BU111 Final Exam Notes PDF

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BU111 Final Exam Notes – Buying and Selling Equities – The Mechanics ** Assume that commission paid on these transactions if 2% on purchase and 2% on sale of investment ** Market Order  Most common type of transaction  To buy a stock you would call a broker and ask to buy a certain number of share...

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BU111 Final Exam Notes – Buying and Selling Equities – The Mechanics ** Assume that commission paid on these transactions if 2% on purchase and 2% on sale of investment ** Market Order  Most common type of transaction  To buy a stock you would call a broker and ask to buy a certain number of shares (100 is a typical ‘board’ lot)  What you pay when buying shares = Price of share × # of shares being bought + 2% commission  What you get for selling shares = Price of share × # of shares being sold – 2% commission Capital Gain q  Whenever you benefit financially by buying an asset and selling it at a higher price  Capital Gain = Price sold – Price paid OR Face Value – Purchase Price Yield  Yield = what you made ÷ what you paid OR yield = Dollar return ÷ dollar invested  Commission and/or interest expense will be deducted from the return and the stock price (or dollars spent on actual investment excluding commissions) will be used as the denominator  Always use face value of $1000 for bonds Going Long and Buying on Margin  Going long o Means investor has purchased a security o Investor is expecting profit when price of a security increases and the investor sells it (buying low, selling high) o Investor pays the price of the investment  Buying on margin o Make profit when security increases in price and is old o Borrows money for part of investment from the broker o The minimum margin is 80% (the investor must put in at least 80% of value of the investment) o The investor does not have to choose to use the full margin available (could choose to provide 90% of investment) o Results in the investor being able to purchase a larger amount of securities with the same amount of money they would have invested when “going long”

o Advantage is leverage – you are able to increase your buying power (buy more with same investment) therefore increasing potential profits) Margin Buying Costs and Risks  When borrowing money from the broker for buying on margin, you must pay interest on the loan  Buying on margin magnifies your risk if the price falls – if you do not sell your shares before the price falls, the amount that you deposited with the broker is no longer enough to meet to margin requirement (80%) o Investor will receive a margin call from their broker requesting to give him more money in order to reduce the value of the loan he has provided o Calculating the margin = (current market value of the investment – loan) ÷ Current market value of the investment o To bring the margin back up to the minimum is to reduce the amount of the loan to bring the margin back up to 80% - this is the margin call amount o Calculating the margin call amount (solve for margin call amount)  Minimum margin requirement = [Current Market value of investment – (Loan – Margin call amount)] ÷ Current market value of investment Calculating Interest on Margin Loan  Assume that interest is compounded annually  Interest expense = loan × interest rate × portion of year that loan was held  Interest expense is deducted from your capital gain when calculating profit (or return) on a stock transaction Calculating Capital Gain and Yield when Going Long or Buying on Margin  When calculating Capital gain, you must subtract all of to your expenses from the revenue that is generated from the sale of the sale of the investment o When going long – expenses are commission when buying and selling security o When buying on margin – expenses are commission and interest you had to pay  Yield = dollars returned ÷ dollars invested = capital gain ÷ dollars invested o The denominator in yield calculation (the dollars invested will only be actual dollars spent to purchase the security o All expenses will be deducted from the dollars returned Leverage  Engaging in a transaction whose value is greater than the actual dollars you have available  Creates potential to make a larger return or loss than indicated by the investment you have made Selling Short  Sell at a high price and buy back when the price drops

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You do not own the shares you are selling – creating a deficit or “short position” in the investor’s account – the subsequent purchase of the shares “covers” or repays this deficit The broker would lend the securities to the investor for them to sell – but they must declare that it is going to be a short sale The proceeds from the sale would remain in the investors account plus addition deposit supplied by the investor (always assume that it’s 50%) – so the minimum credit balance in the account is 150% o Investor would still pay broker 2% Deposit must be 150% CMV - Minimum maintenance margin that must be maintained at all times is 125%-140% o If the value of the stock rises and investor no longer meets maintenance margin – investor would then receive a margin call to deposit more money into account to once again meet the maintenance margin requirement  Broker wants the investor to make this deposit because if the price of stock was to rise again, the broker wants to ensure that there is a sufficient amount of money to cover to buy back the stocks and cover the investors short position  Agreement may be terminated by either at any time (Forced to Cover) Theoretically, the risks are unlimited because there is no limit to the price in which the stock can rise to Risk of Dividends, Margin Call, Unlimited Losses, Forced to cover short at disadvantageous price When the investor covers their short position by buying the stock, the stock is returned and investor receives profit less commissions, and the additional deposit is released to the investor to be used in another transaction (if desired) Dividend declared are the responsibility of the seller – Owner only pays on original share

COMPARE AND CONTRASTS GOING LONG, SHORT SELLING, MARGIN BUYING  Margin Buying – Stock Price Going up  If holding a lot of time probably not going to buy on margin – Interest Bonds      

Represent debt to a company Legal, binding agreement Fixed rate of return (often paid semi-annually) Fixed term – principal repaid at maturity Priority over stockholders Types o Secured vs Unsecured (Debentures)

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o Registered vs. Bearer Features o Callable – Issuer can Recall before maturity – why? Interest rate change. o Serial – investor no change, Business re itre debt in stages rather all at once. Less Risky o Convertible – Convert from debt to equity. Attractive for both. Business has less debt and investor can switch. What impacts the coupon rate at bond issue? o Prevailing interest rates o Credit of issuer o Features What impacts bond price when traded? o Coupon rate + prevailing rates of interest o Changes in credit rating o Economic/market risk o Inflation Yield o Percentage return on any investment o Helps us compare investments o Yield = what you paid ÷ what you paid o Which is equivalent to (interest + capital gain) ÷ what you paid = % o Interest = coupon rate × face value o Capital gain = face value – purchase price o ** Always use a face value of $1000 for bonds** Approximate Yield to Maturity 

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a n n u a l b o n di n t e r e s t a n n u a l c a p i t a l g a i n p r i c ep a i df o r b o n d face value - price paid time to maturity price paid (Time = Years)

coupon rate x face value  

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Assume that you will hold onto bond until maturity Need to calculate “what you made” on annual basis Same yield for all bonds with same risk Can only negotiate Price Paid “If interest rate go up what happens to expected yield” Expected Yield will go up so price paid will decrease “ Inverse Price VS Yield Bond Pricing o Bond prices vary inversely with interest rates o Priced at discount = you pay less than face value ($1000) for the bond o Priced at par = You pay face value for the bond (=$1000) for the bond When reading a bond -> issuer, coupon, maturity, price, yield, change

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When investor purchases bond, it is essentially lending money to the company Principle – when a company issues bonds, it agrees to repay the debt Maturity date – date will be paid back by Face value or par value – specific amount of principle to be repaid back Coupon Rate – interest charged (coupon payments are paid semi-annually – quoted as a percentage of the bonds) Two types of returns: coupon payments and upon maturity company pays investor the principle/face value/par value o If purchase price of bond was less than face value, the difference of what the investor paid to buy the bon and its face value is a capital gain o Capital loss occurs when purchase price is greater than the face value o IF yield is more then Coupon price goes down vice versa Yield to maturity on a bond is the rate of return per year if the bond is held to maturity o Approximate yield to maturity = (coupon rate × face value + annual capital gain/loss) ÷ purchase price of bond  Where the annual capital gain (or loss) = (face value – purchase price) ÷ years to maturity  The approximate yield to maturity is higher than the coupon rate b/c the investor is receiving both interest income AND capital gain b/c the investor bought the bond for less than its face value  NOTE – this formula is only used to calculate the approximate yield to maturity on a bond – to calculate the actual price of a bond you must use the time value of money formula

Stocks  Represents equity/capital for issuing company  Characteristics o Voting rights o No fixed term o Variable return o Discretionary payment (dividends) o Risk Types of stocks Common Stock Voting rights Yes

Dividends

Bankruptcy Price Volatility Marketability Other Features

Preferred stock No – unless number of dividends unpaid – in “arrears” Not necessarily Yes – fixed % - after interest paid on debt but before common dividend (Promise) not legal oblig. Paid after preferred Paid after debt holders Most Volatile Less Volatile (dividends) – sensitive to interest rates More shares, larger market Thinner market Pre-emptive right – Redemption – company can

purchase more shares at set price

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buy back Convertibility – to common Cumulative Participation feature

What impacts a stock price? o Demand and supply of stock due to negative or positive perception/facts o Primary factors  Earnings – above or below expectations, rumors  General market conditions – bull vs bear markets, economy, interest (especially preferred)  Speculation – bought or sold on belief proce will soon move o Price o Price of a Security is a collective expression of all opinions of those who ware buying and selling o Undervalued issue- offers higher return than stocks of similar risk

Mortgages  Form of debt that allows individuals to but real estate  Secured type of debt because the property is used as collateral  Mortgage allows borrower to make large purchases that would otherwise not be possible by the cash in hand  Process of Mortgages: 1. Determine amount to be borrowed 2. Determine amortization period (the number of years you wish to have to pay off your debt – limit of 25 years) 3. Bank will determine your interest rate based on current interest values in market and use the present value of an annuity formula to figure out the size of payments over the period – based on how many payments you would like to make (yearly, monthly…) 4. Sign a mortgage agreement 5. Mortgage agreement will outline the period time (mortgage term) during with you commit to making these payments – after this period of time, you come back and discuss if you want to change your # or size of payments – a new mortgage agreement will then be signed at the end of each term and process is repeated until mortgage is paid off a. It is risky to commit to the same payments over the amortization period because interest rates can change and income may fluctuate for you causing you to want to increase/decrease size of payments  Variations in Mortgage agreements o Most have a fixed-rate mortgage where interest rate and mortgage is the same for the entire mortgage term o Monthly principle and interest payments never change from the first to the last o Types that allow interest to change throughout period

o Can negotiate flexible payments (increase amount of payment or pay lump sum at end of year) Vehicle Leases  Leases allow your to use/rent a new car for a period of time, at the end of the period, you can either give care back or pay the residual value shown in the lease agreement  Components that are relevant to lease agreements o Price of care to be leased o APR (annual percentage rate) which is the interest which will be used in the payment calculation o The amount of the down payment you pay towards the price of the care (paid the day you buy the car) o The residual value, which is depreciated value of what the car will be worth at the end of the lease o The monthly lease payments you make during the term of lease  Price of the car = down payment + lease payments +residual  Vehicle leases differ from leases signed when renting an apartment or house b/c with apartment or house lease there is no residual value and do not have opportunity to take ownership of the house o They are similar in that during the term of the lease, you “own” the property Time Value of Money – Formula page 156  A dollar today is worth more than a dollar in the future because o Real Interest o Risk o Inflation  A rational investor will take these factors into consideration with deciding what he wants to receive (or should be willing to pay) when payments are to be received or made at different points in time Present Value Single Amount  Unknown amount at beginning of timeline  How much is your future value worth today? How much do you need to invest today to get a specific return?  The rate used to calculate present value is referred to as discount rate Future Value Single Amount  When you give/get/have money today and try to find out how much it’ll be in the future  Unknown amount is at the end of the timeline Annuities  A series of equal payments of equal time periods

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Annuity due – when payment begins at start of pay period (today) Ordinary annuity – when payment is made at end of pay period o The result is that you would have one less period in which your money accumulates interest before starting your withdrawals Perpetuity – an annuity that goes on forever (ie dividends or preferred share – as long as company exists, one will receive the payment) When calculating present value of the coupon payments and the present value of the face value of the bond upon maturity, you can calculate what the present value of the bond price should be today

Dealing with Uneven Payment and Compounding Period  Payments and interest compounding rates might occur more than once a year, or payments and interest may occur at different rates o In these cases, must adjust your rate (r), and your compounding periods (n) because the compounding rate much match the payment frequency per year  When interest is compounded and payments are made/received the same number of times per year o “n” must represent total number of payments (number of years × amount of payments per year) o Adjust “r” by dividing it by the number of payments per year o Note – we make the same adjustment to “r” and “n” when dealing with a single payment but multiple compounding periods per year  When interest compounding and payment periods do not match – you must find the rate that matches your payment schedule o Use the effective rate formula for the payment period that your payment schedule indicates o Note – you must adjust “n” in your present or future value formula to reflect the total number of payments  When rate is stated as an Annual Percentage Rate (APR) o Then the effective rate for the payment period = APR ÷ # of payment periods (p) per year o COMPANY PERSPECTVE Repayment

Not required

Principal paid on ma increased risk

Claims on income

Only residual claim (dividends)

Yes, regular, required increased risk

Affect on management control/ownership

Dilutes ownership and control

None

Tax effects

Dividends are not tax deductible

Interest paid to bond deductible

Stocks (Equity)

Bonds (Debt)

1. Which type of financing is more attractive, generally speaking? Why? : Equity vs Debt Financing. Debt Financing because you don’t have to give up any control of your company and the expense associated with the debt is tax deductible so it costs you less. 2. Why not use all debt financing? The more debt you take on the more riskier your company becomes. Debt is much riskier then equity for companies. 3. How much debt does it make sense to carry? Depends on how much money you can afford to take on or carry. Investor Perspective

Stocks (Equity)

Bonds (Debt)

Repayment

No

Principal paid on maturity date

Income

Dividends but discretionary

Coupon/interest - required

Claims on assets in liquidation

After all other creditors are paid (i.e. after bondholders); preferred ahead of common

Along with other creditors, and before stockholders

Ownership/voting rights

Yes. Common- votes; Preferred - no vote

None

Price volatility between instruments of same company

Common- highest; Preferred moderate

Lowest

Pillars 1 & 2– Banks & alternate banks

Make Desposits, Borrow SME- Primary Lending Source

Pillar 3 – Specialized lending/saving intermediaries

Mid - Large Private Equity fianncing/Borrow

Pillar 4 – Investment Dealer

Large and Established Going public, Stocks and Bonds

Pillar 1 and 2: Go to credit union or bank for a Loan Pillar 3: Things like insurance companies that are major investors, venture capitalists, pension funds. What might you go to for then? : For Equity investing. Banks won’t invest as a group in stocks. (Dragons Den) Private equity financing Pillar 4: Where you go when you want to isse public shares and Bonds. When you get really really big and need a lot of money, private equity too much work so you go into investment dealer. This kind of a company which pillar would I go get it from ( Question)

PEST – Technological Factors Elements  Internet – affects buying, selling, communication  Information technologies affect information access, inter-firm cycle times  Not limited to computers and information o Ie swifter wet vs mopping Why  Demands constant learning and scanning  Need to scan environment to know what is coming into the market  Need to understand the technology to incorporate it  Creates significant change and challenge Business Implications  Affects what we produce/ what it can do o Ie mergers are harder today  Affects how we produce and how we sell o Information technology allows access to information from anywhere  Inter-firm relations -> where supplies arrive just in time to use it o Cycle times – how long it takes to produce something  Technology reduces producing time (from manufacturing to designing -> ie cars – before you would have to draw the design

by hand and do calculations, make prototype -> now the computer does it all for you What is technology?  Advancements in equipment and its uses o Often substitutes for/magnifies human effort  Makes humans more powerful and productive o Included human knowledge, work methods, equipment, business processing systems  Ie company trying to sell something is much more effective -> able to target your marketing to your hopeful consumer vs open ended tv ads  Ie facebook counts on you to direct advertisements towards  Includes information for technology o The vario...