFLOW; decreases indicate CASH OUTFLOW like repaying lenders or repurchasing stock.

^NP +100

^LTD +200

^RE -120

NI= +170

CFF= ^EQ + ^Debt - Div

^EQ = 0

^Debt (200+100)

- Div: (RE= NI - Div) OR (-120=170-?) OR -120-170=-290 (290)

CFF= 0 + 300 - 290 = 10

CFO vs. Free Cash Flow (FCF)

FCF is distributable cash! it represents the cash that can be "distributed AFTER funding required reinvestment in PP&E as well as increased working capital." (FCF is one of the most important concepts in finance!)

FCF comes in two flavors:

1. FCF to the firm (FCFF)- is the cash distributable to all the providers of capital (i.e., to both debt and equity holders) and is most commonly used in financial analysis.

FCFF = EBIT (1-tax rate) + Depreciation - CAPEX - Increases in NWC

Where:

Tax rate = percent of earnings a firm pays in tax

Depreciation = Depreciation expense

EBIT = Earnings before interest and taxes

CAPEX = Capital expenditure on PP&E; frequently measured as CFI (required reinvestment)

NWC = Net working capital (current assets - current liabilities) changes (required reinvestment)

*EBIT and (1-tax rate) are referred to as Net Operating Profit After Taxes (NOPAT)

2. FCF to equity (FCFE)- is the cash distributable to the equity holders after satisfying all obligations to debt holders. Dividends are the cash actually distributed to stockholders; FCFE is cash that is distributable to stockholders after funding required reinvestment.

FCFE = NI + Depreciation - CAPEX - Increases in NWC + Increases in Debt

where:

Increases in debt = new borrowings minus any repayment of old debt

FCFE measures the cash distributable to equity holders after all obligations (including interest and principle to debt holders) and required reinvestment are satisfied.

Ratio analysis

Popular tool for three reasons:

1. Standardization

is standardizing each firm's debt by an economically meaningful variable (assets) to discover that one firm has 90% of assets financed with debt and the other only 20%. This gives better insight into the relative debt load of the firms.

2. Flexibility

Ratio analysis is not governed by a set of rules such as Generally Accepted Accounting Principles (GAAP). Rather, the process of calculating and evaluating ratios is economic analysis governed only by the expertise of the analyst. Ratio analysis is a Darwinian process where the best analysts achieve the greatest benefit.

3. Focus

Ratios allow us to quickly discover areas in need of investigation and not what is happening in a company. Ratios don't answer questions about the company; ratios tell you what questions to ask. A ratio that changes through time or deviates from industry norms is essentially a red flag saying, "FOCUS HERE." Ratio changing does not tell us much, but the reason behind the change could make a huge difference in our analysis and subsequent actions.

Ratios (most common)

1) Liquidity ratios-

a firm's ability to meet short-term obligations. Used by short-term creditors such as banks and suppliers.

2) Asset use efficiency

3) Financing

4) Profitability

Ratios ( liquidity)

(are firms' ability to meet short-term obligations)

1. Current ratio = current assets / current liabilities

2. Quick ratio("Acid test") = (current assets - inventory) / current liabilities

3. AR turnover = credit sales / AR ...or (net sales/avg AR)?

4. Average collection period = 365 / AR turnover

5. Inventory turnover = COGS / inventory

6. Days on hand = 365 / inventory turnover

Ratios (efficiency)

(measure how effectively a company/management team uses assets to generate sales or profits)

1. Total Asset turnover (TAT)= sales / total assets

2. Fixed Asset turnover(FAT) = sales / fixed assets

3. OIROI = operating income / total assets

Ratios (financing)

Firms can have dramatically different strategies when it comes to financing assets. Financing, or solvency, ratios are intended to highlight a co's strategic differences. All assets MUST be financed. Financing ratios describe in what proportions the firm uses equity and/or debt to finance assets.

1. Debt ratio = total liabilities/total assets

2. Interest-bearing debt to total capital (IBDTC) = interest-bearing debt/total capital

3. Times interest earned (TIE) = EBIT / Interest expense

4. Financial leverage ratio (FLR) = total assets/equity

Ratios (profitability)

Two categories—based on sales; based on investment (i.e., assets or equity).

Investment Based:

ROA = NI / assets

OR (Profit Margin x Total Asset Turnover)

OR (ROA = (Net Income / Sales) x (Sales / Total Assets)

OR (ROA = ((Sales - Total Costs) / Sales) x (Sales / (Current Assets + Non-Current Assets)

ROE = NI / equity

Sales Based:

Gross margin = gross profit..(sales - COGS) / sales

Operating margin = EBIT / sales

Net margin = NI / sales

Ratios (The DuPont Decomposition)

Granddad of ratios (aka "the DuPont equation")

ROE = Net Income / Sales × Sales / Total Assets × Assets / Equity = Net Margin × TAT × FLR

*Common alternate form of the DuPont equation is: ROE = ROA x FLR

Ratios (analysis)

Three main comparison standards for ratio analysis:

1. Trend Analysis:

This ratio examines a firm's ratios over time, comparing cur yr to prev yrs. (i.e., if we were analyzing Wal-Mart's ratios in 20x6, we can compare them to Wal-Mart in 20x1-20x5. Frequently, trend analysis looks backwards 5-yrs and sometimes forecasts out 3-yrs.

2. Cross-sectional analysis

involves comparing a firm's ratios to a peer group (i.e., competitors, the industry, the market.) Cross-sectional analysis requires data not only target firm, but also the peer group. (sometimes referred to as "recasting" the financial statements)

3. Internal Goal Monitoring:

Ratios can measure progress relative to specific goals set w/in the co. For instance, if management sets a specific goal for ROE, assessment of progress will involve ratio analysis.

Two Pit Falls:

Timing issues:

Mixing data from the income statement and balance sheet causes problems. Consider the ROA calculation for two identical swimsuit manufacturers, one with a balance sheet date of Dec 31 the other w/ balance sheet date of June 30. Since they are identical, they report the same net income. However, the firm with the Dec statements will likely report a much higher asset value and thus a lower ROA.

Accounting issues:

Accounting data is the biggest potential menace in ratio analysis. Rules of accrual accounting allow for significant variation in reported results. Analysts must therefore be careful to understand each firm's accounting choices before assuming their ratios are comparable. (i.e., depr use life)

Ratios (risks)

Truly integrated analysis will include careful consideration of:

External risks:

are changes in the macro-economic cycle, competitive forces, the technological environment, and demographic/societal changes. Questions regarding the impact of the economy on revenues and costs and how the competitive environment impacts growth.

Internal risks:

include the financial viability and flexibility of the firm, willingness to continually innovate, attitude towards compliance w/ laws and controls, and company's culture.

Ratios (legalities)

Failure to operate in prevailing legal constraints can be catastrophic. Though subtle, ratios can clue us to the compliance culture of the firm. (i.e., gyrations in the macro economy impact firm's operating performance.) If management is willing to "stretch" accounting rules to minimize volatility in reported results, the compliance culture of the firm is likely to be poor or corrupt!!!

Ratios (soc responsibility)

Some analysts cringe at "social responsibility," they prefer firms maximize value under established law. A firm may have industry-leading margins today but having poor employee relations will/may experience long-term impairment. Human capital development is vital to the health of the entire organization. Likewise, strong communities and schools lead to a productive labor force. Moreover, environmental issues impact a firm's relationship with its customer base.

Time Value of Money (TVM)

These forces (risk, opportunity, and inflation) fortify one another to make dollar worth more today vs. its future worth.

TVM brings together three variables:

1) amount of the cash flows,

2) the timing of the cash flows,

3) the rate at which the value of the cash flows changes due to the passage of time.

TVM has two basic types of calculations:

1. Present value calculation(PV)

takes a sum in the future and finds a time-adjusted equivalent value at a closer point in time. EX: if you anticipate receiving $150 in 8 yrs, you may want to calculate its present value today (i.e., time 0).

2. Future value calculations (FV)

move cash flows farther into the future. If you are investing $25 today for retirement, calculate its value 50 yrs in the future.

Discount rate(interest rate)

Discount rate (interest rate)- the rate at which a dollar changes in value due to the passage of time. It's AKA: Cost of Capital, the Opportunity Cost of Capital, or the Hurdle Rate. You can think of the discount rate, r, as a function of several parts:

r = Real Risk-Free Rate + Inflation + Risk Premium

Where

r = Nominal discount rate (note: nominal means inflation is included)

Real risk-free rate = The rate earned on riskless investments with 0% inflation

Inflation = The annual decay in the purchasing power of money

Risk premium = Compensation for bearing the risk of a particular investment

Gordon Growth Model

P = D1 / (k-g)

P = stock value based on model

D1 = Expected dividend per share one year from now

k = Required rate of return for equity investor

g = Growth rate in dividends (in perpetuity)

Annuities (ordinary)

Payments are equally spaced, equal amounts.

Payments are made at the "END" of each period.

FVA ordinary

= pmt [({1 + r} n - 1) / r]

= 100 [({1 + 0.13} 3 - 1) / 0.13] = $340.69

PVA ordinary

= pmt [(1 - {1 / (1 + r)n}) / r]

= 100 [1 - {1 / (1.13)3} / .13] = $236.12

Annuities (due)

**Calc: (shift-BGN; shift-SET; shift-QUIT) =BGN

back to END (shift-BGN; shift-SET; shift-QUIT)=END

Ordinary annuity calculations assume payments occur at the end of the period. Annuities Due assume the payments come at the beginning of the period. Annuity Due simply shifts the timing of the PVA and FVA one period further into the future.

PVA at the time of the first pmt or FV at period after last pmt = use Annuity Due approach. ( Leases are an example when contract and pmt are due @ same time.)

PVA one period before the first pmt? use Ordinary Annuity approach.

Characteristics of annuity due:

1. Payments are equally spaced

2. Payments of equal amounts

3. Payments are made at the "BEGIN" of each period

Annuities (perpetuities)

Perpetuities: A perpetuity is a "perpetual annuity" or an unending series of equal pmts. Perpetuities are frequently associated with charitable giving.

PVperpetuity = CF / r (note: r is in decimal form)

Back to our hospital example, if invested funds can earn 5%, the amount you would have to donate today to provide $100,000 per year forever is: 100,000 / .05 = $2,000,000

Annuities (deferred)

Deferred Annuities: A deferred annuity is just an equal series of payments that starts sometime in the future. Calculating the PV of deferred annuities requires multiple steps.

EX: Suppose you retire 30 yrs from today and desire an annual income of $100,000/yr for 20 yrs starting in exactly 30 yrs. Disc is 8%. What is the PV today?

calculation requires two steps:

Step 1:

Find the amount needed in the future. The PV of the $100,000 payments can be calculated either as an ordinary annuity or as an annuity due. Using the ordinary annuity approach, 100,000 [PMT], 8 [I/YR], 30 [N] and solve for [PV] = $1,125,778 (note: we used the ORDINARY ANNUITY approach...so this is a time 29 value!)

Step 2:

To discount $1,125,778 back to today, the PV from Step 1 becomes the FV in step 2: 1,125,778 [FV], 8 [I/YR], 29 [N] and solve for [PV] = $120,827

So, if you have $120,827 to deposit in your savings account today (and you have a savings account that pays 8%), you can fully fund your retirement goals!

APR v. APY (on exam!!!)

APY (aka: effective yield OR effective annual rate). The difference between APR & APY is compounding frequency. Recall, that m is the number of compounds per year. (APR equals the APY when interest compounds are exactly annually)

If compounding frequency is greater than once per year (m > 1), then the effective yield(APY) will be greater than the APR. This is because the APY includes the compounding nature of interest.

Effective yield(APY) = [1 + (i / m)]m - 1

Where i is the stated (or annual) rate. For our savings example, the effective yield is:

Effective yield = (1 + .02)4 - 1

= 8.24%

EX:

The equation to compute the APY is:

APY = (1 + APR / m)m - 1 where m is the number of compounds in a year. So suppose you are interested in a semiannual bond with a 3% APR, this is how you would compute the APY:

APY = (1 + (0.03 / 2))2 - 1 = 3.0225%.

At first blush, the APY looks very close to the APR; there is a difference of only 0.0225%. However, realize the compounding period was only semiannual. Let's suppose you have a credit card with a 18% stated rate (APR) that compounds daily. What would be that APY?

APY = (1 + (0.18 / 365))365 - 1 = 19.716%.

After tax, tax @ .30, then 1-30=70, so (19.716 -70%) = 5.91

TVM in Valuation and Risk Assessment

Business decisions that involve cash flows stretching farther than a few months in future involves TVM analysis. To optimize decision making at your firm, TVM analysis needs to be as basic as breathing!!

Applications used:

Entrepreneurial Finance:

Early stage companies frequently need to attract capital to develop products and markets. Venture capitalists require compensation for investing in these risky ventures and use TVM extensively to evaluate the benefits and related costs of investing.

Capital Budgeting:

is the process of deciding in which potential projects a firm will invest. This requires an exacting calculation of cash flows over time. TVM calcs the benefits and costs of accepting a project. The creation of value within the firm requires careful analysis of these complex long-lived cash flows.

Regulatory Compliance:

When evaluating the regulatory structure of potential new markets or products or faced with regulatory changes, TVM tools allows managers to evaluate compliance alternatives (i.e., outsourcing, capital investment, and whether to partake in an specific industry.)

Social Responsibility:

Corporate citizenship can be an important part of firm operations in that alternatives involve long-term decisions, TVM is valuable in optimizing decisions.

Risk Assessment:

TVM plays a critical role in risk assessment. Frequently takes one of two forms:

1. Risk buckets: Projects are grouped into "risk buckets" with different return requirements. (i.e., high-risk projects are assessed in one bucket with high return requirements. TVM is used to assess the expected return of each project for comparison to the appropriate required return.

2. Sensitivity analysis: TVM is used to assess the PV of projects under diff input assumptions. (i.e., if evaluating a potential merger, "sensitivity analysis" allows you to find the value of the target firm under diff revenue and/or cost projections. Valuations inform managers about risk of merger at various prices.

"four-find-three" system

The "four-find-three" system implies we can also solve for variables other than PV or FV. Suppose you have the following retirement savings parameters:

Age: 35

Retirement age: 65

Monthly savings: $350

Annual return: 9%

We can calculate the amount you will have in your retirement account in 30 years as

350 [PMT], 30 × 12 = 360 [N], 9 / 12 = .75 [I/YR] and solve for [FV] = $640,760.

Bonds

Bonds the primary method for raising capital b/c they avoid the costs of the intermediary; bankster costs!

Bond Valuation = PV of its cash flows, this means the intrinsic value of any asset is the "PV of the Stream of Expected Future Cash Flows Discounted at an appropriate Required Rate of Return."

Bonds make up about 75% of capital supplied to firms.

Bonds are classified as fixed-income securities, meaning they pay a fixed interest pmt each year.

- Pmts are most commonly paid semiannually on corporate bonds, but may be paid annually or even monthly (common on some gov bonds).

The bond market is about three times as big as the stock market on a world scale.

- Typical bond cash flows resemble those of an interest-only loan—none of the principal is repaid until the end of the bond. Bond cash flows are comprised of two distinct parts:

1. Stream of annual or semiannual interest payments (an annuity)

2. Final principal repayment (a lump sum).

Bond (Terms)

Par value:

(aka: face value of the bond) is the sum of money that the corp promises to pay at the bond's expiration. The firm will not see all of the $1,000 and will actually receive $1,000 minus all transaction costs. Majority of corporate bonds have a par value of $1,000; if no other value stated, par value of $1,000 should be assumed.

Coupon rate:

(is the interest rate of the bond, also known as the "coupon yield".) It is contractually set when the bond is issued and cannot be changed during the life of the bond. Multiplying the coupon rate by the par value gives the amount of the bond's yearly coupon/interest pmt. (i.e., $1,000 par value bond with a 9% coupon rate will pay $1,000 × .09 = $90 in interest annually.)

Maturity:

(The rate of return investors recv on bonds is called "yield to maturity".) Bonds are finite-term securities b/c they have a starting or issue date, and an ending or expiration/maturity date. Maturity is number of yrs from when bond is issued to its expiration. (as short as 3 mos to 30 yrs., and 100 years in Japan.)

Annual & Semiannual pmts:

Most US bonds pay interest semiannual; European bonds typically pay int annually. For annual payments, the amount of the payment is simply the coupon (or interest) rate times the par value of the bond. In the example above, this yielded an annual interest payment of $1,000 × .09 = $90/year; semiannual payments (every 6 mos), bondholder recvs half of the annual payment ($45 every 6 months.)

Covenants:

The indenture lists the covenants associated with the bond. These covenants outline things the company is obligating itself to do or not do in order to protect bondholders.

There are two types of bond covenants:

1. Affirmative covenants- describe things the co. pledges itself to do. (i.e., paying taxes on time, maintaining a certain level of working capital, and maintaining a minimum debt ratio.)

2. Negative covenants- are things the company pledges to not do (i.e., not to sell off certain assets, not to pay out large dividends, or not to issue new debt with a superior client.) If co. does not comply w/ covenants in its bond indentures, it's in default!

Bond (valuation)

Bond Valuation = PV of its cash flows and means the "Intrinsic Value of any Asset = PV of the Stream of Expected Future Cash Flows Discounted at an appropriate Required Rate of Return."

"Four solve Five" Four inputs defines the unknown-the fifth button- this unknown will usually be PV or I/Y (in bonds I/Y= yield to maturity). IF YTM and Coupon Rate are equal, then FV=PV(ignoring transaction costs) aka: "Issuing at Par".

Bond (types)

Debentures:

are not secured w/ collateral; very risky!

Subordinated debentures:

Like normal debentures, subordinated debentures are debentures that have a lower claim to assets if firm liquidates than normal debentures.

Mortgage bonds:

has specific collateral backing it(i.e., real estate). Issued w/ specific asset as collateral. If corp defaults, mortgage bondholders receive that asset.

Zeros:

(aka: zero coupon bonds), zeros pay no coupon payments—their coupon rate is 0%! Traded at deep discounts.

Eurobonds:

are payable in currency not native to the country in which it is issued. (i.e., An American bond, issued in Europe, that is payable in dollars, is a specific type of Eurobond called a Eurodollar bond.)

Foreign bonds:

A bond that is issued in a domestic market by a foreign entity, in the domestic market's currency. They are paid in a different currency than the country's issuing it(i.e., if a Chinese firm floats debt in the US and the debt is payable in dollars, then China has floated a foreign bond.)

Muni-bonds:

(short for municipal bonds) are floated by local governments (states, cities, and counties) to usually fund infrastructure improvements (i.e., roads, gov buildgs, and are almost always exempt from fed tax-attractive for investors in high tax brackets.)

Treasury bonds:

are bonds issued by the fed gov to support deficit spending and range from (short-term 3-month T-bills) to (long-term, 30-year T-bonds). B/c they are backed by fed gov taxing, they're often used as risk-free investments in financial models.

Convertible bonds:

Convertibility refers to the ability to convert a bond into equity securities, usually common stock and may be added to any of the above bond types. Gives investor rights to trade each bond for a set number of shares of com stk whenever s/he chooses.

Bond (ratings)

All publicly traded bonds have ratings that measure the level of risk of bonds. Ratings are given by prof rating agencies that evaluate the creditworthiness of the co. that issued the bond (like S&P, Moody's, and Fitch).

EX: If a firm has high debt ratios and low liquidity ratios, it will be viewed as more risky than a firm with similar operations and market share but lower debt ratios and higher liquidity ratios.

AAA-BBB = very low risk, investment grade bonds

BB and below = very high risk (speculative or high-yield debt bonds, aka: JUNK BONDS)

Equity (common stock)

Stock and equity are synonyms in the world of finance.

Common stock represents equity ownership in a firm. Along with ownership comes voting rights which majority of CS includes. CS holders have the lowest/last claim on earnings and assets of the co, meaning that common stockholders receive dividends each year (and cash, in the case of company liquidation), ONLY after everyone else (debt holders and preferred stockholders) gets paid. **Corporate Governance are the control issues involved in running a company.

Equity represents ownership in a firm and those stockholders have certain rights:

1. Right to Residual Claim

on earnings and assets of the co. Each year, after the co. pays for its ops and pays its creditors, any residual or remaining earnings belong to the shareholders in proportion to the percentage of shares they own. Same is true if the firm fails and is liquidated. After the ops and creditors are paid, shareholders receive what's left over based on % of stock they own.

2. Right to Vote

on co. mgmt and policies in regular stockholder meetings. Lrg equity positions, lrg holders of stock, and voting stock holders are permitted into meetings.

Stock has no maturity or expiration date. If firm is around, the stock is in full force. Equity holders could experience 1000% returns. In finance, this unlimited earnings potential is known as "Capturing the Upside."

Stocks are variable-return securities(CFs uncertain and vary); bonds are fixed-return securities(CFs are certain and fixed).

Equity (importance)

1. Equity (usually common stock) will likely constitute a large portion of an individual's investment portfolio and retirement fund. (Investors need to understand the sources of stock value.)

2. Understanding how to determine the value of a company will help in deciding whether to join it.

3. Stock options derive their value from the stock of the company. (Understanding stock valuation will help in calculating the real value of the total compensation package.)

4. The stock market is one of the vehicles through which capitalism functions. (Those living in a capitalistic society need to understand stock valuation and the stock market to truly grasp the workings of their economy.)

Equity (valuation)

Stock value = present value of its future expected cash flows.

........."Good Co. v Good Investment"

Good Company

is not necessarily a good invest. if all investors know GoodCo is a good company, they'll buy GoodCo stock, bidding up price until it's as high or higher than the intrinsic value of GoodCo's future cash flows.

If you buy now at its intrinsic value or "correct" price, you're unlikely to realize substantial gains.

Good Investment

AveCo, (an "average" co), is selling for $10 but has an intrinsic value of $25 p/s. Invest in AveCo b/c it's undervalued and then wait for market to wise up and bid it up to its real $25 value-it's intrinsic value, the sell!

Equity (common stock valuation-single holding period)

Single Holding Period Model:

assumes that an investor buys a stock today, holds for one year, then sells it back. Investor potentially generates a return from two sources: Dividends and Stock Price Increase. Value of the stock's PV is calc'd by estimating future cash flows from two sources and then discounting them back to the present.

EX: I buy one share of GrowBig stock today. We expect the stock to pay a dividend of $5.50 at year end, forecasted stock price of $120. If we require a 15% rate of return on our investment, how much is the stock today? Vo = (V1+D1)/ (1+Kcs)

I/Y = 15, n = 1, FV = 125.50; PV 109.13

Single period Holding Period Return (HPR)

This method is alternative, and ignores using TVM.

HPR = [(P1 + D1)/P0]- 1

Gordon Growth Models

Do= dividend paid: $5.00

g= 10%

D1= D0 x (1+g) = D1 = 5.00 × 1.10 = $5.50.

This makes sense—if we assume that dividends will grow at 10% each year forever, then D1 is simply going to be 10% larger than D0.

We can employ the Gordon Growth Model:

V0 = D1 / (kcs - g)

= $5.50 / (.15 - .10) = $110.00 p/s

Solve for Kcs: Kcs = D1 / V0 + g

Solve for g: g = Kcs - D1 / V0

Preferred stock has no growth; only fixed % of dividends paid.

P = D1 / (kps)

GGM can be manipulated to solve for D or kps

D = V * kps

kps = D/V

Equity (preferred stock)

is a hybrid security; has some elements that resemble equity and others that resemble debt and only 15% of corps issue ps. Most Angel or VCs (investment groups) want convertible ps. Util offer ps b/c they're regulated and pay heavy divs.

Equity side:

it is like common stock b/c has no fixed maturity.

Debt side:

Like bonds and loans, pmts (dividends) from preferred stock are fixed and shareholders typically do not have voting rights. Preferred stock pays same dividend yearly, no matter how well or poorly the co performs. Unlike debt payments, companies are allowed to skip pmts of preferred stock dividends without default.

Penalty for skipping ps dividends is the company can't pay anything to cs until ps are paid in full and aka: "Holding Dividends in Arrears".

Most preferred stock is cumulative. If a co. skips pmt of a ps dividend one year, it's still required to pay that dividend sometime in the future before paying any common dividends!

Payoff or claim hierarchy:

the claim or payoff order is first, debt holders, second, preferred stockholders, and third, common stockholders.

Equity (preferred stock valuation)

Vps = D/kps [or] V=D/r

where Vps is the value or price of the stock, D is the annual fixed dividend and kps is the discount rate or required rate of return (not the dividend rate).

Using the Gordon Growth Model we can adjust by taking out "g" since there is a fixed dividend.

from V0= D0(1+g)/(Kcs-g)

to V0=D0/Kps

EX: Xerox issued $75 million worth of 8.25% preferred stock at $50 per share par value. Required rate of return is 9.50%. What would we pay for the stock today?

To calculate the fixed annual dividend, simply multiply the par value by the quoted percentage to get .0825 × $50 = $4.125 per year.

Vps = D/kps

Vps = $4.125 / .095 = $43.42

As with the Gordon Growth Model, the preferred stock equation can be manipulated to solve for D or kps

D = V * kps

kps = D/V

V=D/r

Perpetuity (forever pmts):

CF / r

[or]

V= D/r

CAPM (Capital Asset Pricing Model) 4-elements:

Four elements of CAPM:

1. E(R) = Required Rate of Return

2. Rf = Risk Free Rate (consistent, no fluctuations...i.e., Treasury bond)

3. Β = Beta (Measure of stock volatility, standard deviation, derivations)

4. Rm = Market Rate (based on an average return from a basket of stocks)

(Rm-Rf) = market premium

CAPM (Statistics-Mean)

Statistical moment:

is a measure of the shape of the distribution at a particular point. The first, and perhaps most common moment, is the mean.

Mean(first moment):

is the best estimate for the Expected Value.

X(mean) = Xi * 1/n

Standard Deviation(second moment):

(σ) = √ (1/n-1) (Xi - X)*2

Expected Returns

E[R] is a more appropriate calculation that accounts for various economic states in the upcoming year.

This equation says that the expected return is equal to the weighted average of returns in the jth economic state, where the weights are the probabilities π of that state occurring.

Idiosyncratic & Systematic (non-diversifiable) risks

Idiosyncratic risk:

portion of risk that is diversifiable. Risk that is specific to an asset or a small group of assets. Idiosyncratic risk has little or no correlation with market risk, and can therefore be substantially mitigated or eliminated from a portfolio by using adequate diversification.

Systematic (non-diversifiable) risk:

portion of risk that is not diversifiable. Only systematic risk affects the expected return of an individual stock.

Markowitz Efficient Frontier

consists of a frontier of various portfolios of a given set of stocks that are efficient, or, in other words, have the highest level of expected return for a given level of risk. A risk averse investor that has a penchant for higher returns and lower risk will select a portfolio of stocks that is on the Markowitz Efficient Frontier, which will be located in Quadrant 1.

Market risk premium

Is the difference between the expected return for the market and the risk free rate

beta (β)

is the ratio of the co-variance of a stock's returns and market returns to the variance of market returns.

In the CAPM, β measures the firm's systematic risk.

CAPM (implications)

FCFE(free cash flow to equity)

FCFE measures the cash distributable to equity holders after all obligations (including interest and principle to debt holders) and required reinvestments are satisfied.

FCFF(free cash flow to firm)

A measure of financial performance that expresses the net amount of cash that is generated for the firm, consisting of expenses, taxes and changes in net working capital and investments.

Regression analyses

Common type: Ordinary Least Squares

The slope of the regression line: BETA (not alpha)

Slope of this regression line? 4.2 & 3:

4.2/3 =1.4

Covariance: 3.5 & 2: 3.5/2= 1.75

Cost of Capital

required return from those who provide capital

WACC

Re = Cost of common equity, which is usually calculated using the Gordon Growth Model, the CAPM, or the mean of past common stock returns

Rp = Cost of preferred equity, which is calculated using the perpetuity model discussed in Topic 7

Rd= Before-tax cost of debt, which is usually the yield-to-maturity on a company's bonds or the interest rate on a company's debt

τ = Marginal tax rate for the company

Floatation costs

are costs incurred by a firm that issues new securities.The firm will usually hire an investment bank, underwriter or syndicate to sell these shares in a primary market, and therefore increase the cost of capital. Flotation costs are accounted for in two ways:

1. float costs are subtracted from the price of equity

2. add a percentage to the cost of capital.

Spontaneous accounts

are those that, of necessity, vary automatically with sales. Current assets (i.e., cash, marketable securities, a/r, and inv), a/p, and accrued expenses(accrued wages). Historical ratio of cash as a percent of sales would be calculated as cash/sales.

Line Items (non-spontaneous or discretionary accounts)

do not increase automatically with sales, left to the discretion of management in order to increase or decrease these accounts. (i.e., long-term debt, N/P, and common stock accounts, PP&E)

Percent of Sales

used to estimate the year after forecast. Usually calculated by dividing the asset by sales. Engineering fees / sales = %, then take % and multiply against current year's sales to get the estimate.