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Flashcards in Managerial Finance Deck (116):
1

Finance

the study of how people allocate scarce resources over time
- decisions are made across time
- decisions are made in an environment of uncertainty
- decisions are made in the context of a financial system

2

Financial System

the set of markets and other institutions used for financial contracting and the exchange of assets and risks
1. markets for stocks, bonds and other financial instruments
2. financial intermediaries such as banks and insurance companies
3. the regulatory bodies that govern all of these institutions (e.g. Fed, SEC, etc.)

3

Financial Intermediaries (6 types)

Firms who's primary business is to provide customers with financial products/services that cannot be obtained more efficiently by transacting directly in security markets.
For example:
1. Commercial Banks (individuals) - facilitate payments, make loans, buy corporate bonds
2. Investment Banks (corporate & govt) - raises capital, advises, trades securities, manages M&A
3. Venture Capital Firms - type of private equity capital typically for early-stage, high-potential, growth companies - eventual IPO or trade/sale of company
4. Asset Management Companies (e.g. hedge/mutual funds). Invest in securities versus directly with companies using bottom-up (looks at the strength of the potential) or top-down (looks at industries) investment methods
5. Regulatory Institutions - central banks, SEC, IMF, etc that regulate markets and intermediaries
6. Insurance Companies - allow businesses and households to shed risk

4

Flow of Funds

financial system allows for the transfer of funds from surplus units (such as savers) that have excess resources to deficit units (such as businesses that need resources) that are in need through the markets and through intermediaries

5

Functions of Financial System (6)

1. transfers through time, borders and among industries
2. provides ways of managing risk
3. provide ways of clearing and settling payments to facilitate trade
4. provide mechanism for pooling resources and subdividing ownership (e.g. mutual funds)
5. to provide price information to help coordinate decentralized decision making in various sectors of the economy
6. provide ways of dealing with incentive problems created when one party to a transaction has information that the other party does not (or when one acts for an agent of the other)

6

Transferring Economic Resources

1. Intertemporal - borrowing and lending are ways of transferring resources across time
2. Across Space - e.g. using your debit card at a store, a US company investing in China

7

Managing Risk

- creating securities or contracts with payoffs of differing risk. Buying and selling these securities then allows investors to change their risk profile.
- buying derivative securities such as options and futures, investors can actually take on new risk or reduce their existing risk. Examples are the sale of insurance policies and call options on stock or credit-default swaps.
- issuing shares in their firm is a way for entrepreneurs to share the risk of the enterprise with others
- futures contracts offset risk
- buy insurance to offset risk
- CDOs (collateralized debt obligations) - pooled assets

8

Clearing & Settling Payments

- mobile payments (e.g. Chase Quickpay)
- write a check, use a credit card, etc.
- clearing house (when you buy stocks, this is what facilitates the exchange)
- CHIPS - clearing house interbank payments systems - most banks are a member

9

Credit Cards (Sections)

1. Merchant Processor - establishes a connection b/w merchant and CC processor - performs credit check on merchant or leases a terminal.
2. Credit Card Association - establishes rules and guidelines for card issuance and acceptance
3. Credit Card Processor - receives and processes credit card applications, maintains cardholder data
4. Card Issuer - establishes criteria to approve or deny applicants and sets credit limits, interest rates and fees (ultimate risk taker)
* All of the above get a fee so the merchant makes less than the actual transaction

10

Pooling Resources/Subdividing Shares

- mutual funds provide a way for investors to come together and buy larger amounts of securities in an efficient manner (don't have to find one person with it all)
- the corporate firm allows individuals to own parts of the enterprise
- limited partnerships allow individuals to participate in enterprises and reap tax benefits

11

Providing Information

- asset prices and interest rates provide critical signals to firm managers in their selection of investment projects
- to make investments, you need information
- crash of '87 happened due to lack of information - thus, the introduction of index options
- markets act as aggregators of information and incorporate them into prices
- firms collect other information through organizations such as Bloomberg, etc. which have their own databases
- some firms provide "new" information by taking what's out there an analyzing it

12

Incentive Problems (2 types)

1. Moral Hazard - the ignorant party lacks information about the performance of the agree-upon transaction or lacks the ability to retaliate for the breach of the agreement (i.e. a situation in which a party is more likely to take risks because the costs that could result will not be borne by the party taking the risk)
2. Adverse Selection - one of the parties to a transaction lacks information while negotiating (e.g. insurance company doesn't know someone is high risk while accepting them)

13

Principal-Agent Problems

Special case of the Moral Hazard problem when one party (the agent) undertakes to act on behalf of the other (principal). However, if the agent can't be costlessly monitored, s/he might act in his/her own interests to the detriment of the principal (e.g. manager might act to conservatively because they don't want the business to fail but if they forego some risky investments, it might be at the detriment of the business

14

Incentive Problem Solutions

1. Moral Hazard
- managers given shares of stock or options
- collateralization of loans
2. Adverse Selection
- banks cultivate long-term relationships with their clients (clients are more likely to share information, the bank has history, etc)
- firms can signal using mechanisms such as dividends and capital structure
- firms can signal quality through the offering of guarantees

15

Types of Financial Markets

1. Equity Markets
2. Fixed Income Markets
a. money market
b. long-term capital market for debt securities
3. Derivatives
a. Options
b. Forwards
c. Futures

16

Rates of Return

Fixed income securities have promised rates of return
- however, the borrower might not be able to pay the promised annual return or the principle so the return might be less than the promised
- e.g. investor buys a bond for $100 on 1/1 and receives interest of $8 on 12/31 (8% per annum). Suppose on 12/31, the bond drops in value to $98 because investors believe that the likelihood of the investor paying off the bond in full is less than certain. The actual return on the bond over the year is [8+(98-100)/100 = 6%

17

Nominal versus Real Rate of Return

- Investor buys a bond for $100 on 1/1 and receives $8 on 12/31. If the price of the bond remains at $100
- the "nominal" rate of return is 8/100 = 8% (i.e. doesn't account for inflation)
- Suppose the prices have risen 3% i.e. a basket of goods that cost $100 on 1/1 cost $103 at the end of the year
- therefore, the investor has given up "one" basket of goods on 1/1 for (100+8)/103 = 1.0485 baskets of goods at the end of the year
- the "real" rate of return is 4.85% (i.e. does account for inflation)

18

Expected Rates of Return

- prices of traded assets are set according to the return that investors expect to get on average on their investments
- e.g. if an assets is expected to be worth $120 at the end of the year, and no cash distributions are expected, then an investor desiring an expected return of 12% will pay 120/1.12 or $107.14 for the asset

19

Determinants of Expected Rates of Return

1. expected productivity of capital goods (e.g. mines, factories, etc.)
2. degree of uncertainty about the productivity of capital goods (i.e. the greater the uncertainty, the greater the required expected rate of return)
3. time preferences by people (people don't want to wait for their money)
4. risk aversion
5. expected inflation (greater the inflation, the greater required expected rate of return)

20

Corporate Finance

every decision a business makes has financial implications and any decision which affects the finances of a business is a corporate finance decision - overall, everything a business does fits in the category

21

Corporate Governance

- the entirety of a corporation's organization and structure as well as the contracts, implied and explicit, between the firm and its stakeholders (who can do what and why they can do it)
- determines its direction and performance

22

Firm Structures (non-corporate)

1. Sole Partnerships - one owner who has unlimited personal liability
2. Partnerships - more than one owner who are all liable for the firm's debt (increases the confidence of the firm's clients)
3. Limited Partnership - has general partners (run the business) and limited partners (cannot be legally involved in the decisions)
4. Limited Liability Company (LLC) - no general partners, all partners can run the business
5. S-Corporation - between an LLC and a corporation - limited number of shareholders it can have, has a perpetual life and stock is transferable (unlike an LLC)

23

Corporation (corporate firm structure)

- also called C-corporation
- legally defined entity separate from its owners (owners not liable for any of the company's obligations)
- must be legally formed according to the laws of the state where it's incorporated

24

Stock vs. Equity vs. Dividends

- entire ownership stake of a corporation is divided into shares known as stock
- the collection of all outstanding shares is known as equity
- when profits are paid out to shareholders, they are called dividends (e.g. dividends per share)
- shareholders are taxed against their dividends while the company is taxed against its profits (in contrast to an S-corporation)

25

Ownership vs. Control of Corporations

- usually many owners, not feasible for them all to have a direct say in management
- shareholders exercise control with a board of directors sometimes headed by the CEO who is delegated most day-to-day decisions

26

Shareholding and Ownership

-shareholders are not the direct owner of the assets - only have indirect control over the actions of corporations
- they own rights to a stream of cash flows

27

Agent vs. Principle

agents act
principles are on behalf of whom the act is done

28

Corporate Bankruptcy

- company files for bankruptcy so it has protection of its assets from creditors while it reorganizes the company
- creditors usually then have control
- shareholders then have much less power (another example why it's different than ownership)

29

Stock Markets

- to support the most important thing to an outsider, the market offers liquidity of investments (stocks)
- shares are traded on organized exchanges (Nasdaq, NYSE, etc.) who match buyers and sellers

30

Objective of a Firm

- objective is to maximize firm value
- "value" is the sum of all values that accrue to all participants in the firm - stockholders, bondholders, managers, employees, AND society

31

Stockholder Value

- stockholders are sometimes incentivized to monitor managers to maximize firm value (with the goal of not reducing overall firm value

32

Agency Cost

- explicit and implicit costs of suboptimal outcomes due to the conflicts of interest that arise between all of the "participant" groups - managers, stockholders, bondholders and society
- a key part of corporate governance is to design a set of controls, regulations and incentives to minimize agency cost

33

Managerial Compensation

- in order to align incentives of managers and shareholders, manager compensation is often tied to shareholder welfare
- may be given stock they are not allowed to sell but this is expensive
- may be given stock options but it might cause risky behavior
- managers might put their interests first like in the example of overpaying in takeovers

34

Annual Meeting

- annual meeting of the board of directors
- another mechanism for controlling management
- diluted by the following:
- many don't go (cost exceeds value of their holdings)
- incumbent management has an advantage in terms of proxy voting - if a proxy are not voted, votes are auto-incumbent
- when confronted with managers they don't like, often shareholders "vote with their feet"

35

Problems with Board of Directors (2)

1. the CEO hand-picks most of them
2. Directors lack expertise to ask the necessary tough questions

36

Ways Managers Subvert Takeover Attempts (4)

1. Greenmail - managers of the target firm buy the buyers existing stake and a price much greater than the price than the buyer paid in return for them signing a "standstill" agreement
2. Golden Parachute - provisions in employment contracts where managers get a payment if they lose their jobs in a take-over
3. Poison Pills - the target company attempts to make its stock less attractive to the acquirer by selling existing shareholders shares at a discount either before or after the takeover
4. Shark Repellents - 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
THE BEST DEFENSE is running your business well and earning good returns

37

Negative Information Released about a Firm

- managers often suppress information and delay the release of bad news and sometimes reveal fraudulent information
- analysts benefit from uncovering negative news
- when firms mislead the market, the punishment is quick and savage

38

Critiques of Market Prices as Reflectors of Value

1. prices are more volatile than reported
2. markets overreact to good and bad news
3. markets are short-sighted and don't consider long-term implications of actions taken by the firm
4. markets are manipulated by insiders

39

Firms and Society

- corporate decisions can also create social costs and benefits (e.g. environmental with pollution, quality of life by offering employment)
- if firms consistently create large social costs, government response is for laws and regulations to be passed and societal response is loss of business and value

40

Functions of Financial Statements

Financial Statements have to be modified and/or understood appropriately to be useful
1. Provide information to the owners and creditors of the firm about the company's current status and past financial performance
2. Provide a convenient way for owners and creditors to set performance targets and impose restrictions on managers
3. Provide convenient templates for financial planning

41

Balance Sheet

- snapshot of the firm's assets and liabilities at a given point in time
- assets are in order of liquidity
- liabilities are listed in order of time to maturity

42

Asset Types

divided into:
1. Current Assets - cash and marketable securities, A/R, inventories, other such as prepaid expenses
2. Long-Term Assets - net property, plant and equipment (net PP&E - original cost minus depreciation)

43

Asset Points

- when a firm acquires another, it will list the assets on balance sheet - often pay more than book value
- difference listed as goodwill
- intangible assets are trademarks, patents, etc. - they depreciate over time using amortization (like depreciation but for intangible)

44

Liability Types

1. Current - will be satisfied within one year (A/P, short-term debt, etc)
2. Long-Term - maturity of more than a year (

45

Long-Term Liabilities

- capital leases: long-term leases for the use of assets
- deferred taxes: taxes owed but not paid (when firm's financial acting income exceeds it income for taxes due to depreciating assets), over time the discrepancy will disappear and the tax due will be paid

46

Deferred Tax Assets

- taxable income is less that reported income (e.g. warranty expense - product cost incurred now but warranty, not until later - only if needed to be paid out)
- if warranty claims are lower in earlier periods and higher in later periods, the amounts deductible in later periods will produce tax benefits now = deferred tax asset

47

Stockholders Equity

- current liabilities + long-term liabilities = total liabilities
- assets - total liabilities = stock holders equity (aka book value of equity)
- this number does is not always accurate bc based on historical values vs. market values
- market price of share x shares outstanding = market capitalization (expected future assets to be distributed)

48

Market Value vs. Book Value

- assets - total liabilities = stock holders equity (aka book value of equity)
- this number does is not always accurate bc based on historical values vs. market values

49

Balance Sheet

Current Assets + Fixed Assets = Current Liabilities + Long-Term Liabilities + Shareholders Equity

50

Income Statement

While the balance sheet is a snapshot, the income statement is like a video of the firm's operations for a given period.
- Revenues first and then deduct any expenses
- Matching Principle = GAAP requires the IS to show revenue when it accrues and match the expense required to generate the revenue

51

Gross Profit

Sales revenue - costs incurred to make and sell the products

52

Operating Expenses

expenses in the ordinary course of running a business - but not directly related to producing the goods (e.g. marketing, R&D, admin expenses, etc.).

53

EBIT

Earnings before interest and taxes - other sources of income or expenses that arise from activities that are not a central part of the business (e.g. investment income)

54

Net Income and Earnings Per Share

from EBIT, deduct interest paid and corporate taxes to determine net income
Earnings per share = NI/Shares Outstanding

55

Accounting vs. Economic Measures of Income

Return to a stockholder (economic) = rate of return on his investment (ending price of share - beginning price on share + cash dividend)/beginning price of share
Return on Equity (accounting) = net income/shareholders equity
- Difference is ROE does not incorporate impact on share price of future expected returns

56

Financial Ratios

- ratio analysis allows for better comparison through time or between companies
- Profitability Ratios - measure ROE
- Liquidity Ratios - how easily a firm can lay its hands on cash (current ratio = CA/CL)
- Financial Leverage Ratios - how heavily the firm is in debt
- Efficiency of turnover ratios - how productively the firm is using assets
- Market Value Ratios

57

Benchmarking

- Ratios are not helpful by themselves, they need to be compared to something

58

Time Trend Analysis and Peer Group Analysis (Two Types of Benchmarking)

TTA - used to see how the firm's performance is changing through time
PTA - compare to similar companies or within industries

59

Standardized Financial Statements

- Common Size Balance Sheet - compare all accounts as a % of total assets
- Common Size Income Statement - compute all line items as a % of sales
- Make it easier to compare financial information particularly as the company grows
- Also useful for comparing companies of different sizes, particularly within the same industry

60

Statement of Cash Flows

A firm's cash flows can be quite different from its net income...IS doesn't recognize capital exp. as expenses that year (even though money was paid for the thing)
IS recognizes rev/expenses when sales are made even though money might not be yet collected
Statement of Cash flows show inflows and outflows of cash:
1. Operating Activities - earnings related activities (buying inventories, insurance payments, sales and expenses)
2. Investing and Financial Activities - relate to acquisition and disposal of non-cash assets (assets generate income over time like loans)

61

Notes to Financial Statement

- useful in assessing financial health of the firm
Often contain:
- explanation of accounting methods used
- greater detail regarding certain assets and liabilities
- info on equity structure of firm
- changes in operations
- off-balance sheet items

62

Determinations of Growth

1. Profit Margin - operating efficiency (how well it controls cost)
2. Total Asset Turn-over - asset use efficiency
3. Financial Leverage - choice of optimal debt ratio
4. Dividend Policy - choice of how much to pay investors and how much to re-invest in firm

63

Earnings Growth Rate

earnings depends on investment base and any rate of return the firm earns on investment base

64

Sustainable Growth

tells us how fast the equity of the firm can grow, without increasing financial leverage and without any additional outside equity
the internal growth rate will be lower than the sustainable growth rate, since the leverage ratio will drop.

65

Internal Growth Rate

The rate at which the business as a whole, i.e. the total assets of the firm can grow without additional external financing.
the internal growth rate will be lower than the sustainable growth rate, since the leverage ratio will drop.

66

Adverse Selection and Example

occurs when one of the parties to a transaction lacks information while negotiating.
e.g. people with high risk are more likely to buy insurance. This might happen if the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. This causes a problem because the presence of a disproportionately large number of high risk individuals raises the premium even for low-risk individuals who desire to be insured.

67

Two Functions of the Stock Market in terms of Stock Value Maximization

1. it provides an objective measurement of stock or stockholder value
2. it allows the firm to use the stock price as an input into incentive mechanisms. This promotes stock value maximizing behavior on the part of managers and other firm employees.

68

Control of the Firm Given Bankruptcy

management continues to have control of the firm for a limited period of time, usually 120 days; however, they are no longer working on behalf of shareholders, but rather on behalf of all of the firm's security holders. Bondholders and other creditors of the firm have a say in any proposed reorganization of the firm's capital structure.

69

Enterprise Value

= market value + debt - cash
it's the theoretical take-over price

70

Interest Coverage Ratio

= EBIT (aka Income)/Interest Expense
the lower the ratio, the more the company is burdened by debt

71

Profitability Ratios

profitability and how it relates to the value of a firm's shares
denominator is Sales

72

Liquidity Ratios

firms often use information from the balance sheet to assess its financial solvency or liquidity.
- a higher current or quick ratio means less risk of a firm experiencing a cash shortfall in the future

73

Current Ratio

current assets(minus inventory)/current liabilities
- assesses if the firm has sufficient working capital to meet it's short term needs.
- a higher current or quick ratio means less risk of a firm experiencing a cash shortfall in the future
- inventory is excluded because it may not be very liquid and a sudden increase in the inventory could mean the company is having trouble selling its products

74

Quick Ratio

cash + short-term assets + AR/current liabilities
- a higher current or quick ratio means less risk of a firm experiencing a cash shortfall in the future

75

Gross Margin

gross profit/sales
- reflects a firm's ability to sell a product for more than it's producing it

76

Operating Margin

operating income/sales
- reveals how much a company earns before interest and taxes from each dollar of sales
- by comparing operating margin across the industry, can assess the relative efficiency of a firm's operations

77

Working Capital Ratios

combine the information in the income statement and the balance sheet to gauge how efficiently the firm is utilizing its net working capital
- A/R Days = AR/Daily Sales (number of days of sales receivables represent)
- Inventory Turnover = annual cost of sales/inventory

78

Asset Circle

Assets used to generate cash flows -> cash flows are paid to debt (paid first) and equity (remaining money) holders (who contribute capital for the purchase of these assets) -> Assets (circle)

79

Shareholders Equity

- original amount paid for by share purchases at the time of the IPO plus retained earnings
- Is this the same as stock price? No - Stockholders Equity has to do with the past, Stock Price with the future
- ROE doesn't incorporate impact on the share price of future expected returns

80

Interest Coverage Ratios

- firms ability to meet obligations
- EBIT/interest
- benchmark is 5 or above...anything 1.5 or below, lenders question a company's ability to pay

81

Leverage Ratios

- the extent to which a firm relies on debt as a source of financing
- debt to equity ratio

82

Valuation Ratios

- market value of a firm...used to assess if the value is over or under valued
- price-to-earnings ratio
- market capitalization/net income
- share price/earnings per share

83

Operating Returns

- evaluate the firm's return on investment (ROE - return on equity...a high ROE indicates the firm is able to find profitable investment opportunities)
- ROE = net income/book value of equity
- ROA (return on assets) = net income + interest expense/book value of assets
- interest expense in the numerator because the denominator includes both debt and equity investors

84

NPV & IRR

- net present value and internal rate of return
- how people decide whether to invest in a project
- if the NPV > 0, invest
- IRR is the rate of return that makes the NPV = 0 (where

85

NPV Equation

- Future Value = Present Value x (1+r)^years
- NPV = PV(benefits) - pv(costs)

86

Interest Rate

"exchange rate" between earlier money and later money (normally the later money is certain)

87

Discount Rate vs. Compounding Rate

- DR = rate used to convert future value to present value
- CR = rate used to convert present value to future value

88

Required Rate of Return vs. Cost of Capital

- RRR - the rate investors demand for providing the firm with funds for investments (from the investors point of view)
- the higher the rate of return available, the more investors will be willing to supply
- COC - the rate at which the firm obtains funds for investment (from the firms point of view)
- the lower the rate firms have to pay, the more they will demand since more investment projects will meet the cost of the firm's funds
- in equilibrium, the RRR = COC and this will be the market rate and the rate used to discount future values into present value

89

Opportunity Cost of Capital

the rate that the firm has to pay investors in order to obtain additional $ of funds (i.e. marginal cost of capital)

90

Effects of Compounding

- compounding means that the rate at the second period includes what you made in interest in the first period (vs. simple which only always takes into account the principle amount each year)
- effects are small for a small number of periods but increases exponentially as the number of periods increases

91

Present Value Relationships

- for a given interest rate, the longer the time period, the lower the present value
- for a given time period, the higher the interest rate, the smaller the present value

92

Number of Periods Equation

t = ln(FV/PV) / ln(1+r)

93

APR

Annual Percentage Rate - banks refer to interest rates on loans and deposits in the form of APR with a certain frequency of compounding
- e.g. a loan might carry an APR of 18% per annum with monthly compounding meaning the loan will carry a monthly rate of interest of 18/12 = 1.5% per month
- APR is also called the standard rate of interest in contrast to the Effective Rate of interest which is the additional dollars the borrower will have to pay if the loan is repaid at the end of a year over and above the additional principal

94

Frequency of Compounding

-affects the future and present values of cash flows
- the stated rate of interest can deviate significantly from the effective interest rate
- e.g. 10% annual interest rate with semiannual compounding = 1.05^2 = 10.25%
- Effective Annualized Rate = (1+r/m)^m - 1
- m is the frequency of compounding

95

PV of an Annuity

- can be calculated by taking each cash flow and discounting it back to the present and adding up the PVs.
- PV (A,r,n) = A/r[1-(1/(1+r)^n)]
A = Annuity
r = discount rate
n = number of years

96

Valuing a Consol Bond

- bond that has no maturity and pays a fixed coupon
- e.g. 6% consol bond, the value of the bond given a rate of 9% is $60/.09 = $667

97

Growing Perpetuity

- cash flow that's expected to grow at a constant rate forever
- PV of Growing Perpetuity = CF/(r-g)
- g is the constant growth rate
- r is the discount rate

98

Law of One Price

- In the absence of frictions, the same good will sell for the same price in different locations
- if equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets
- reasons:
1. double arbitrage (quasi-arbitrage)
2. buyers will buy from the lower cost location, sellers will sell to the person offering the highest price

99

Arbitrage

- the practice of buying and selling goods in different markets to take advantage of a price difference
- arbitrage opportunity = situation where you can make a profit without taking any risk or investment
- a market with no arbitrage opportunities is a "normal market"

100

Equilibrium

- how prices of goods are determined
- where quantity demanded equals quantity supplied

101

Frictions that can upset the Law of One Price

- operational costs
- experience

102

Law of Once Price and Financial Assets

- financial asset = an asset that will generate future cashflows
- assuming cashflows are riskless,
- denote Pt - the price today (t = 0), of an asset that pays $1 at time t and zero at all other times (but is worth more than zero, less than $1 because you can sell it before t) = primary assets
- prices of these primary assets can be used to price financial assets other than primary assets (will be the same everywhere because of the law of one price)

103

Primary Financial Assets - Annualized Rate of Return

- unit of account can be different from the means of payment (e.g. java units)
- example: P1 will be $1 at one year. Now, it's worth $0 but can be sold for $0.90 (i.e. denote price) so the return is 11.11%
- price of P2 will be $1 at one year. Now it's worth $0 but can be sold for $0.7831 so the return is 27.70%
- taking both into account, the annualized return is 13%

104

Effective Annual Rate (EAR)

- the actual amount of interest that will be earned at the end of one year
- if you borrow $1 for 1 year and under the terms of the agreement, you pay $1.12 a the end of the year, the effective annual rate of return is 12% [(1.12 - 1)/1]
- if you borrow $1 for one month, pay $1.01 at the end of the month, your annual effective rate of return is 12.685% (1.01)^12

105

Perpetuity and Growing Perpetuity

- Perpetuity = Stream of cash flows that occur at regular intervals and last forever
- Growing Perpetuity = stream of cash flows that occur at regular intervals and grow at a constant rate forever

106

Annuity and Growing Annuity

Annuity = stream of N equal cash flows paid at regular intervals
Growing Annuity = stream of N growing cash flows paid at regular intervals

107

Annual Percentage Rate (APR)

- amount of simple interest earned in one year (i.e. interest earned without the effect of compounding)

108

Interest Rates

- return on a short-term, risk-free security (usually a treasury security)
- yields on longer-term securities
- complex rates of return on all treasury securities (and sometimes all bonds)

109

Determinants of Interest Rates

- productivity of real assets in the economy
- degree of uncertainty about the productivity of capital goods
- time preferences by investors
- risk aversion
- expected inflation

110

Nominal Rate, Real Rate and Inflation

- nominal rate (r) does NOT account for inflation (pi)
- real rate (R) does account for inflation (pi)
- R = r - pi or r = R + pi

111

T-Bills, Bonds and Notes

- T-bill = promise to pay money 6 months in the future
- treasury notes = medium maturity
- treasury bonds = longer maturity

112

Yield-to-Maturity

Internal rate of return by the buyer of a note/bond/t-bill

113

Dupont Identity

An expression that breaks return on equity (ROE) down into three parts: Operating efficiency, which is measured by profit margin- Asset use efficiency, which is measured by total asset turnover- Financial leverage, which is measured by the equity multiplier

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

If ROE is unsatisfactory, the Du Pont identity helps locate the part of the business that is underperforming.

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Dupont Identity

An expression that breaks return on equity (ROE) down into three parts: Operating efficiency, which is measured by profit margin- Asset use efficiency, which is measured by total asset turnover- Financial leverage, which is measured by the equity multiplier

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

If ROE is unsatisfactory, the Du Pont identity helps locate the part of the business that is underperforming.

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Derivative

- The type of investment that allows an individual to buy an option on a security
- Derivatives are types of investments where the investor does not own the underlying asset, but he or she makes a bet on the direction of the price movement of the underlying asset via an agreement with another party.
- derivative instruments include options, swaps, futures and forward contracts

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Sustainable Growth Rate vs. Internal Growth Rate

The internal growth rate is the growth rate a firm can sustain if it uses only internal financing—that is, retained earnings—to finance future growth. A problem arises when a firm relies only on internal financing to support asset growth: Through time, its debt ratio will fall because as asset values grow, total debt stays constant—only retained earnings finance asset growth. If total debt remains constant, as assets grow the debt ratio decreases. As we noted above shareholders often become disgruntled if, as the firm grows, a decreasing debt ratio (increasing equity financing) dilutes their return. So as firms grow, managers must often try to maintain a debt ratio that they view as optimal. In this case, managers finance asset growth with new debt and retained earnings. The maximum growth rate that can be achieved this way is the sustainable growth rate.