FINMAN EBOOK
CHAPTER 1
Finance - “the system that includes the
circulation of money, the granting of credit, the
making of investments, and the provision of
banking facilities.”
3 areas of finance:
1. Financial management (corporate finance)focuses on decisions relating to how much and
what types of assets to acquire, how to raise the
capital needed to purchase assets, and how to
run the firm so as to maximize its value.
- have difficulty obtaining large sums of
capital
2. Partnership - legal arrangement between two
or more people who decide to do business
together. Firm’s income is allocated on a pro
rata basis to the partners and is taxed on an
individual basis.
all of the partners are generally subject to
unlimited personal liability. Unlimited liability
makes it difficult for partnerships to raise large
amounts of capital.
2. Capital markets relate to the markets where
interest rates, along with stock and bond prices,
are determined.
3. Corporation - legal entity created by a state,
and it is separate and distinct from its owners
and managers.
3. Investments relate to decisions concerning
stocks and bonds and include a number of
activities:
a) Security analysis - finding the proper
values of individual securities (i.e.,
stocks and bonds).
b) Portfolio theory - the best way to
structure portfolios, or “baskets,” of
stocks and bonds. Rational investors
want to hold diversified portfolios in
order to limit risks, so choosing a
properly balanced portfolio is an
important issue for any investor.
c) Market analysis - the issue of whether
stock and bond markets at any given
time are “too high,” “too low,” or
“about right.”
Corporations also have unlimited lives, and it is
easier to transfer shares of stock in a
corporation than one’s interest in an
unincorporated business.
Most corporations’ earnings are subject to
double taxation—the corporation’s earnings are
taxed;
4. Limited Liability Company (LLC) - A popular
type of organization that is a hybrid between a
partnership and a corporation.
**LLPs are used for professional firms in the
fields of accounting, law, and architecture, while
LLCs are used by other businesses.
Determinations of Value
**Behavioral Finance - investor psychology is
examined in an effort to determine whether
stock prices have been bid up to unreasonable
heights in a speculative bubble or driven down
to unreasonable lows in a fit of irrational
pessimism.
4 Forms of Business Organization
1. Proprietorships - unincorporated business
owned by one individual.
Advantages:
easy and inexpensive to form;
subject to few government regulations;
subject to lower income taxes than are
corporations.
Disadvantages:
unlimited personal liability
- life of the business is limited to the
life of the individual who created it
1st Top Box - managerial actions which
ultimately determine the company’s stock price.
2nd Top Box - differentiates true vs. Perceived
TRUE means the cash flows and risk
that investors would expect if they had all of the
information that existed about a company.
PERCEIVED means what investors
expect, given the limited information they
have.
3rd Top Box • Intrinsic value - These are estimate of a stock’s
“true” value based on accurate risk and return
data. The intrinsic value can be estimated, but
not measured precisely.
Intrinsic value is a long-run concept.
Management’s goal should be to take
actions designed to maximize the firm’s intrinsic
value, not its current market price.
Maximizing the intrinsic value will maximize the
average price over the long run, but not
necessarily the current price at each point in
time
• Market price - The stock value based on
perceived but possibly incorrect information as
seen by the marginal investor (investor whose
views determine the actual stock price).
3 ways of transfer:
1. Direct - when a business sells its stocks
or bonds directly to savers. This procedure
is used mainly by small firms, and relatively
little capital is raised by direct transfers.
2. Indirect through INVESTMENT BANKS The company sells its stocks or bonds to
the investment bank, which then sells
these same securities to savers.
**Underwriter - facilitates the issuance of
securities
3. Indirect
through
FINANCIAL
INTERMEDIARY - The intermediary obtains
funds from savers in exchange for its
securities. The intermediary uses this
money to buy and hold businesses’
securities, and the savers hold the
intermediary’s securities.
When the stock is at EQUILIBRIUM:
Actual Market Price = Intrinsic Value
Stockholder Manager Conflicts
Useful Motivational Tools:
1. reasonable compensation packages,
2. firing of managers who don’t perform well
3. the threat of hostile takeovers
Managers Response
If a firm’s stock is undervalued = corporate
raiders (people who target corporations for
takeover because they are undervalued) will see
it as a bargain and will attempt to capture the
firm in a hostile takeover (acquisition of a
company over the opposition of its
management.)
Management’s
primary
financial
goal
is Shareholders Wealth Maximization (The
primary financial goal for managers of publicly
owned companies implies that decisions should
be made to maximize the long-run value of the
firm’s common stock.)
CHAPTER2
Capital allocation process
In a well-functioning economy, capital flows
efficiently from those with surplus capital to
those who need it.
Financial Markets
People and organizations wanting to borrow
money are brought together with those who
have surplus funds in the financial markets.
Types of Markets
1. Physical Asset vs. Financial Asset Markets
i. Physical Assets Markets (Tangible or
Real Asset Markets) - for physical
products
ii. Financial Assets Markets - deal with
stocks, bonds, notes, and mortgages.
**Financial markets also deal with derivative
securities whose
values
are derived from
changes in the prices of other assets.
2. Spot vs. Future Markets
i. Spot Markets - The markets in which
assets are bought or sold for “on-thespot” delivery.
ii. Future Markets - markets in which
participants agree today to buy or sell
an asset at some future date.
3. Money vs. Capital Markets
i. Money Markets - The financial
markets in which funds are borrowed
or loaned for short periods (less than
one year).
ii. Capital Markets - The financial
markets
for
stocks
and
for
intermediate- or long-term debt (one
year or longer).
4. Primary vs. Secondary Markets
i. Primary Markets - Markets in which
corporations raise capital by issuing
new securities.
ii. Secondary Markets - Markets in
which securities and other financial
assets are traded among investors
after they have been issued by
corporations.
5. Private vs. Public Markets
i. Private Markets - Markets in which
transactions are worked out directly
between two parties. (Ex: Bank loans &
Private Debt Placements)
iii. Public Markets - Markets in which
standardized contracts are traded on
organized exchanges.
**securities that are traded in public
markets are held by a large number of
individuals.
**Healthy economy is dependent on efficient
funds transfers from people who are net savers
to firms and individuals who need capital
Instrument
Money
Capital
Treasury Bills
Treasury Notes &
Bankers Acceptance
Bonds
Commercial Paper
Mortgages
Negotiable
State & Local Bonds
certificates
of Corporate Bonds
deposits
Leases
Money Market & Preferred Stock
Mutual Funds
Common Stock
Eurodollar Markets
Consumer
credit
(credit card debt)
Derivatives - Any financial asset whose value is
derived from the value of some other
“underlying” asset.
Kinds of Financial Institutions
1. Investment Banks - organization that
underwrites and distributes new investment
securities and helps businesses obtain financing.
They traditionally help companies to raise
capital.
- Help corporations design securities
with features that are attractive to investors
- buy these securities from the
corporation & resell them to savers.
2. Commercial banks - The traditional
department store of finance serving a variety of
savers and borrowers.
3. Financial services corporations - A firm that
offers a wide range of financial services,
including investment banking, brokerage
operations, insurance, and commercial banking.
4. Credit unions - cooperative associations
whose members are supposed to have a
common bond, such as being employees of the
same firm.
5. Pension funds - retirement plans funded by
corporations or government agencies for their
workers and administered by banks/insurance
companies. Pension funds invest primarily in
bonds, stocks, mortgages, and real estate.
6. Life insurance companies - take savings in the
form of annual premiums and make payments
to the beneficiaries of the insured parties
7. Mutual funds - Corporations/Organizations
that pool investor funds to purchase financial
instruments and thus reduce risks through
diversification.
**Actively
managed
funds try
to
outperform the overall markets
**Indexed funds are designed to simply
replicate the performance of a specific
market index
8. Exchange Traded Funds (ETFs) - ETFs buy a
portfolio of stocks of a certain type and then sell
their own shares to the public.
9. Hedge Funds - HF are largely unregulated.
These funds typically have large minimum
investments and are marketed primarily to
institutions and individuals with high net worths.
10. Private Equity Companies - organizations
that operate much like hedge funds; but rather
than purchasing some of the stock of a firm,
private equity players buy and then manage
entire firms.
** Direct funds transfers are common among
individuals and small businesses and in
economies where financial markets and
institutions are less developed.
Stock Market
- where the prices of firms’ stocks are
established.
** primary goal of financial managers: maximize
their firms’ stock prices therefore knowledge of
the stock market is important.
2 Basic Stock Market:
1. Physical Location Exchange - tangible entities
2. Electronic Dealer Based Markets/OTC
Markets - A large collection of brokers and
dealers, connected electronically by telephones
and computers, that provides for trading in
unlisted securities.
** dealer markets - Includes all facilities that are
needed to conduct security transactions not
conducted on the physical location exchanges.
Dealer Market System Consists of:
1. the relatively few dealers who hold
inventories of these securities
2. the thousands of brokers who act
as agents
3. the computers, terminals, and
electronic
networks
that
provide
a
communication link between dealers and
brokers.
3 Distinct categories in Stock Market
Transactions
1. Outstanding shares of established publicly
owned companies that are traded; the
secondary market.
2. Additional shares sold by established publicly
owned companies: the primary market.
3. Initial Public Offering or IPO - The market for
stocks of companies that are in the process of
going public.
** When the market is strong, many companies
go public to bring in new capital and to give
their founders an opportunity to cash out some
of their shares.
Oversubscibed = demand for shares at the
offering price >> the number of shares issued.
Stock Market Efficiency
Terminologies:
Market price - The current price of a stock.
Intrinsic value - The price at which the stock
would sell if all investors had all knowable
information about a stock.
Equilibrium price - The price that balances buy
and sell orders at any given time.
Efficient market - market in which prices are
close to intrinsic values and stocks seem to be in
equilibrium.
Market efficient = investors can buy and sell
stocks and be confident that they are getting
good prices
Market Inefficient = investors may be afraid to
invest and may put their money “under the
pillow,” which will lead to a poor allocation of
capital and economic stagnation.
**Bid–ask spread - the difference between bid
and ask prices, represents the dealer’s markup,
or profit.
**closely held, corporations - corporation that
is owned by a few individuals who are typically
associated with the firm’s management. Their
stock is called Closely Held Stock
** publicly owned corporation - corporation
that is owned by a relatively large number of
individuals who are not actively involved in the
firm’s management.Their stock is called Publicly
Held Stock
Efficient markets hypothesis (EMH) - It implies
that, on average, asset prices are about equal to
their intrinsic values. It is the cornerstones of
modern finance theory.
Stock price too low = rational trades would buy
the stocks pushing price to proper level.
Stock price too high = rational trader will sell the
stock pushing price to its equilibrium level.
EMH 2 key points:
1. It is often difficult or risky for traders to take
advantage of mispriced assets.
2. why mispricings can occur in the first place.
Other studies suggest that people’s willingness
to take a gamble depends on recent
performance.
** Overconfidence may in part stem from two
other biases: (1) self-attribution bias and (2)
hindsight bias.
CHAPTER 3
FINANCIAL STATEMENTS
Annual report - A report issued annually by a
corporation to its stockholders. It contains basic
financial statements as well as management’s
analysis of the firm’s past operations and future
prospects.It is the most important report.
4 Basic Financial Statements:
1. Balance sheet
- shows what assets the company owns
and who has claims on those assets as of a given
date. The “snapshot” of firms position at
specific point in time.
LS = Assets company owns
1. Current Asset (Working Capital) converted to cash within 1 year
2. Long term assets - assets expected
to be used for more than one year
RS = Liabilities + Stockholders equity (the claims
against assets)
1. Current liabilities - claims that must
be paid off within one year
2. Long-term debt - bonds that
mature in more than a year.
3. Stockholders equity - amount that
stockholders paid the company when
shares were purchased + amount of
earnings the company has retained
since its origination.
SHE = Pain in capital + Retained Earnings
(RE = represent the cumulative total of all
earnings kept by the company during its life.)
Book Value per share = Total common
equity/share outstanding
Net Working Capital = CA - CL
Net Operating Working Capital (NOWC) = CA (CL - NP)
2. Income Statement - shows the firm’s sales
and costs during some past period
Earnings per share (EPS) - “the bottom line” &
the most important to stockholder
EPS = Net
Outstanding
Income
/
Common
Shares
Dividends per share = Dividends paid to
common stockholders / Common Shares
outstanding
Operating Income is EBIT
3. Statement of cash flow - shows how much
cash the firm began the year with, how much
cash it ended up with, and what it did to
increase or decrease its cash.
4. Statement of Stockholders equity - shows
the amount of equity the stockholders had at
the start of the year, the items that increased or
decreased equity, and the equity at the end of
the year.
Free cash flow (FCF) - The amount of cash that
could be withdrawn without harming a firm’s
ability to operate and to produce future cash
flows.
FCF = [EBIT (1-Tax Rate) + Dep & Amortization] [Capital Expenditures + NOWC]
EBIT (1-Tax Rate) is NOPAT or Net Operating
Profit After Taxes = The profit a company would
generate if it had no debt and held only
operating assets.
+ FCF = firm is generating more than enough
cash to finance current investments in fixed
assets and working capital
- FCF = company does not have sufficient
internal funds to finance investments in fixed
assets and working capital
Market value added (MVA) - The excess of the
market value of equity over its book value.
Market Value of Firms Equity - Book Value
Higher MVA = better the job management
is doing for the firm’s shareholders.
Economic value added (EVA) - Excess of NOPAT
over capital costs. “Economic Profit”. EVA is an
estimate of a business’s true economic profit for
a given year, and it often differs sharply from
accounting net income.
EVA
= NOPAT - Annual Dollar of cost of capital
= EBIT (1-TR) - (Total Invested capital x After Tax
Percentage cost of capital)
EVA is positive = after-tax operating income
exceeds the cost of the capital needed to
produce that income, and management’s
actions are adding value for stockholders.
Averge cash balance increase = average daily
collection* changed of old & new transaction
Working Capital Notes
Inventory Management
Traditional Inventory management - EOQ
Objective = to deliver goods at the lowest cost
(more on labor)
Cash Management
AR Management
Inventory Management
Cash Management
3 reasons needed as to why we have cash
management?
1. Transactional - to respond to the
daily operations
2. Speculative - “trends ” since its ever
changing:
a) Prices, cost, consumption
pattern,
investments,
expansion
3. Precautionary - for emergency
Modern inventory system - JIT (mas magastos)
Objective = deliver goods at the most
reasonable price (mas matipid sa storage cost)
(more on technology)
Ordering cost - cost needed for placing the
order, waiting for order & other related cost in
ordering (also inspection cost example rin)
Its important to maintain a minimum cash
balance
Order size
Annual demand (10,000 monthly * 12)
No. Of orders
Ordering cost
Higher order size, lower orders cost then lower
ordering cost
Baumol Cash Management
Optimum cash balance - specific level of cash to
pacify the 3 reaons
Carrying Cost (holding cost) - maintain an
inventory
*insert formula
Carrying cost per unit
* Average Inventory (order size/2)
Total Carrying cost
Where D = annual demand
T = transaction cost
I = interest rate
Higher OS, Higher average inventory then
higher carrying cost
Average Cash balance = OCB/2
No. Of Cash Transfer
Requirement/OCB
=
Annual
Cash
Relevant cost = transfer cost + carrying cost
Be careful! If the given is monthly cash payment,
multiply it by 12 to get the annual demand!
EOQ is a bit similar to OCB but remember that
EOQ talks about the number of orders while
OCB talks about the number of transfers
What is important in financial management
FLOAT is the difference between Bank Balance
and Books Bank Balance
Which may be Negative or Positive FLOAT
Lock Box System
EOQ in units
2 * annual demand * cost per order/ carrying
cost perentage
EOQ in Pesos
Peso amount of annual demand = annual
demand* carrying cost/ %
Lead Time Quanty = gaano ka naghihintay sa
order and received
Normal usage (Annual Requirment/No.of
working days) * Normal Lead Time
Safety Stock Quantity (pasobra) = SSQ in usage
(Max Units - Normal Units) * Normal Lead time
+ SSQ in time (MaxTime-Normal Time)xNormal
Usage
ReOrder Point (kelan mag-orrder) = Lead time
quantity + Safety sstock quantoty
Maximum Inventory Level = SSQ + OS
Minimum Inventory Level = SSQ
AR Management
(for credit & collection management)
Crdit managemnt - making of credit policies &
terms
Higher discount rate, more attractive for th
buyer to pay early
2/10 and n/30
Effective Discount Rate - tells whether the
discount rate is right
EDR vs. ROI (Net Income/Average Investment)
Seller EDR < ROI of money collected = offer
Buyer EDR > ROI of money = ignore
EDR = (no. Of day in a year use 360 / non
discount days) * discount rate/100% - dicount
rate
Incremental Analysis - studies the changes
Increase
Collection Period
The faster collection, the better (mas maraming
available problem)