THE FIRM AND THE FINANCIAL MANAGER
CORPORATE FINANCE:
Corporate finance is an area of finance that deals with sources of funding, the capital
structure of corporations, the actions that managers take to increase the value of the
firm to the shareholders, and the tools and analysis used to allocate financial resources.
SOLE PROPRIETOR:
Sole proprietor is a single owner of a business who has no partners and no
shareholders. The proprietor is personally liable for all the firm’s obligations.
PARTNERSHIP:
A partnership is a form of business where two or more people share ownership, as well
as the responsibility for managing the company and the income or losses the business
generates. That income is paid to partners, who then claim it on their personal tax
returns – the business is not taxed separately, as corporations are, on its profits or
losses.
CORPORATION:
Business owned by stockholders who are not personally liable for the business’s
liabilities.
LIMITED LIABILITY:
The legal protection available to the shareholders of privately and publicly owned
corporations under which the financial liability of each shareholder for the company's
debts and obligations is limited.
REAL ASSETS:
Assets used to produce goods and services are known as real assets. Common
examples include land, buildings, inventory, precious metals, commodities, real estate,
and machinery.
FINANCIAL ASSETS:
Financial assets are tangible assets that you can quickly convert into cash. Stocks,
bonds, cash reserves, bank deposits, trade receivables, notes receivable and shares
are all common examples of financial assets.
FINANCIAL MARKETS:
Markets in which financial assets or securities are traded is known as financial markets.
Securities include stocks and bonds.
CAPITAL BUDGETING DECISION:
A Capital Budgeting Decision may be defined as the firm’s decision to invest its current
funds (Cash Flows) most efficiently in the long term assets in anticipation of an
expected flow of benefits over a series of years.
FINANCING DECISION:
Decision how to raise the money to pay for investments in real assets. It is concerned
with the borrowing and allocation of funds required for the investment decisions.
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CAPITAL STRUCTURE:
Capital structure is the way a corporation finances its assets through some combination
of equity, debt, or hybrid securities.
CAPITAL MARKETS:
A capital market is a financial market in which long-term debt (over a year) or equitybacked securities are bought and sold.
FINANCIAL INSTITUTIONS:
A financial institution (FI) is a company engaged in the business of dealing with financial
and monetary transactions such as deposits, loans, investments, and currency
exchange like a bank or insurance company.
FINANCIAL MARKETS:
Financial Market refers to a marketplace, where creation and trading of financial assets,
such as shares, debentures, bonds, derivatives, currencies, etc. take place.
 Primary Market: A financial market, wherein the company listed on an
exchange, for the first time, issues new security or already listed company brings
the fresh issue.
 Secondary Market: Alternately known as Stock market, a secondary market is
an organized marketplace, wherein already issued securities are traded between
investors, such as individuals, merchant bankers, stock brokers and mutual
funds.
AGENCY PROBLEMS:
The agency problem is a conflict of interest inherent in any relationship where one party
is expected to act in another's best interests. In corporate finance, the agency problem
usually refers to a conflict of interest between a company's management and the
company's stockholders.
The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the manager’s
best interest to maximize his own wealth.
STAKEHOLDER:
A stakeholder is a person or party that has an interest in a company and can either
affect or be affected by the business.
What are the major business functions and decisions for which the firm’s
financial managers are responsible?
The overall task of financial management can be broken down into (1) the investment,
or capital budgeting, decision and (2) the financing decision. In other words, the
firm has to decide (1) how much to invest and what assets to invest in and (2) how to
raise the necessary cash. The objective is to increase the value of the shareholders’
stake in the firm.
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The financial manager acts as the intermediary between the firm and financial
markets, where companies raise funds by issuing securities directly to investors, and
where investors can trade already-issued securities among themselves. The financial
manager also may raise funds by borrowing from financial intermediaries like banks
or insurance companies. The financial intermediaries in turn raise funds, often in small
amounts, from individual households.
In small companies there is often only one financial executive. However, the larger
corporation usually has both a treasurer and a controller. The treasurer’s job is to
obtain and manage the company’s financing. By contrast, the controller’s job is one of
inspecting to see that the money is used correctly. Large firms may also appoint a chief
financial officer, or CFO.
Why does it make sense for corporations to maximize their market values?
Value maximization is usually taken to be the goal of the firm. Such a strategy
maximizes shareholders’ wealth, thereby enabling shareholders to pursue their personal
goals. However, value maximization does not imply a disregard for ethical decision
making, in part because the firm’s reputation as an employer and business partner
depends on its past actions.
THE TIME VALUE OF MONEY
FUTURE VALUE:
The value at some future time of a present amount of money, or a series of payments,
evaluated at a given interest rate.
SIMPLE INTEREST:
Interest earned only on the original investment or principal.
COMPOUND INTEREST:
Interest paid (earned) on any previous interest earned, as well as on the principal
borrowed (lent).
PRESENT VALUE:
Present value is the current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.
DISCOUNT RATE:
Interest rate used to compute present values of future cash flows.
ANNUITY:
Annuity represents a series of equal payments or receipts occurring over a specified
number of equidistant periods.
ORDINARY ANNUITY:
Payments and receipts occur at the end of each period.
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ANNUITY DUE:
Payments or receipts occur at the beginning of each period.
PERPETUITY:
Perpetuity is an annuity that has no end, or a stream of cash payments that continues
forever.
INFLATION:
Inflation is the increase in the prices of goods and services over time.
NOMINAL INTEREST RATE:
Nominal interest rate refers to the interest rate before taking inflation into account.
Nominal can also refer to the advertised or stated interest rate on a loan, without taking
into account any fees or compounding of interest.
REAL INTEREST RATE:
The real interest rate is the rate of interest an investor, saver or lender receives (or
expects to receive) after allowing for inflation. Real interest rate is approximately the
nominal interest rate minus the inflation rate.
EFFECTIVE ANNUAL INTEREST RATE:
The effective annual interest rate is the interest rate that is actually earned or paid on an
investment, loan or other financial product due to the result of compounding over a
given time period. It is also called the effective interest rate, the effective rate or the
annual equivalent rate.
ANNUAL PERCENTAGE RATE (APR):
An annual percentage rate (APR) is the annual rate charged for borrowing or earned
through an investment. APR is expressed as a percentage that represents the actual
yearly cost of funds over the term of a loan. This includes any fees or additional costs
associated with the transaction but do not take compounding into account.
FINANCIAL PLANNING
What Is Financial Planning?
Financial planning is a process consisting of:
1. Analyzing the investment and financing choices open to the firm.
2. Projecting the future consequences of current decisions.
3. Deciding which alternatives to undertake.
4. Measuring subsequent performance against the goals set forth in the financial plan.
PLANNING HORIZON:
The planning horizon is the amount of time an organization will look into the future when
preparing a strategic plan.
PRO FORMA:
Pro forma is a Latin term that means ―for the sake of form‖ or ―as a matter of form.‖ In
the world of investing, pro forma refers to a method by which firms calculate financial
results using certain projections or presumptions.
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PERCENTAGE OF SALES MODELS:
It is a planning model to calculate how much financing is needed to increase sales.
INTERNAL GROWTH RATE:
Internal growth rate is the maximum rate of growth in sales and assets that a company
can achieve using only retained earnings. It is the rate of growth up to which the
company might not need any external financing.
Formula:
Internal Growth Rate =
Retained Earnings
Total Assets
SUSTAINABLE GROWTH RATE:
The sustainable growth rate is the highest growth rate the firm can maintain without
increasing its financial leverage.
Formula:
Sustainable growth rate = plowback ratio return on equity
ACCOUNTING AND FINANCE
BALANCE SHEET:
Balance sheet is a financial statement that shows the value of the firm’s assets and
liabilities at a particular time.
COMMON SIZE BALANCE SHEET:
A common size balance sheet is a balance sheet that displays both the numeric value
and relative percentage for total assets, total liabilities, and equity accounts.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP):
Generally accepted accounting principles (GAAP) refer to a common set of accepted
accounting principles, standards, and procedures that companies and their accountants
must follow when they compile their financial statements.
BOOK VALUE:
Book value is a net worth of the firm according to the balance sheet. Book values are
based on historical or original values.
MARKET VALUE:
Market value refers to the current or most recently-quoted price for a market-traded
security or assets.
INCOME STATEMENT:
Income statement is a financial statement that shows the revenues, expenses, and net
income of a firm over a period of time.
COMMON-SIZE INCOME STATEMENT:
A common size income statement is an income statement in which each line item is
expressed as a percentage of the value of revenue or sales.
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STATEMENT OF CASH FLOWS:
It is a financial statement that shows the firm’s cash receipts and cash payments over a
period of time.
MARGINAL TAX RATE:
A marginal tax rate is the tax rate incurred on each additional dollar of income. The
marginal tax rate for an individual will increase as income rises. This method of taxation
aims to fairly tax individuals based upon their earnings, with low-income earners being
taxed at a lower rate than higher income earners.
AVERAGE TAX RATE:
The average tax rate is the total amount of tax divided by total income.
FINANCIAL STATEMENT ANALYSIS
LEVERAGE RATIOS:
A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a
business entity against several other accounts in its balance sheet, income statement,
or cash flow statement. These ratios provide an indication of how the company’s assets
and business operations are financed (using debt or equity).
LIQUIDITY RATIOS:
Liquidity ratios are measurements used to examine the ability of an organization to pay
off its short-term obligations.
ACTIVITY/EFFICIENCY RATIOS:
Activity ratio also known as efficiency or turnover ratio, measure how effectively the firm
is using its assets.
PROFITABILITY RATIOS:
Profitability ratios are of two types – those showing profitability in relation to sales and
those showing profitability in relation to investment. Together, these ratios indicate the
firm’s overall effectiveness of operation.
Return on Assets/investment (ROA):
Return on assets is a profitability ratio that shows the percentage of profit a company
earns in relation to its overall resources. It is commonly defined as net income divided
by total assets
Return on Equity (ROE):
The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm
to generate profits from its shareholders investments in the company. In other words,
the return on equity ratio shows how much profit each dollar of common stockholders’
equity generates.
DU PONT SYSTEM:
The Du Pont analysis also called the Du Pont model is a financial ratio based on the
return on equity ratio that is used to analyze a company’s ability to increase its return on
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equity. In other words, this model breaks down the return on equity ratio to explain how
companies can increase their return for investors.
Return on assets or investment and Du Pont analysis:
The DuPont method was break the calculation of the return on assets ratio in two
separate parts: calculation of the net profit margin and the total asset turnover.
Return on assets (ROA) = Net profit margin X Total assets turnover
Return on equity (ROE) and Du Pont analysis:
The DuPont method breaks return on equity down into three parts.
Return on Equity (ROE) = Net profit margin X Total assets turnover X Equity multiplier
BENCHMARK:
It is a Standard or a set of standards, used as a point of reference for evaluating
performance or level of quality.
MARKET VALUE ADDED:
It is the difference between the market value of the firm’s equity and its book value.
RESIDUAL INCOME/ECONOMIC VALUE ADDED OR EVA):
Economic value added (EVA) is a measure of a company's financial performance based
on the residual wealth calculated by deducting its cost of capital from its operating profit,
adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it
attempts to capture the true economic profit of a company.
WORKING CAPITAL MANAGEMENT AND SHORT-TERM PLANNING
NET WORKING CAPITAL/WORKING CAPITAL:
Net working capital (NWC) is the difference between a company’s current assets and
current liabilities. A positive net working capital indicates a company has sufficient funds
to meet its current financial obligations and invest in other activities.
CASH CONVERSION CYCLE:
It is a period between firm’s payment for materials and collection on its sales.
Cash conversion cycle = (inventory period + receivables period) – accounts payable
period
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CARRYING COSTS:
Carrying costs, also known as holding costs and inventory carrying costs, are the costs
a business pays for holding inventory in stock. A business can incur a variety of carrying
costs, including taxes, insurance, employee costs, depreciation, the cost of keeping
items in storage, the cost of replacing perishable items, and opportunity costs.
SHORTAGE COSTS:
Shortage cost is the cost of having a shortage and not being able to meet demand from
stock.
OR
The marginal profit that is lost when a customer orders an item that is not immediately
available in stock.
FACTORING:
Factoring is a financial transaction and a type of debtor finance in which a business
sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.
LINE OF CREDIT:
A line of credit is a credit facility extended by a bank or other financial institution to a
government, business or individual customer that enables the customer to draw on the
facility when the customer needs funds.
CASH AND INVENTORY MANAGEMENT
FLOAT:
Float is duplicate money present in the banking system during the time between a
deposit being made in the recipient's account and the money being deducted from the
sender's account.
PAYMENT FLOAT:
Interval between the days a check is written (decreasing the firm's cash balance) and
the day the amount is actually deducted from firm's bank balance.
AVAILABILITY FLOAT:
Availability float is the time between when a check is deposited and when the funds are
available to the recipient.
NET FLOAT:
Net float is a difference between payment float and availability float.
Net float = payment float – availability float
CONCENTRATION BANKING:
It is a system whereby customers make payments to a regional collection center which
transfers funds to a principal bank.
LOCK-BOX SYSTEM:
System whereby customers send payments to a post office box and a local bank
collects and processes checks.
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ZERO-BALANCE ACCOUNT:
It is a corporate checking account in which a zero balance is maintained. The account
requires a master (parent) account from which funds are drawn to cover negative
balances or to which excess balances are sent.
REMOTE DISBURSEMENT:
A system in which the firm directs checks to be drawn on a bank that is geographically
remote from its customer so as to maximize check clearing time
ECONOMIC ORDER QUANTITY:
The Economic Order Quantity (EOQ) is the number of units that a company should add
to inventory with each order to minimize the total costs of inventory—such as holding
costs, order costs, and shortage costs.
MONEY MARKET:
Market for short-term financial assets is known as money market.
CREDIT MANAGEMENT AND COLLECTION
TERMS OF SALE:
The delivery and payment terms agreed between a buyer and a seller like Credit,
discount, and payment terms offered on a sale.
OPEN ACCOUNT:
A payment term under which the buyer promises to pay the seller within a
predetermined number of days, and the seller does not restrict the availability of
documents that control possession rights to the goods.
CREDIT ANALYSIS:
Credit analysis is the process of determining the ability of a company or person to repay
its debt obligations. In other words, it is a process that determines the credit risk or
default risk.
CREDIT POLICY:
Credit policy is the Standards set to determine the amount and nature of credit to
extend to customers.
COLLECTION POLICY:
A collection policy is the set of procedures a company uses to ensure payment of
accounts receivable.
AGING SCHEDULE:
An aging schedule is a summarized presentation of accounts receivable into separate
time brackets that rank the receivables based upon the days until due or the days past
due.
BANKRUPTCY:
Bankruptcy is the legal proceeding involving a person or business that is unable to
repay outstanding debts.
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WORKOUT:
Agreement between a company and its creditors establishing the steps the company
must take to avoid bankruptcy.
LIQUIDATION:
Liquidation is the process of bringing a business to an end and distributing its assets to
claimants.
REORGANIZATION:
Reorganization is a process designed to revive a financially troubled or bankrupt firm.
Reorganization is an attempt to extend the life of a company facing bankruptcy through
special arrangements and restructuring to minimize the possibility of past situations
reoccurring.
VALUING BONDS
BOND:
A bond, also known as a fixed-income security, is a debt instrument created for the
purpose of raising capital. They are essentially loan agreements between the bond
issuer and an investor, in which the bond issuer is obligated to pay a specified amount
of money at specified future dates.
COUPON RATE:
Coupon rate is the rate of interest paid by bond issuers on the bond's face value to
bondholder.
FACE VALUE:
Face value, also referred to as par value or nominal value, is the value shown on the
face of a security certificate.
PERPETUAL BOND:
A perpetual bond is bon that never matures. It has an infinite life.
NON-ZERO COUPON PAYING BOND:
Non-zero coupon bond is a coupon paying bond with a finite life. A non-zero coupon
bond adjusted for semi-annual compounding.
ZERO-COUPON BOND:
Zero coupon bond is a bond that pays no interest but sell at a deep discount from its
face value, it provide compensation to investors in the form of price of appreciation.
CURRENT YIELD:
Current yield is an annual return of a bond or any other fixed-income security.
The current yield is equal to the annual interest earned divided by the current price of
the bond.
YIELD TO MATURITY:
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it
matures.
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RATE OF RETURN:
A rate of return (ROR) is the net gain or loss on an investment over a specified time
period, expressed as a percentage of the investment’s initial cost.
Gains on investments are defined as income received plus any capital gains realized on
the sale of the investment.
YIELD CURVE:
Graph of the relationship between time to maturity and yield to maturity.
DEFAULT (OR CREDIT) RISK:
Default risk is the risk that a bond issuer will not make its promised principal and interest
payments. It is also known as a bond's credit risk.
OR
The risk that a bond issuer may default on its obligations is called default risk (or credit
risk).
DEFAULT PREMIUM:
Default premium is the additional yield on a bond investors require for bearing credit
risk.
TYPES OF DEFAULT RISK:
The credit scores established by the rating agencies can be grouped into two
categories:
 Investment grade
 Non-Investment grade (or junk bond).
INVESTMENT GRADE:
Investment-grade debt or bond is considered to have low default risk and is generally
more sought-after by investors.
Non-investment grade OR JUNK BOND:
Non-investment grade debt or bond offers higher yields than safer bonds, but it also
comes with a significantly higher chance of default.
While the grading scales used by the rating agencies are slightly different, most debt is
graded similarly. Any bond issue given a AAA, AA, A, or BBB rating by S&P is
considered investment grade. Anything rated BB and below is considered noninvestment grade.
FLOATING-RATE BONDS:
Floating-rate bond is a bond whose interest amount fluctuates in step with the market
interest rates, or some other external measure. Price of floating rate bonds remains
relatively stable because neither a capital gain nor a capital loss occurs as market
interest rates go up or down.
CONVERTIBLE BONDS:
A convertible bond is a fixed-income debt security that yields interest payments, but can
be converted into a predetermined number of common stock or equity shares.
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The conversion from the bond to stock can be done at certain times during the bond's
life and is usually at the discretion of the bondholder.
VALUING STOCKS
COMMON STOCK:
Common stock is a security that represents ownership in a corporation.
Holders of common stock exercise control by electing a board of directors and voting on
corporate policy. Common stockholders are at the bottom of the priority ladder in terms
of ownership structure; in the event of liquidation, common shareholders have rights to
a company's assets only after bondholders, preferred shareholders and other debt
holders are paid in full.
INITIAL PUBLIC OFFERING (IPO):
An initial public offering (IPO) refers to the process of offering shares of a private
corporation to the public in a new stock issuance.
DIVIDEND:
A dividend is a payment made by a corporation to its shareholders, usually as a
distribution of profits
PRICE-EARNINGS (P/E) MULTIPLE:
The price-earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a
company's share (stock) price to the company's earnings per share. The ratio is used
for valuing companies and to find out whether they are overvalued or undervalued.
LIQUIDATION VALUE:
Liquidation value is the net proceeds that would be realized by selling the firm’s assets
and paying off its creditors.
MARKET-VALUE BALANCE SHEET:
It is a financial statement that uses the market value of all assets and liabilities.
DIVIDEND DISCOUNT MODEL:
The dividend discount model (DDM) is a method of valuing a company's stock price
based on the theory that its stock is worth the sum of all of its future dividend payments,
discounted back to their present value. In other words, it is used to value stocks based
on the net present value of the future dividends.
CONSTANT-GROWTH DIVIDEND DISCOUNT MODEL:
Constant growth dividend is a version of the discount model in which assumes that the
dividend grow forever at a constant rate.
ZERO GROWTH MODEL:
Zero growth model assumes that dividends will grow forever at the rate g = 0.
NONCONSTANT GROWTH OR GROWTH PHASES MODEL:
Growth phase model assumes that dividends for each share will grow at two or more
different growth rates.
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PAYOUT RATIO:
The dividend payout ratio is the ratio of the total amount of dividends paid out to
shareholders relative to the net income of the company. It is the percentage of earnings
paid to shareholders in dividends.
PLOWBACK RATIO:
Plowback ratio (also known as retention ratio) is the percentage of a company's
earnings that are retained and reinvested by the company. It equals 1 minus the
dividend payout ratio.
PRESENT VALUE OF GROWTH OPPORTUNITIES (PVGO):
PVGO stands for present value of growth opportunities and it represents the component
of a company’s stock value that corresponds to the investors’ expectations of growth in
earnings. PVGO can be calculated as the difference between the values of a company
minus the present value of its earnings assuming zero growth. It is also called value of
growth.
SUSTAINABLE GROWTH RATE:
The sustainable growth rate is the highest growth rate the firm can maintain without
increasing its financial leverage.
Formula:
Sustainable growth rate = plowback ratio return on equity
INTRODUCTION TO RISK, RETURN, AND THE
OPPORTUNITY COST OF CAPITAL
MARKET INDEX:
Market index is a measure of the investment performance of the overall market.
DOW JONES INDUSTRIAL AVERAGE:
The Dow Jones Industrial Average (DJIA), or simply the Dow, is a stock market index
that measures the stock performance of 30 large companies listed on stock exchanges
in the United States.
STANDARD & POOR’S COMPOSITE INDEXES:
The S&P 500 or just the S&P is a stock market index that measures the stock
performance of 500 large companies listed on stock exchanges in the United States.
RETURN:
Income received on an investment plus any change in market price, usually expressed
as a percent of the beginning market price of the investment.
RISK:
Risk is the variability of return from those that are expected.
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SYSTEMATIC RISK OR MARKET RISK:
Systematic risk is the variability of the return on stock or portfolio associated with
changes in return on the market as a whole.
UNSYSTEMATIC RISK OR UNIQUE RISK:
Unsystematic risk is the variability of the return on stock or portfolios not explained by
general market movements. It is avoidable through diversification.
MATURITY PREMIUM:
Maturity premium (or maturity risk premium) is extra average returns from investing in
long- versus short-term Treasury securities.
OR
A maturity risk premium is the amount of extra return you'll see on your investment by
purchasing a bond with a longer maturity date. Maturity risk premiums are designed to
compensate investors for taking on the risk of holding bonds over a lengthy period of
time. Generally speaking, the longer the time until maturity, the higher the maturity risk
premium.
RISK PREMIUM:
Risk premium represents the extra return above the risk-free rate that an investor needs
in order to be compensated for the risk of a certain investment.
VARIANCE:
The Variance is defined as the average of the squared differences from the Mean.
STANDARD DEVIATION:
Standard deviation is a statistical measure of the variability of a distribution around its mean. It
is the square root of variance.
DIVERSIFICATION:
Diversification is a strategy designed to reduce risk by spreading the portfolio across
many investments. Diversification reduces variability.
NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA
OPPORTUNITY COST OF CAPITAL:
Opportunity cost of capital is the expected rate of return given up by investing in a
project.
NET PRESENT VALUE (NPV):
Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time.
NPV is used in capital budgeting and investment planning to analyze the profitability of
a projected investment or project.
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PROFITABILITY INDEX (PI):
The Profitability Index (PI) measures the ratio between the present value of future cash
flows and the initial investment. The index is a useful tool for ranking investment
projects and showing the value created per unit of investment.
The Profitability Index is also known as the Profit Investment Ratio (PIR) or the Value
Investment Ratio (VIR).
PAYBACK PERIOD:
The payback period refers to the amount of time it takes to recover the cost of an
investment. Simply put, the payback period is the length of time an investment reaches
a breakeven point.
INTERNAL RATE OF RETURN (IRR):
Internal rate of return (IRR) is the interest rate at which the net present value of all the
cash flows (both positive and negative) from a project or investment equal zero.
Internal rate of return is used to evaluate the attractiveness of a project or investment. If
the IRR of a new project exceeds a company’s required rate of return, that project is
desirable. If IRR falls below the required rate of return, the project should be rejected.
BOOK OR ACCOUNTING RATE OF RETURN:
The accounting rate of return (ARR) is the percentage rate of return expected on an
investment or asset as compared to the initial investment cost.
ARR divides the average revenue from an asset by the company's initial investment to
derive the ratio or return that can be expected over the lifetime of the asset or related
project. ARR does not consider the time value of money or cash flows.
MUTUALLY EXCLUSIVE PROJECTS:
In capital budgeting, mutually-exclusive projects refer to a set of projects out of which
only one project can be selected for investment.
EQUIVALENT ANNUAL COST:
Equivalent annual cost (EAC) is the annual cost of owning and maintaining an asset
determined by dividing the net present value of the asset purchase, operations and
maintenance cost by the present value of annuity factor.
It is a capital budgeting tool used by companies to compare assets with unequal useful
lives. The same concept can be applied to analyze projects which have unequal useful
lives.
CAPITAL RATIONING:
Capital rationing is the act of placing restrictions on the amount of new investments or
projects undertaken by a company.
This is accomplished by imposing a higher cost of capital for investment consideration
or by setting a ceiling on specific portions of a budget. Companies may want to
implement capital rationing in situations where past returns of an investment were lower
than expected.
HARD CAPITAL RATIONING:
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Hard capital rationing or ―external‖ rationing occurs when the company faces problems
in raising funds in the external equity markets. This can lead to the shortage of capital to
finance the new projects in the company.
SOFT CAPITAL RATIONING:
Soft capital rationing or ―internal‖ rationing is caused due to the internal policies of the
company. The company may voluntarily have certain restrictions that limit the number of
funds available for investments in projects.
USING DISCOUNTED CASH-FLOW ANALYSIS
TO MAKE INVESTMENT DECISIONS
DEPRECIATION TAX SHIELD:
A depreciation tax shield is a tax reduction technique under which depreciation expense
is subtracted from taxable income. The amount by which depreciation shields the
taxpayer from income taxes is the applicable tax rate, multiplied by the amount of
depreciation.
STRAIGHT-LINE DEPRECIATION:
It is a constant depreciation for each year of the asset’s accounting life.
MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS):
MACRS stands for modified accelerated cost recovery system. It is the current system
allowed to calculate tax deductions on account of depreciation for depreciable assets. It
allows a larger deduction in early years and lower deductions in later years when
compared to the straight-line method.
RISK, RETURN, AND CAPITAL BUDGETING
MARKET PORTFOLIO:
A market portfolio is a theoretical bundle of investments that includes every type of
asset available in the world financial market, with each asset weighted in proportion to
its total presence in the market. The expected return of a market portfolio is identical to
the expected return of the market as a whole.
BETA:
It is an index of systematic risk. It measures the sensitivity of a stock’s return to change
in the return on market portfolio. The beta for a portfolio is simply a weighted average of
the individual stock betas in the portfolio.
MARKET RISK PREMIUM:
The market risk premium is the difference between the expected return on a market
portfolio and the risk-free rate.
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CAPITAL ASSET PRICING MODEL (CAPM):
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship
between the expected return and risk of investing in a security. It shows that the
expected return on a security is equal to the risk-free return plus a risk premium, which
is based on the beta of that security.
SECURITY MARKET LINE:
The security market line (SML) is a visual representation of the capital asset pricing
model or CAPM. It shows the relationship between the expected return of a security and
its risk measured by its beta coefficient. In other words, the SML displays the expected
return for any given beta or reflects the risk associated with any given expected return.
COMPANY COST OF CAPITAL:
Expected rate of return demanded by investors in a company, determined by the
average risk of the company’s assets and operations.
PROJECT COST OF CAPITAL:
Minimum acceptable expected rate of return on a project given its risk.
THE COST OF CAPITAL
COST OF CAPITAL:
It is a required rate of return on the various types of financing.
WEIGHTED-AVERAGEOF CAPITAL (WACC):
The weighted average cost of capital (WACC) is the rate that a company is expected to
pay on average to all its security holders to finance its assets
FLOTATION COSTS:
Flotation cost is the total cost incurred by a company in offering its securities to the
public. They arise from expenses such as underwriting fees, legal fees and registration
fees.
PROJECT ANALYSIS
PROJECT ANALYSIS:
Project analysis is the examination of all costs or problems of the project before work on
its started.
CAPITAL BUDGETING:
The process of identifying, analyzing and selecting investment projects whose returns
(cash flow) are expected to extend beyond one year.
SENSITIVITY ANALYSIS:
Sensitivity Analysis is a tool used in financial modeling to analyze how the different
values of a set of independent variables (input) affect a specific dependent variable
(output) under certain specific conditions.
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For example, Sensitivity Analysis can be used to study the effect of a change in interest
rates on bond prices if the interest rates increased by 1%. The ―What-If‖ question would
be: ―What would happen to the price of a bond If interest rates went up by 1%?‖. This
question is answered with sensitivity analysis.
FIXED COST:
Fixed cost is the cost that does not depend on the level of output.
VARIABLE COST:
Variable cost is the costs that change as the level of output changes.
SCENARIO ANALYSIS:
Scenario Analysis is the process of calculating the value of a specific investment, or a
certain group of investments, under a variety of scenarios i.e. future possibilities. In
other words, we estimate expected cash flows and asset value under various scenarios,
with the intent of getting a better sense of the effect of risk on value.
SIMULATION ANALYSIS:
The Simulation Analysis is a method, wherein the infinite calculations are made to
obtain the possible outcomes and probabilities for any choice of action.
BREAK-EVEN ANALYSIS:
The Break-Even Analysis is a method adopted by the firms to determine that how much
should be produced or sold at a minimum to ensure that the project does not lose
money. Simply, the minimum quantity at which the loss can be avoided is called as a
break-even point.
OPERATING LEVERAGE:
Operating leverage measures a company’s fixed costs as a percentage of its total costs.
DEGREE OF
OPERATING LEVERAGE (DOL):
The percentage change in the firm’s operating profit (EBIT) resulting from A 1 percent
change in output.
DECISION TREE:
Decision tree is a diagram of sequential decisions and possible outcomes.
AN OVERVIEW OF CORPORATE FINANCING
TREASURY STOCK:
Stock that has been repurchased by the company and held in its treasury is known as
treasury stock.
ISSUED SHARES:
Issued shares are the shares that have been issued by the company.
OUTSTANDING SHARES:
Shares that have been issued by the company and are held by investors is known as
outstanding shares.
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AUTHORIZED SHARE CAPITAL:
Maximum number of shares that the company is permitted to issue, as specified in the
firm’s articles of incorporation.
PAR VALUE:
Value of security shown on certificate is known as par value.
ADDITIONAL PAID-IN CAPITAL:
Additional paid-in capital is the difference between issue price and par value of stock. It
is also called capital surplus.
RETAINED EARNINGS:
Retained earnings are the cumulative amount of earnings since the corporation was
formed minus the cumulative amount of dividends that were declared. Retained
earnings are the corporation's past earnings that have not been distributed as dividends
to its stockholders.
MAJORITY VOTING:
A type of voting right in which stockholders are granted one vote for each director's
position for each share held. Thus, the holder of 100 shares would have the right to cast
100 votes for each position for which an election is held. Under this system, any
stockholder or group holding 51% of the shares voting is able to control every position
up for election. It is also called statutory voting.
CUMULATIVE VOTING:
A system of voting for directors of a corporation in which shareholder's total number of
votes is equal to the number of shares held multiplied by the number of directors to be
elected.
For example, an owner of 200 shares is permitted a total of 1,200 votes if six positions
are to be voted on. These 1,200 votes may be cast for a single director, may be split
between two directors, or may be allocated equally among all six directors.
PROXY CONTEST:
A proxy contest is a strategy in which outsiders compete with management for
shareholders vote in order to take control of the company. It is also called proxy fight or
war.
PREFERRED STOCK:
Stock that takes priority over common stock in regard to dividends.
NET WORTH:
Net worth is the book value of common stockholders’ equity plus preferred stock.
FLOATING-RATE PREFERRED:
A preferred stock paying a dividend that varies from time to time. Usually, the dividend
rate is the same as the interest rate on a Treasury security.
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PRIME RATE:
The prime rate is the benchmark interest rate charged by banks to large customers with
good to excellent credit. (But the largest and most creditworthy corporations can, and
do, borrow at less than prime.)
FUNDED DEBT:
Funded debt is any debt repayable more than 1 year from the date of issue. Debt due in
less than a year is termed unfunded and is carried on the balance sheet as a current
liability.
SINKING FUND:
A sinking fund is a fund containing money set aside or saved to pay off a debt or bond.
CALLABLE BOND:
A callable bond (redeemable bond) is a type of bond that provides the issuer of the
bond with the right, but not the obligation, to redeem the bond before its maturity date at
specified call price.
SUBORDINATED DEBT:
Subordinated debt (also known as subordinated loan, subordinated bond, subordinated
debenture or junior debt) is debt which ranks after other debts if a company falls into
liquidation or bankruptcy.
SECURED DEBT:
Debt that has first claim on specified collateral in the event of default.
EUROBOND:
A Eurobond is an international bond issued that is denominated in a currency not native
to the country where it is issued. It is also called external bond.
PRIVATE PLACEMENT:
Private placement is a sale of securities to a limited number of investors without a public
offering.
PROTECTIVE COVENANT:
A protective covenant is a term of agreement that restrict the issuer of bond to take
certain action to protect the bondholder.
WARRANT:
Warrant or stock warrant is giving right to investors to buy shares from a company at a
stipulated (fixed) price before a set date.
INTERNALLY GENERATED FUNDS:
Cash reinvested in the firm: depreciation plus earnings not paid out as dividends.
TECHNICAL ANALYSIS:
Technical analysis is the use of specific market generated data for the analysis of both
aggregate stock prices (market indices or industry averages) and individual stock.
TREND ANALYSIS:
Trend analysis is a technique used in technical analysis that attempts to predict the
future stock price movements based on recently observed trend data. Trend analysis is
based on the idea that what has happened in the past gives traders an idea of what will
happen in the future.
RANDOM WALK THEORY:
Security prices change randomly, with no predictable trends or patterns.
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FUNDAMENTAL ANALYSIS:
Fundamental analysis at the company level involves analyzing basic financial variables
in order to estimate the company’s intrinsic value. These variables include sales, profit
margins, depreciation, the tax rate, sources of financing, asset utilization, and other
factors.
HOW CORPORATIONS ISSUE SECURITIES
VENTURE CAPITAL:
Venture capital is financing that investors provide to startup companies and small
businesses that are believed to have long-term growth potential. Venture capital
generally comes from well-off investors, investment banks and any other financial
institutions.
INITIAL PUBLIC OFFERING (IPO):
It is a first offering of stock to the general public.
UNDERWRITER:
Underwriter is a company, usually an investment bank that helps companies introduce
their new securities to the market.
SPREAD:
Spread is a difference between public offer price and price paid by underwriter.
PROSPECTUS:
A prospectus is a legal document issued by companies that are offering securities for
sale.
UNDERPRICING:
Issuing securities at an offering price set below the true value of the security.
FLOTATION COSTS:
Flotation cost is the total cost incurred by a company in offering its securities to the
public. They arise from expenses such as underwriting fees, legal fees and registration
fees.
SEASONED OFFERING:
An issue of additional stock by a company whose stock already is publicly traded is
called a seasoned offering.
RIGHTS ISSUE:
Issue of securities offered only to current stockholders.
GENERAL CASH OFFER:
Sale of securities opens to all investors by an already public company.
SHELF REGISTRATION:
Shelf registration, shelf offering, or shelf prospectus is a type of public offering where
certain issuers are allowed to offer and sell securities to the public without a separate
prospectus for each act of offering and without the issue of further prospectus.
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LEASING
LEASE:
The lease is a contract whereby one party, the lessor, grants the right to use a particular
asset for a period of time to the other party, the lessee (or tenant), which will pay for the
transfer of the right to use a fixed amount regularly.
OPERATING LEASE:
Operating lease is a shorter-term lease under which the lessor is responsible for
insurance, taxes, and upkeep. It may be cancelable by the lessee on short notice.
FINANCIAL LEASE:
Financial lease is a longer-term, fully amortized lease under which the lessee is
responsible for maintenance, taxes, and insurance. Usually it is not cancelable by the
lessee without penalty.
TAX-ORIENTED LEASE:
A lease in which the lessor is the owner of the leased asset for tax purposes is called a
tax-oriented lease. Such leases are also called tax leases or true leases.
LEVERAGED LEASE:
A leveraged lease is a tax-oriented lease in which the lessor borrows a substantial
portion of the purchase price of the leased asset on a nonrecourse basis, meaning that
if the lessee stops making the lease payments, the lessor does not have to keep making
the loan payments.
SALE AND LEASEBACK:
Sale-and-leaseback is financial transaction in which one sells an asset and leases it
back for the long term; therefore, one continues to be able to use the asset but no
longer owns it.
NET ADVANTAGE TO LEASING (NAL):
The NPV that is calculated when is deciding whether to lease an asset or to buy it.
LEVERAGE AND CAPITAL STRUCTURE
CAPITAL STRUCTURE:
The mix (or proportion) of a firm’s permanent long-term financing represented by debt,
preferred stock, and common stock equity.
FINANCIAL LEVERAGE:
Financial leverage (sometimes referred to as gearing) is a technique involving the use
of debt (borrowed funds) rather than fresh equity in the purchase of an asset, with the
expectation that the after-tax profit to equity holders from the transaction will exceed the
borrowing cost.
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DEGREE OF FINANCIAL LEVERAGE:
The percentage change in the firm’s earning per share (EPS) resulting from a 1 percent
change in operating profit.
FINANCIAL RISK:
The added variability in earning per share (EPS) plus the risk of possible insolvency that
is induced by the use of the financial leverage.
BUSINESS RISK:
It is the inherent uncertainty in the physical operations of the firm. Its impact is shown in
the variability of the firm’s operating income (EBIT).
TOTAL FIRM RISK:
It is the variability in earning per share (EPS). It is the sum of business plus financial
risk.
Total firm risk = business risk + financial risk
DEGREE OF TOTAL LAVERAGE:
The percentage change in a firm’s earning per share (EPS) resulting from a 1 percent
change in output (sales).
MERGERS, ACQUISITIONS, AND CORPORATE CONTROL
METHODS TO CHANGE MANAGEMENT:
There are four methods to change management:
1. Proxy contests
2. Mergers and acquisitions
3. Leveraged buyouts
4. Divestitures and spin-offs
PROXY CONTEST:
A proxy contest is a strategy in which outsiders compete with management for
shareholders vote in order to take control of the company. It is also called proxy fight or
war.
MERGER:
The merger is the process by which two or more companies take a strategic decision to
come together and merge together as one company with a new name.
ACQUISITION:
The acquisition is the process by which one company acquires another company. The
financially strong company acquires more than 50% of shares to take over another
company.
TENDER OFFER:
The tender offer is a public, open offer or invitation by an investor to all the current
shareholders of a public traded firm to purchase or part of their shares for sale at a
certain price and time.
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LEVERAGED BUYOUT (LBO):
A leveraged buyout (LBO) is the purchase of a company using a large amount of debt
or borrowed cash to fund the acquisition.
MANAGEMENT BUYOUT (MBO):
A management buyout (MBO) is a form of acquisition where a company's existing
managers acquire a large part or all of the company from either the parent company or
from the private owners.
DIVESTITURE:
The Divestiture means the sale or disposition of certain company’s assets or a business
unit which is not performing well and is disposed of either through closure, sale or
bankruptcy.
SPIN-OFF:
A spinoff is a type of divestiture in which the divested unit becomes an independent
company (perhaps through an IPO) instead of being sold to a third party.
RESTRUCTURING:
Restructuring is the corporate management term for the act of reorganizing the legal,
ownership, operational, or other structures of a company for the purpose of making it
more profitable, or better organized for its present needs.
POISON PILL:
Poison pill is a Measure taken by a target firm to avoid acquisition; for example, the right
for existing shareholders to buy additional shares at an attractive price if a bidder
acquires a large holding.
WHITE KNIGHT:
A white knight is a hostile takeover defense whereby a 'friendly' individual or company
that acquires a corporation at fair consideration, that is on the verge of being taken over
by an 'unfriendly' bidder or acquirer, who is known as the black knight.
SHARK REPELLENT:
Shark repellent is a slang term for any one of a number of measures taken by a
company to fend off an unwanted or hostile takeover attempt. In many cases, a
company will make special amendments to its charter or bylaws that become active only
when a takeover attempt is announced or presented to shareholders with the goal of
making the takeover less attractive or profitable to the acquisitive firm. It is also known
as a "porcupine provision."
INTERNATIONAL FINANCIAL MANAGEMENT
FOREIGN EXCHANGE MARKET:
The Foreign Exchange Market is a market where the buyers and sellers are involved in
the sale and purchase of foreign currencies.
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EXCHANGE RATE:
It is an amount of one currency to purchase one unit of another.
SPOT RATE OF EXCHANGE:
A spot rate of exchange represents a contracted rate or price for the purchase or sale of
currency for immediate delivery and payment on the spot date.
FORWARD EXCHANGE RATE:
The forward exchange rate is the price of currency for delivery at some time in the
future.
LAW OF ONE PRICE:
The law of one price is the economic theory that states the price of an identical security,
commodity or asset traded anywhere should have the same price regardless of location
when currency exchange rates are taken into consideration, if it is traded in a free
market with no trade restrictions. The law of one price exists because differences
between asset prices in different locations should eventually be eliminated due to the
arbitrage opportunity.
PURCHASING POWER PARITY (PPP):
Theory that the cost of living in countries is equal and exchange rates adjust to offset
inflation differentials across countries.
PPP states that although some goods may cost different amounts in different countries,
the general cost of living should be the same in any two countries.
INTERNATIONAL FISHER EFFECT:
Theory that real interest rates in all countries should be equal, with differences in
nominal rates reflecting differences in expected inflation.
INTEREST RATE PARITY:
Interest rate parity theory says that the interest rate differential must equal the
differential between the forward and spot exchange rates.
EXPECTATIONS THEORY OF EXCHANGE RATES:
Expectations theory of exchange rates, which predicts that the forward rate equals the
expected future spot exchange rate.
EXCHANGE RATE RISK:
Exchange-rate risk, also called currency risk, is the risk that changes in the relative
value of certain currencies will reduce the value of investments denominated in a
foreign currency.
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