THE BEST FINANCE 251 NOTES PDF

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TOPIC 1:SOLEPROPRIETORSHIPPARTNERSHIP COMPANYWHO OWNS THEBUSINESSMANAGER PARTNERS SHAREHOLDERSOWNER’SLIABILITYUNLIMITED UNLIMITED LIMITEDSEPARATION OFOWNERS ANDMANAGERSNO NO USUALLYOWNERS ANDBUSINESS TAXEDSEPARATELYNO NO YESPrivate companies- firm’s shares are held by small number of shareholders th...

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TOPIC 1:

SOLE PROPRIETORSHIP

PARTNERSHIP

COMPANY

WHO OWNS THE BUSINESS

MANAGER

PARTNERS

SHAREHOLDERS

OWNER’S LIABILITY

UNLIMITED

UNLIMITED

LIMITED

SEPARATION OF OWNERS AND MANAGERS

NO

NO

USUALLY

OWNERS AND BUSINESS TAXED SEPARATELY

NO

NO

YES

Private companies- firm’s shares are held by small number of shareholders that include companies’ original founders, venture capitalists, etc Public companies- shares listed on a stock exchange Investing decision- also known as capital budgeting - A decision to invest in a tangible asset (PPE) and intangible assets Financing decision- on the form (debt, equity) and amount of financing a firm’s investments Money markets - Debt securities of less than one year trades: treasury securities, commercial paper, bills, loans - Loosely connected dealer markets - Banks are major players Capital markets: - Equity and long-term debt claims are traded - Auction markets Primary market: - For government and corporations initially issued securities - Public offering - needs underwriting, more regulations, costly - Private offering- large financial institutions, less costly

Secondary market: - existing financial claims are traded - Dealer market - Auction market - Getting market value of securities is easier

TOPIC 2: Liquidity ratios: Current ratio: current  assets/ current liabilities - Indicated company’s ability to pay CL from CA Quick ratio: (CA - Inventory)/ CL - How well company can meet its short term obligations with its most liquid assets - Ratio of 1 considered normal Cash ratio: Cash/CL  - Firm’s ability to pay off its CL with only cash and cash equivalents NWC to Total Assets: NWC/TA  - Percentage of remaining liquid assets (with TCL subtracted) compared to company’s TA Interval measure = CA/average  daily operating costs - How fast quick assets can be converted into cash Financial leverage ratios: Total debt ratio: total liabilities/ total assets - Measures proportion of a company’s assets that are financed by debt Debt/ Equity ratio: (TA-TE)/TE or long-term debt+CL/ equity Equity multiplier: TA/TE = 1+L/E ratio - Measures amount of firm’s assets that are financed by or owed by the shareholders Long- term debt ratio= long term debt/ (long term debt + total equity) - Proportion of long-term debt a company uses to finance its assets, relative to amount of equity used for same purpose Times interest earned ratio: EBIT/ interest - How many times a company can cover its interest charges on a pre-tax earning basis Cash coverage ratio: (EBIT + depreciation)/ interest

Asset management ratios: Inventory turnover ratio: COGS/ inventory

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Efficiency ratio. Shows how effectively inventory is managed- how many times average inventory is sold during a period. Days’ sales in inventory: 365/ Inventory turnover - Number of days it will take to sell all inventory Receivables turnover: Sales/ Receivables - How many times a business can turn AR into cash during a period Days sales outstanding: Accounts receivable/ average daily sales or 365/ receivables turnover - Number of days on average it takes customers to pay invoices Fixed assets turnover: sales/ net fixed assets - Used to measure operating performance. How company is able to generate net sales from fixed- asset investments, namely PPE, net of depreciation TA turnover: Sales/TA - Company’s ability to generate sales from its assets

Profitability ratios: Profit margin: net income/ sales - How much of every $ in sales company keeps in earnings ,, BEP: EBIT/TA - Earning power before income taxes and financial leverage ROA: net income/ TA - How well TA employed to make a profit - Lowered by debt. Interest expense lowers net income, which lowers ROA ROE: Net income (- preferred dividend if any)/ total common equity - Ability to generate profit from shareholder’s investments - Use of debt lowers equity and if equity < net income, then ROE increases - ROE and shareholder wealth are correlated - ROE does not consider risk - ROE does not consider amount of capital invested - Only focuses on return and not risk

Simple interest: Initial investment x (1 + (interest rate x number of periods)

Compounding interest:

Semi- annual compounding period= Annual interest rate/ 2 Monthly compounding interest rate = Annual interest rate/ 12

For a given amount to be received in the future and for a given interest rate available, the longer the amount is to be received the lower the PV of that amount For a given amount to be received in the future, the higher the interest rate, the smaller the PV

Annuity:

PV of Annuity: PV of Annuity Due:

FV of ordinary Annuity:

FV of Annuity due:

Annuity due- when payment is made during the beginning of the period (If finding FV,individual payments from n=1 to n=n periods. If finding PV, then individual payments from

n=0 to n=n-1) Ordinary annuity- payment due at the end of the period ( If finding FV, then individual payments from n=0 to n=n-1 periods. If finding PV, then individual payments from n=1 to n=n periods.)

Solve the PV of each payment individually APR: stated rate of interest. Computed as (r x n) EAR: considers compounding. Computed as (1 + r)^n -1

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Will always be higher than APR as long as account compounded more than once a year and interest rate grates than zero

TOPIC 3: Investment returns -

Measure financial results of an investment Returns can be historical or prospective Dollar terms: Amount received- amount invested Percentage terms: (Amount received - amount invested)/ amount invested

Total percentage return: Dividend yield + capital gains yield

This is holding period return

Expected return- return an investor expects to earn on an asset - expected return

Required return- return an investor requires on an asset given its risk and market interest rates

Historical return: If historical return is given, can also calculate historical std.

Risk -

Possibility that an actual return will differ from expected return Uncertainty in the distribution of possible outcomes

Risk averse- investors would require an increased return as compensation for increased risk Risk neutral- investors choose investment with higher return regardless of risk

Risk seeking- investors prefer investments with greater risk even if they have lower expected returns Measure risk through standard deviation- measure of the dispersion of possible outcomes Greater the standard deviation, greater the risk

Standard deviation measures total risk of an investment The larger the std deviation, the higher the probability that actual returns will be far away from expected returns

Portfolios

Expected return: The weights must add up to 1 Or can find expected return by finding portfolio return in each possible state, weighted by probability of that state occurring (same as individual securities)

Can calculate the standard deviation for portfolios the same way as individual stocks but there’s also an alternative method:

Covariance- how the performance of two assets move or do not move together. - Measure how two assets; rate of return vary together over the same mean time period

Correlation coefficient: measures how returns move in relation to each other. - Between +1 (returns always move together to -1 ( returns always move oppositely)

Diversification: investing in more than one security to reduce risk - Two perfectly positively correlated, diversification has no effect on risk - Two stocks perfectly negatively correlated, portfolio is perfectly diverse Market risk is non diversifiable (systematic risk) Company-unique risk is diversifiable (unsystematic risk) - Can be reduced/ eliminated by increasing number of investments in portfolio - Each investment much smaller percentage of portfolio, muting effect on overall portfolio - Firm specific actions can be either positive or negative. In a large portfolio, these effects will average out to zero Total risk= Company-specific risk + market risk Std deviation of returns is measure of total risk. For well diversified portfolios, unsystematic risk is very small - Well-diversified portfolio; total risk is equivalent to systematic risk - Not the case for an individual asset Market risk: unexpected changes in interest rates, changes in cash flows due to tax rate changes, foreign competition and overall business cycle

Beta - a measure of market risk -

Measures how an individual stock’s returns vary with market returns Measure of sensitivity of an individual stock’s return to changes in the market

Without regression, use high-low method (take highest return year and lowest return year) Then calculate the slope of the betas (rise/run) or change in return of asset/ change in return of market The steeper the line, the higher the beta so higher market risk -

Firm when beta = 1 has average market risk. Stock is no more/ less volatile than market beta>1 - more volatile than the market (tech firms) Beta < 1- less volatile than market

Std deviation for overall risk, beta for market risk

Required rate of return:

rRF= risk free rate of return

CAPM 1. Uses variance of actual returns around an expected return as a measure of risk 2. Measures non-diversifiable risk with beta 3. Translated beta into expected return : Expected return = risk free rate + Beta*risk premium Defines relationship between risk and required return If we know risk measure (beta) of asset, can use CAPM to determine required return

For a fairly priced asset, expected return is on the SML For underpriced asset, it is above the SML For overpriced asset, it is below the SML Limitations of CAPM: - Model makes unrealistic assumptions - Parameters of model cannot be precisely estimated (market index can be wrong, firm may have changed estimation period) - Model does not work well Coefficient of variance: - First pass at comparing risk and return for individual shares - Measure of risk associated with an investment for each 1 percent of expected return - Measures relative risk

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The lower the coefficient, the better since lower risk

Portfolio systematic risk measure;

Summary: To measure risk, we use: Total risk- std deviation Market risk- beta Total risk - market risk + unique risk To measure return, we use: E(R) = Pr1*r1 + Pr2*r2… Realised return = Holding period return (can use either nominal annual return or effective annual return) Risk and return: CAPM- market risk and E(R)- discount rate Characteristic line- relationship between market return and individual return. Slope of the line is Beta

TOPIC 4: Interest Rate fundamentals: Several factors can influence the equilibrium interest rate such as: - Inflation, which is a rising trend in the prices of goods and services - Risk, which leads investors to expect higher return on investments - Liquidity preference, which refers to the general tendency of investors to prefer short term securities ( can get in and out of investment quickly)

The real rate of interest: rate that creates equilibrium between supply of savings and demand for investment funds in a perfect world, without inflation where suppliers and demanders of funds have no liquidity preferences and no risk It changes with economic conditions, tastes and preferences

Nominal/ Actual rate of Interest: Actual rate charged by supplier of funds and paid by demander. Is the advertised/ published rate Actual return you will get on deposit + adjustment for what we expect inflation to be in the future Differs from real rate because of: - Inflationary expectations reflected in an inflation premium (IP) - Issuer and issue characteristics such as default risks and contractual provisions as reflected in a risk premium (RP)

The risk free rate is the real rate of interest plus expected inflation premium. IP is driven by investors’ expectations about inflation- the more inflation they expect, the higher the IP and the higher the nominal interest rate.

Term structure of interest rates: Relationship between maturity and rate of return for bonds with similar levels of risk Graphic depiction would be the yield curve. Yield to maturity is the compound annual rate of return earned on a debt security purchased on a given day and held to maturity.

Expectations Theory- reflects investor expectations about future interest rates. An expectation of rising interest rates results in an upward-sloping yield curve. Same for downward sloping.

Liquidity preference theory- long-term rates are generally higher than short term rates (so yield curve is upward sloping) because investors think short term investments to be more liquid and less risky.

Market Segmentation theory- market for loans is segmented on basis of matury and supply of and demand for loans within each segment determines its prevailing interest rate. Slope of yield curve is determined by relationship between prevailing rates in each market segment.

Capital Market Efficiency -

If markets are efficient, investors and financial managers can believe securities are priced at or near true value More efficient a security market, more likely securities are priced at or near true value Overall efficiency of capital market depends on operational and informational efficiency Operational efficiency focuses on bringing buyers and sellers together at lowest possible cost

Market efficiency can either be strong, semi-strong or weak Degree to which the price of investment reflects the information available about it. Strong form states the price of security in the market reflects all information-public and private. Semi- strong implies that only public info available to all investors is reflected in security’s market price - Investors with access to inside/private info can earn abnormal returns - Public share markets in australia are an example - New info immediately reflected in market price

Weak form- all info contained in security’s past prices is reflected in current prices. Not possible to earn abnormally high returns by looking for patterns in prices.

Market for corporate bonds: -

Large investors in corporate bonds are superannuation fund, investment funds and life insurance companies. Trades in this market tend to be in very large blocks of securities, most transactions take place through dealers in the OTC market.

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Only small number of existing total bonds trade on single day- corporate bond market is thin compared to money market for securities

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Less marketable than securities with higher trading volume

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Prices in bond market tend to be more volatile

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Bond market not considered very transparent- trades OTC, difficult for investors to view prices, trading volumes

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Transactions negotiated between buyers and sellers- little centralised reporting of these deals

Debt/ Borrowing

What is a bond? A security that obligates the issuer to make specified payments to the bondholder. Coupon- series of interest payments made to bond holder Face Value- payment at the maturity date of the bond Coupon rate- annual interest payment as a percentage of face value

Yield to maturity- required return of the investor (discount rate)

Bond Valuation Basic valuation model- value of any asset is the present value of all future cash flows it is expected to provide over the relevant time period.

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Face value (how much its worth when repaid by the borrower on maturity date = future value) What causes Interest rate changes for bonds? - Yield curves - Inflation expectations - Default risk - Country risk - Global factors Risk characteristics of debt instruments that are responsible for most of the differences in corporate borrowing costs: 1. Security’s marketability 2. Call feature 3. Default risk 4. Term to maturity Pricing a bond issue: Coupon rate (= issue YTM) = benchmark yield + credit risk premium (bond spread- often quoted in basis points)

Credit risk premium reflects: rating of issuer, ranking of debt The risk of default: When investing in bonds, there’s always the risk that the issuer may default - Investment grade bonds - Speculative grade bonds - Junk bonds Bond rating: Individuals and small businesses must rely on outside agencies for information on default potential of bonds - Moody’s Investors Service and Standard and Poor - Both rank bonds in order of expected probability of default, publish ratings as letter grades Debt covenants: Imposed by lender to protect its position Restrict actions of borrowing firms - Specifies min level of net working capital - Prohibition against selling debtors - Prohibit taking on extra debt/ pledging assets - Prohibition against taking extra leases - Restrictions on dividend payments

Bond Value Behaviour: In practice, the value of a bond in the marketplace is rarely equal to its par value. Whenever the required rate of return on a bond differs from it’s coupon interest rate, the bond’s value will differ from its par value. Required return will likely differ because - Economic conditions have changed- shift in basic cost of long term funds - Firm’s risk has changes

No calculation needed as the required return (yield to maturity) is the same as the coupon, therefore, face value must be equal to present value of bond. As the market interest rate falls below the coupon rate, the price of the bond gets higher. Value of the fixed stream of future payments rises. Vice versa.

Semi- annual bonds. How do these affect bond valuation:

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Time period. Paying coupons twice a year doubles the total number of cash flows to be discounted in the PV formula Discount rate. Since time periods are now half-years, the discount rate is also changed from annual rate to the half- year rate.

Twice as many interest payments but each worth only half as much ($4 instead of $8) Discounting at 3% at semi-annual rate. Discounting back at 6 semi-annual periods.

Yields: A YTM is a promised yield. An investor will only earn promised YTM if: - All coupons and face value paid in full and on time - All coupons are reinvested at the YTM - The bond is held to its maturity date YTM market’s required return or YTM, bond’s market value will be > par value - If cash flows to investor is greater than what they require, willing to pay more to acquire the bond 3. Two identical bonds except for matury, the price of long term bond will change more than short term bond given a change in market interest rates Loan pricing: Loan rate= base rate + margin Base rate reflects lenders cost of funds Margin reflects: - Risk grade of borrower (credit risk) - Amount and quality of security offered

- Borrower’s alternative/ competitive pressures - Overall bank/ customer relationship Borrower also faces non-interest charges (establishment fee, etc)

TOPIC 4 PART B Companies can raise cash for investment by also selling new shares - Bond is a contractual agreement between borrower and lender - Share has no fixed obligations, it allows investor to become partial owner - Equity has no maturity date

Equity securities: Ordinary shares: - Can be privately owned by private investors, closely owned by individual investor or publicly owned by a broad group of investors. - Large companies are publicly traded and have their sha...