Reviewer in Financial Management_1st Long Exam

8/10/2019 Reviewer in Financial Management_1st Long Exam

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Reviewer in Financial Management

Chapter 1

Finance can be defned as the science and art o managing money.

At the personal level, fnance is concerned with individuals decisions abouthow much o their earnings they spend, how much they save, and how they investtheir savings.

In a business conte t, fnance involves the same types o decisions! how frmsraise money rom investors, how frms invest money in an attempt to earn a proft,and how they decide whether to reinvest profts in the business or distribute thembac" to investors.

Financial Services is the area o fnance concerned with the design and delivery o advice and fnancial products to individuals, businesses, and governments.

#areer opportunities include ban"ing, personal fnancial planning,investments, real estate, and insurance.

Career Opportunities in Finance: Managerial Finance

Managerial fnance is concerned with the duties o the fnancial managerwor"ing in a business.

Financial managers administer the fnancial a$airs o all types o

businesses%private and public, large and small, proft&see"ing and not& or&proft.

'hey per orm such varied tas"s as developing a fnancial plan or budget,e tending credit to customers, evaluating proposed large e penditures, and raisingmoney to und the frms operations.

Pro essional Certifcations in Finance !

#hartered Financial Analyst (#FA) * +$ered by the #FA Institute, the#FA program is a graduate&level course o study ocused primarily onthe investments side o fnance.

#ertifed 'reasury ro essional (#' ) * 'he #' program re-uiresstudents to pass a single e am that is ocused on the "nowledge ands"ills needed or those wor"ing in a corporate treasury department.

#ertifed Financial lanner (#F ) * 'o obtain #F status, students mustpass a ten&hour e am covering a wide range o topics related topersonal fnancial planning.


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American Academy o Financial Management (AAFM) * 'he AAFMadministers a host o certifcation programs or fnancial pro essionalsin a wide range o felds. 'heir certifcations include the #harter

ort olio Manager, #hartered Asset Manager, #ertifed Ris" Analyst,#ertifed #ost Accountant, #ertifed #redit Analyst, and many other

programs.

ro essional #ertifcations in Accounting * Most pro essionals in thefeld o managerial fnance need to "now a great deal about accountingto succeed in their obs. ro essional certifcations in accountinginclude the #ertifed ublic Accountant (# A), #ertifed ManagementAccountant (#MA), #ertifed Internal Auditor (#IA), and many programs.

Legal Forms o Business Organization

A sole proprietorship is a business owned by one person and operated orhis or her own proft.

A partnership is a business owned by two or more people and operated orproft.

A corporation is an entity created by law. #orporations have the legalpowers o an individual in that it can sue and be sued, ma"e and be party tocontracts, and ac-uire property in its own name.


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Sta ehol!ers are groups such as employees, customers, suppliers,creditors, owners, and others who have a direct economic lin" to the frm.

A frm with a stakeholder focus consciously avoids actions that would provedetrimental to sta"eholders. 'he goal is not to ma imi/e sta"eholder well&being but to preserve it.


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0uch a view is considered to be 1socially responsible.1

"he role o Business #thics

Business ethics are the standards o conduct or moral udgment that applyto persons engaged in commerce.

2iolations o these standards in fnance involve a variety o actions! 3creativeaccounting,4 earnings management, misleading fnancial orecasts, insidertrading, raud, e cessive e ecutive compensation, options bac"dating,bribery, and "ic"bac"s.

5egative publicity o ten leads to negative impacts on a frm

$o%ert &' Coo e( a noted ethicist, suggests that the ollowing -uestions be used

to assess the ethical viability o a proposed action! Is the action arbitrary or capricious6 7oes the action un airly single out

an individual or group6

7oes the action a$ect the morals, or legal rights o any individual orgroup6

7oes the action con orm to accepted moral standards6

Are there alternative courses o action that are less li"ely to cause actual orpotential harm6

#thics programs see to !

reduce litigation and udgment costs

maintain a positive corporate image

build shareholder confdence

gain the loyalty and respect o all sta"eholders

'he e pected result o such programs is to positively a$ect the frms share price.

Marginal cost)%eneft anal*sis is the economic principle that states thatfnancial decisions should be made and actions ta"en only when the addedbenefts e ceed the added costs

Marginal cost&beneft analysis can be illustrated using the ollowing simplee ample.


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'he frms fnance and accounting activities are closely&related and generallyoverlap.

In small frms accountants o ten carry out the fnance unction, and in largefrms fnancial analysts o ten help compile accounting in ormation.

+ne ma or di$erence in perspective and emphasis between fnance andaccounting is that accountants generally use the accrual method while infnance, the ocus is on cash 8ows.

9hether a frm earns a proft or e periences a loss, it must have a su cient

ow of cash to meet its obligations as they come due. 5ow contrast the di$erences in per ormance under the accounting method

(accrual basis) versus the fnancial view (cash basis)!

Finance and accounting also di$er with respect to decision&ma"ing!


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A principal-agent relationship is an arrangement in which an agent actson the behal o a principal. For e ample, shareholders o a company(principals) elect management (agents) to act on their behal .

&genc* pro%lems arise when managers place personal goals ahead o the

goals o shareholders. &genc* costs arise rom agency problems that are borne by shareholders

and represent a loss o shareholder wealth.

,ncentive plans are management compensation plans that tie managementcompensation to share price= one e ample involves the granting o stoc"options.

Per ormance plans tie management compensation to measures such as> 0 or growth in > 0. er ormance shares and?or cash bonuses are used ascompensation under these plans.

"he "hreat o "a eover

9hen a frms internal corporate governance structure is unable to "eepagency problems in chec", it is li"ely that rival managers will try to gaincontrol o the frm.

'he threat o ta"eover by another frm, which believes it can enhance thetroubled frms value by restructuring its management, operations, andfnancing, can provide a strong source o e ternal corporate governance.

Chapter .

Financial ,nstitutions / Mar ets

Firms that re-uire unds rom e ternal sources can obtain them in three ways!

@. through a fnancial institution

. through fnancial mar"ets

B. through private placements


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Financial institutions are interme!iaries that channel the savings oindividuals, businesses, and governments into loans or investments.

'he "ey suppliers and demanders o unds are individuals, businesses, andgovernments.

In general, individuals are net suppliers o unds, while businesses andgovernments are net demanders o unds.

Commercial Ban s( ,nvestment Ban s( an! the Sha!o0 Ban ing S*stem

Commercial %an s are institutions that provide savers with a secure placeto invest their unds and that o$er loans to individual and businessborrowers.

,nvestment %an s are institutions that assist companies in raising capital,advise frms on ma or transactions such as mergers or fnancialrestructurings, and engage in trading and mar"et ma"ing activities.

'he sha!o0 %an ing s*stem describes a group o institutions that engagein lending activities, much li"e traditional ban"s, but these institutions do notaccept deposits and are there ore not sub ect to the same regulations astraditional ban"s.

Financial ,nstitutions / Mar ets: Financial Mar ets

Financial mar ets are orums in which suppliers o unds and demanders ounds can transact business directly.

'ransactions in short term mar"etable securities ta"e place in the moneymar"et while transactions in long&term securities ta"e place in the capitalmar"et.

A private placement involves the sale o a new security directly to aninvestor or group o investors.

Most frms, however, raise money through a pu%lic o ering o securities,which is the sale o either bonds or stoc"s to the general public.

'he primar* mar et is the fnancial mar"et in which securities are initiallyissued= the only mar"et in which the issuer is directly involved in thetransaction.

0 econ!ar* mar ets are fnancial mar"ets in which preowned securities(those that are not new issues) are traded.


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'he mone* mar et is created by a fnancial relationship between suppliersand demanders o short&term unds.

Most money mar"et transactions are made in mar eta%le securities whichare short&term debt instruments, such as ;.0. 'reasury bills, commercialpaper, and negotiable certifcates o deposit issued by government, business,and fnancial institutions, respectively.

Investors generally consider mar"etable securities to be among the leastris"y investments available.

'he capital mar et is a mar"et that enables suppliers and demanders o

long&term unds to ma"e transactions. 'he "ey capital mar"et securities are bonds (long&term debt) and both

common and pre erred stoc" (e-uity, or ownership).

Bon!s are long&term debt instruments used by businesses andgovernment to raise large sums o money, generally rom a diversegroup o lenders.

Common stoc are units o ownership interest or e-uity in acorporation.

Pre erre! stoc is a special orm o ownership that has eatures oboth a bond and common stoc".

Bro er mar ets are securities e changes on which the two sides o a transaction,the buyer and seller, are brought together to trade securities.

'rading ta"es place on centrali/ed trading 8oors.


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> amples include! 5C0> >urone t, American 0toc" > change

2ealer mar ets are mar"ets in which the buyer and seller are not broughttogether directly but instead have their orders e ecuted by securities dealers that3ma"e mar"ets4 in the given security.

'he dealer market has no centrali/ed trading 8oors. Instead, it is madeup o a large number o market makers who are lin"ed together via amass&telecommunications networ".

'he 5asda- mar"et is one e ample

As compensation or e ecuting orders, mar"et ma"ers ma"e money on the spread(bid price * as" price).

"he $ole o Capital Mar ets

From a frms perspective, the role o capital mar"ets is to be a li-uid mar"etwhere frms can interact with investors in order to obtain valuable e ternalfnancing resources.

From investors perspectives, the role o capital mar"ets is to be an e:cientmar"et that allocates unds to their most productive uses.

An e3cient mar et allocates unds to their most productive uses as a resulto competition among wealth&ma imi/ing investors and determines andpublici/es prices that are believed to be close to their true value.

Advocates o behavioral fnance, an emerging feld that blends ideas romfnance and psychology, argue that stoc" prices and prices o other securitiescan deviate rom their true values or e tended periods.

'hese people point to episodes such as the huge run up and subse-uentcollapse o the prices o Internet stoc"s in the late @DDEs, or the ailure omar"ets to accurately assess the ris" o mortgage&bac"ed securities in themore recent fnancial crisis, as e amples o the principle that stoc" pricessometimes can be wildly inaccurate measures o value.

'he >thics o Insider 'rading

Martha 0tewart was convicted o conspiracy, obstruction, and ma"ingalse statements to ederal investigators and served months in ail,

months o home confnement, years o probation, and a GBE,EEE fne.

Haws prohibiting insider trading were established in the ;nited 0tatesin the @DBEs. 'hese laws are designed to ensure that all investors haveaccess to relevant in ormation on the same terms.


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owever, many mar"et participants believe that insider trading shouldbe permitted.

I e:ciency is the goal o fnancial mar"ets, is allowing or disallowinginsider trading more unethical6

7oes allowing insider trading create an ethical dilemma or insiders6

"he Financial Crisis: Financial ,nstitutions an! $eal #state Finance

Securitization is the process o pooling mortgages or other types o loansand then selling claims or securities against that pool in a secondary mar"et.

Mortgage-%ac e! securities represent claims on the cash 8ows generatedby a pool o mortgages and can be purchased by individual investors, pension

unds, mutual unds, or virtually any other investor. A primary ris" associated with mortgage&bac" securities is that homeowners

may not be able to, or may choose not to, repay their loans.

"he Financial Crisis: Spillover # ects an! the +reat $ecession

As ban"s came under intense fnancial pressure in EEJ, they tightened theirlending standards and dramatically reduced the -uantity o loans they made.

#orporations ound that they could no longer raise money in the moneymar"et, or could only do so at e traordinarily high rates.

As a conse-uence, businesses began to hoard cash and cut bac" one penditures, and economic activity contracted.

Business "a4es

Koth individuals and businesses must pay ta es on income.

'he income o sole proprietorships and partnerships is ta ed as the income o the individual owners, whereas corporate income is sub ect to corporateta es.

Koth individuals and businesses can earn two types o income%ordinaryincome and capital gains income.

A capital gain is the amount by which the sale price o an asset e ceeds theassets purchase price.

In calculating ta es, corporations may deduct operating e penses andinterest e pense but not dividends paid.


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'his creates a built&in ta advantage or using debt fnancing as the ollowinge ample will demonstrate.

As the e ample shows, the use o debt fnancing can increase cash 8ow and> 0, and decrease ta es paid.

'he ta deductibility o interest and other certain e penses reduces theiractual (a ter&ta ) cost to the proftable frm.

It is the non&deductibility o dividends paid that results in double ta ationunder the corporate orm o organi/ation.

Chapter 5

"he Four 6e* Financial Statements: "he ,ncome Statement


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'he income statement provides a fnancial summary o a companysoperating results during a specifed period.

Although they are prepared -uarterly or reporting purposes, they aregenerally computed monthly by management and -uarterly or ta purposes.

'he %alance sheet presents a summary o a frms fnancial position at agiven point in time.

'he statement balances the frms assets (what it owns) against its fnancing,which can be either debt (what it owes) or e-uity (what was provided byowners).

'he statement o retaine! earnings reconciles the net income earnedduring a given year, and any cash dividends paid, with the change in retainedearnings between the start and the end o that year.

'he statement o cash 7o0s provides a summary o the frms operating,investment, and fnancing cash 8ows and reconciles them with changes in itscash and mar"etable securities during the period.

'his statement not only provides insight into a companys investment,fnancing and operating activities, but also ties together the income

statement and previous and current balance sheets.


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$atio anal*sis involves methods o calculating and interpreting fnancial

ratios to analy/e and monitor the frms per ormance.

Current and prospective shareholders are interested in the frms current anduture level o ris" and return, which directly a$ect share price.

Creditors are interested in the short&term li-uidity o the company and itsability to ma"e interest and principal payments.

Management is concerned with all aspects o the frms fnancial situation,and it attempts to produce fnancial ratios that will be considered avorableby both owners and creditors.

Cross-sectional anal*sis is the comparison o di$erent frms fnancialratios at the same point in time= involves comparing the frms ratios to thoseo other frms in its industry or to industry averages

Benchmar ing is a type o cross-sectional analysis in which the frms ratiovalues are compared to those o a "ey competitor or group o competitorsthat it wishes to emulate.


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#omparison to industry averages is also popular, as in the ollowing e ample.

"ime-series anal*sis is the evaluation o the frms fnancial per ormanceover time using fnancial ratio analysis

#omparison o current to past per ormance, using ratios, enables analysts toassess the frms progress.

7eveloping trends can be seen by using multiyear comparisons.

'he most in ormative approach to ratio analysis combines cross&sectional andtime&series analyses.

8sing Financial $atios: Cautions a%out 8sing $atio &nal*sis

@. Ratios that reveal large deviations rom the norm merely indicate the possibility o a problem.

. A single ratio does not generally provide su:cient in ormation rom which to udge the overall per ormance o the frm.

B. 'he ratios being compared should be calculated using fnancial statementsdated at the same point in time during the year.

L. It is pre erable to use audited nancial statements .

. 'he fnancial data being compared should have been developed in the same

way.. Results can be distorted by in ation.

Hi-uidity Ratios

#urrent ratio N #urrent assets O #urrent liabilities

7eterminants o li-uidity needs

Harge enterprises generally have well established relationships withban"s that can provide lines o credit and other short&term loanproducts in the event that the frm has a need or li-uidity.

0maller frms may not have the same access to credit, and there orethey tend to operate with more li-uidity.


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&ctivit* $atios

Inventory turnover N #ost o goods sold O Inventory

Average Age o Inventory N B O Inventory turnover

'otal asset turnover N 0ales O 'otal assets

7ebt ratio N 'otal liabilities O 'otal assets

'imes interest earned ratio N >KI' O interest

Fi ed& ayment coverage Ratio (F #R)


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Profta%ilit* $atios

+perating proft margin N +perating profts O sales

5et proft margin N >arnings available or common stoc"holders O 0ales

Return on total assets (R+A) N >arnings available or common stoc"holders O 'otalassets

Return on >-uity (R+>) N >arnings available or common stoc"holders O #ommonstoc" e-uity

rice >arnings ( ?>) Ratio N Mar"et price per share o common stoc" O >arnings per

share

Mar et $atios

where,

2uPont S*stem o &nal*sis


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"he 2uPont s*stem o analysis is used to dissect the frms fnancialstatements and to assess its fnancial condition.

It merges the income statement and balance sheet into two summarymeasures o proftability.

'he Modifed 7u ont Formula relates the frms R+A to its R+> using thefnancial leverage multiplier (FHM), which is the ratio o total assets tocommon stoc" e-uity!

'he 7u ont system frst brings together the net pro t margin, whichmeasures the frms proftability on sales, with its total asset turnover, whichindicates how e:ciently the frm has used its assets to generate sales.

R+A N 5et proft margin 'otal asset turnover

0ubstituting the appropriate ormulas into the e-uation and simpli ying

results in the ormula given earlier,

'he modifed 7u ont Formula relates the frms return on total assets to itsreturn on common e-uity. 'he latter is calculated by multiplying the return ontotal assets (R+A) by the fnancial leverage multiplier 9FLM ( which is theratio o total assets to common stoc" e-uity!

R+> N R+A FHM

Chapter ; #ash 8ow (as opposed to accounting 3profts4) is the primary ingredient in

any fnancial valuation model.

From an accounting perspective, cash 8ow is summari/ed in a frmsstatement o cash 8ows.


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From a fnancial perspective, frms o ten ocus on both operating cash 8ow,which is used in managerial decision&ma"ing, and ree cash 8ow, which isclosely monitored by participants in the capital mar"et.

2epreciation is the portion o the costs o f ed assets charged against

annual revenues over time. 7epreciation or ta purposes is determined by using the modifed

accelerated cost recovery system (MA#R0).

+n the other hand, a variety o other depreciation methods are o ten used orreporting purposes.

;nder the basic MA#R0 procedures, the depreciable value o an asset is itsull cost, including outlays or installation.

5o ad ustment is re-uired or e pected salvage value.

For ta purposes, the depreciable li e o an asset is determined by its MA#R0recovery predetermined period.


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'he statement o cash 8ows summari/es the frms cash 8ow over a given

period o time. Firms cash 8ows all into three categories!

Operating 7o0s: cash 8ows directly related to sale and production othe frms products and services.

,nvestment 7o0s: cash 8ows associated with purchase and sale oboth f ed assets and e-uity investments in other frms.

Financing 7o0s: cash 8ows that result rom debt and e-uityfnancing transactions= include incurrence and repayment o debt, cashin8ow rom the sale o stoc", and cash out8ows to repurchase stoc" orpay cash dividends.


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,nterpreting Statement o Cash Flo0s

'he statement o cash 8ows ties the balance sheet at the beginning o theperiod with the balance sheet at the end o the period a ter considering theper ormance o the frm during the period through the income statement.

'he net increase (or decrease) in cash and mar"etable securities should bee-uivalent to the di$erence between the cash and mar"etable securities onthe balance sheet at the beginning o the year and the end o the year.

A frms operating Cash Flo0 9OCF is the cash 8owa frm generates rom normal operations% rom the production and sale o itsgoods and services.

+#F may be calculated as ollows!


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Free cash Flo0

Free cash 8ow (F#F) is the amount o cash 8ow available to investors(creditors and owners) a ter the frm has met all operating needs and paid orinvestments in net f ed assets (5FAI) and net current assets (5#AI).

9here!

"he Financial Planning Process

'he fnancial planning process begins with long&term, or strategic, fnancialplans that in turn guide the ormulation o short&term, or operating, plans andbudgets.

'wo "ey aspects o fnancial planning are cash planning and proft planning.

#ash planning involves the preparation o the frms cash budget.

roft planning involves preparation o pro orma statements.

"he Financial Planning Process:Long-"erm 9Strategic Financial Plans

Hong&term (strategic) fnancial plans lay out a companys planned fnancialactions and the anticipated impact o those actions over periods ranging rom

to @E years.

Firms that are sub ect to high degrees o operating uncertainty, relativelyshort production cycles, or both, tend to use shorter planning hori/ons.

'hese plans are one component o a companys integrated strategic plan(along with production and mar"eting plans) that guide a company towardachievement o its goals.

Hong&term fnancial plans consider a number o fnancial activities including!

roposed f ed asset investments


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Research and development activities

Mar"eting and product development

#apital structure

0ources o fnancing 'hese plans are generally supported by a series o annual budgets and proft

plans.

"he Financial Planning Process:Short-"erm 9Operating Financial Plans

Short-term 9operating fnancial plans speci y short&term fnancial actionsand the anticipated impact o those actions.

Pey inputs include the sales orecast and other operating and fnancial data.

Pey outputs include operating budgets, the cash budget, and pro ormafnancial statements.

Cash Planning: Cash Bu!gets

'he cash %u!get or cash orecast is a statement o the frms plannedin8ows and out8ows o cash that is used to estimate its short&term cashre-uirements.

'ypically, the cash budget is designed to cover a @&year period, divided intosmaller time intervals.

'he more seasonal and uncertain a frms cash 8ows, the greater the numbero intervals.

A sales orecast is a prediction o the sales activity during a given period,based on e ternal and?or internal data.

'he sales orecast is then used as a basis or estimating the monthly cash8ows that will result rom pro ected sales and rom outlays related to

production, inventory, and sales. 'he sales orecast may be based on an analysis o e ternal data, internal

data, or a combination o the two.

An e4ternal orecast is a sales orecast based on the relationships observedbetween the frms sales and certain "ey e ternal economic indicators.


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An internal orecast is a sales orecast based on a buildup, or consensus, o sales orecasts through the frms own sales channels.

Proft Planning:Pro Forma Statements

Pro orma fnancial statements are pro ected, or orecast, incomestatements and balance sheets.

'he inputs re-uired to develop pro orma statements using the most commonapproaches include!

Financial statements rom the preceding year

'he sales orecast or the coming year

Pey assumptions about a number o actors

'he development o pro orma fnancial statements will be demonstratedusing the fnancial statements or 2ectra Manu acturing.

A simple method or developing a pro orma income statement is thepercent-o -sales method.

'his method starts with the sales orecast and then e presses the cost

o goods sold, operating e penses, interest e pense, and otheraccounts as a percentage o pro ected sales.

#learly, some o the frms e penses will increase with the level osales while others will not.

the use o past cost and e pense ratios generally tends to understate pro ts when sales are increasing. (Hi"ewise, it tends to overstate pro ts when sales are decreasing. )

'he best way to generate a more realistic pro orma income statementis to segment the frms e penses into f ed and variable components,as illustrated in the ollowing e ample.

'he


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#valuation o Pro Forma Statements

'he ma or wea"nesses o the approaches to pro orma statementdevelopment outlined above lie in two assumptions!

'hat the frms past fnancial per ormance will be replicated in theuture

'hat certain variables (such as cash, accounts receivable, andinventories) can be orced to ta"e on certain 3desired4 values.

'hese assumptions cannot be ustifed solely on the basis o their ability tosimpli y the calculations involved.

owever pro orma statements are prepared, analysts must understand howto use them to ma"e fnancial decisions.

Financial managers and lenders can use pro orma statements toanaly/e the frms in8ows and out8ows o cash, as well as its li-uidity,

activity, debt, proftability, and mar"et value. 2arious ratios can be calculated rom the pro orma income statement

and balance sheet to evaluate per ormance.

#ash in8ows and out8ows can be evaluated by preparing a pro ormastatement o cash 8ows.

A ter analy/ing the pro orma statements, the fnancial manager canta"e steps to ad ust planned operations to achieve short&term fnancialgoals.

Chapter =

"he $ole o "ime >alue in Finance

Most fnancial decisions involve costs Q benefts that are spread out overtime.


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'ime value o money allows comparison o cash 8ows rom di$erent periods.

'he answer depends on what rate o interest you could earn on any moneyyou receive today.

For e ample, i you could deposit the G@,EEE today at @ per year, youwould pre er to be paid today.

Alternatively, i you could only earn on deposited unds, you would bebetter o$ i you chose the G@,@EE in one year.

"he cash in7o0s an! out7o0s o a frm can be described by its generalpattern.

'he three basic patterns include a single amount( an annuit*( or a mi4e!stream:


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Future >alue o a Single &mount

Future value is the value at a given uture date o an amount placed ondeposit today and earning interest at a specifed rate. Found by applyingcompound interest over a specifed period o time.

Compoun! interest is interest that is earned on a given deposit and hasbecome part o the principal at the end o a specifed period.

Principal is the amount o money on which interest is paid.

9e use the ollowing notation or the various inputs!

! n N uture value at the end o period n

"! N initial principal, or present value

r N annual rate o interest paid. ( #ote$ +n fnancial calculators, , istypically used to represent this rate.)

n N number o periods (typically years) that the money is le t ondeposit

'he general e-uation or the uture value at the end o period n is

! n N "! (@ S r )n

Present >alue o a Single &mount


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Present value is the current dollar value o a uture amount%the amount omoney that would have to be invested today at a given interest rate over aspecifed period to e-ual the uture amount.

It is based on the idea that a dollar today is worth more than a dollar

tomorrow. 2iscounting cash 7o0s is the process o fnding present values= the inverse

o compounding interest.

'he discount rate is o ten also re erred to as the opportunity cost, thediscount rate, the re-uired return, or the cost o capital.

'he present value, "!, o some uture amount, ! n , to be received n periodsrom now, assuming an interest rate (or opportunity cost) o r, is calculated asollows!

&nnuities

An annuit* is a stream o e-ual periodic cash 8ows, over a specifed time period. 'hese cash 8ows can be in ows o returns earned on investments or out ows o

unds invested to earn uture returns.

An or!inar* 9!e erre! annuit* is an annuity or which the cash 8owoccurs at the end o each period

An annuit* !ue is an annuity or which the cash 8ow occurs at thebeginning o each period.


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An annuity due will always be greater than an otherwise e-uivalentordinary annuity because interest will compound or an additionalperiod.

Fin!ing the Future >alue o an Or!inar* &nnuit*

Cou can calculate the uture value o an ordinary annuity that pays an annualcash 8ow e-ual to C by using the ollowing e-uation!

As be ore, in this e-uation r represents the interest rate and n represents thenumber o payments in the annuity (or e-uivalently, the number o yearsover which the annuity is spread).

Fin!ing the Present >alue o an Or!inar* &nnuit*

Cou can calculate the present value o an ordinary annuity that pays anannual cash 8ow e-ual to C by using the ollowing e-uation!


Fin!ing the Future >alue o an &nnuit* 2ue

Cou can calculate the present value o an annuity due that pays an annualcash 8ow e-ual to C by using the ollowing e-uation!


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Fin!ing the Present >alue o an &nnuit* 2ue

Cou can calculate the present value o an ordinary annuity that pays anannual cash 8ow e-ual to C by using the ollowing e-uation!


Fin!ing the Present >alue o a Perpetuit*

A perpetuit* is an annuity with an infnite li e, providing continual annualcash 8ow.

I a perpetuity pays an annual cash 8ow o #F, starting one year rom now,the present value o the cash 8ow stream is

Future >alue o a Mi4e! Stream

I the frm e pects to earn at least J on its investments, how much will itaccumulate by the end o year i it immediately invests these cash 8ows whenthey are received6

'his situation is depicted on the ollowing time line.


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Present >alue o a Mi4e! Stream

I the frm must earn at least D on its investments, what is the most it should payor this opportunity6

'his situation is depicted on the ollowing time line.

Compoun!ing ,nterest More Fre?uentl* "han &nnuall*

#ompounding more re-uently than once a year results in a higher e$ectiveinterest rate because you are earning on interest on interest more re-uently.

As a result, the e$ective interest rate is greater than the nominal (annual)interest rate.


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Furthermore, the e$ective rate o interest will increase the more re-uentlyinterest is compounded.

A general e-uation or compounding more re-uently than annually

@ominal an! # ective &nnual $ates o ,nterest

'he nominal 9state! annual rate is the contractual annual rate o interestcharged by a lender or promised by a borrower.

'he e ective 9true annual rate 9#&$ is the annual rate o interestactually paid or earned.

In general, the e$ective rate T nominal rate whenever compounding occursmore than once per year

Special &pplications o "ime >alue: 2eposits @ee!e! to &ccumulate aFuture Sum


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'he ollowing e-uation calculates the annual cash payment ( C ) that wed have tosave to achieve a uture value ( ! n)!

Special &pplications o "ime >alue: Loan &mortization

Loan amortization is the determination o the e-ual periodic loan paymentsnecessary to provide a lender with a specifed interest return and to repay theloan principal over a specifed period.

'he loan amorti/ation process involves fnding the uture payments, over theterm o the loan, whose present value at the loan interest rate e-uals theamount o initial principal borrowed.

A loan amortization sche!ule is a schedule o e-ual payments to repay aloan. It shows the allocation o each loan payment to interest and principal.

'he ollowing e-uation calculates the e-ual periodic loan payments %C & necessary to provide a lender with a specifed interest return and to repay theloan principal %"!&over a specifed period!

It is o ten necessary to calculate the compound annual interest or growth rate(that is, the annual rate o change in values) o a series o cash 8ows.

'he ollowing e-uation is used to fnd the interest rate (or growth rate)representing the increase in value o some investment between two timeperiods.

#hapter J

$is an! $eturn Fun!amentals


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In most important business decisions there are two "ey fnancialconsiderations! ris" and return.

>ach fnancial decision presents certain ris" and return characteristics, andthe combination o these characteristics can increase or decrease a frms

share price. Analysts use di$erent methods to -uanti y ris" depending on whether they

are loo"ing at a single asset or a port olio %a collection, or group, o assets.

$is is a measure o the uncertainty surrounding the return that aninvestment will earn or, more ormally, the variability o returns associatedwith a given asset.

$eturn is the total gain or loss e perienced on an investment over a givenperiod o time= calculated by dividing the assets cash distributions during theperiod, plus change in value, by its beginning&o &period investment value.

'he e pression or calculating the total rate o return earned on any assetover period t, r t , is commonly defned as

9here!

r t N actual, e pected, or re-uired rate o return during period t

C t N cash (8ow) received rom the asset investment in the time period t * @ to t

" t N price (value) o asset at time t %ending value&

" t * @ N price (value) o asset at time t * @ ( beg. 2alue)

$is Pre erences


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>conomists use three categories to describe how investors respond to ris".

$is averse is the attitude toward ris" in which investors wouldre-uire an increased return as compensation or an increase in ris".

$is neutral is the attitude toward ris" in which investors choose theinvestment with the higher return regardless o its ris".

$is see ing is the attitude toward ris" in which investors pre erinvestments with greater ris" even i they have lower e pected returns.

$is o a Single &sset:$is &ssessment

Scenario anal*sis is an approach or assessing ris" that uses severalpossible alternative outcomes (scenarios) to obtain a sense o the variabilityamong returns.

+ne common method involves considering pessimistic (worst), mostli"ely (e pected), and optimistic (best) outcomes and the returnsassociated with them or a given asset.

$ange is a measure o an assets ris", which is ound by subtracting thereturn associated with the pessimistic (worst) outcome rom the returnassociated with the optimistic (best) outcome.

Pro%a%ilit* is the chance that a given outcome will occur.

A pro%a%ilit* !istri%ution is a model that relates probabilities to theassociated outcomes.

A %ar chart is the simplest type o probability distribution= shows only alimited number o outcomes and associated probabilities or a given event.

A continuous pro%a%ilit* !istri%ution is a probability distribution showingall the possible outcomes and associated probabilities or a given event.

Keware o the Klac" 0wan

Is it ever possible to "now or sure that a particular outcome can never

happen, that the chance o it occurring is E 6 In the EEU best seller, 'he (lack )wan$ 'he *mpact of the +ighly

*mprobable , 5assim 5icholas 'aleb argues that seemingly improbableor even impossible events are more li"ely to occur than most peoplebelieve, especially in the area o fnance.


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'he boo"s title re ers to the act that or many years, people believedthat all swans were white until a blac" variety was discovered inAustralia.

'aleb reportedly earned a large ortune during the EEU* EEJ fnancial crisis by

betting that fnancial mar"ets would plummet

$is Measurement

Stan!ar! !eviation 9 r is the most common statistical indicator o anassets ris"= it measures the dispersion around the e pected value.

#4pecte! value o a return 9 r is the average return that an investment is

e pected to produce over time.

9here!

r N return or the th outcome

"r t N probability o occurrence o the th outcome

n N number o outcomes considered

'he e pression or the standard deviation o returns, r , is


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In general, the higher the standard deviation, the greater the ris"

5orman #ompanys past estimates indicate that the probabilities o the pessimistic,most li"ely, and optimistic outcomes are , E , and , respectively. 5otethat the sum o these probabilities must e-ual @EE = that is, they must be based onall the alternatives considered


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"a%le A'; "he Calculation o the Stan!ar! 2eviation o the $eturns or&ssets & an! B 9Cont '

Matter o act

All 0toc"s Are 5ot #reated >-ual

0toc"s are ris"ier than bonds, but are some stoc"s ris"ier than others6

A recent study e amined the historical returns o large stoc"s andsmall stoc"s and ound that the average annual return on large stoc"s

rom @D & E@@ was D.J , while small stoc"s earned @@.D per yearon average.

'he higher returns on small stoc"s came with a cost, however.

'he standard deviation o small stoc" returns was a whopping B .J ,whereas the standard deviation on large stoc"s was ust E. .


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Coe3cient o >ariation

'he coe3cient o variation , CV , is a measure o relative dispersion that isuse ul in comparing the ris"s o assets with di$ering e pected returns.

A higher coe:cient o variation means that an investment has more volatilityrelative to its e pected return.

$is o a Port olio

In real&world situations, the ris" o any single investment would not be viewedindependently o other assets.

5ew investments must be considered in light o their impact on the ris" andreturn o an investors port olio o assets.

'he fnancial managers goal is to create an e3cient port olio( a port oliothat ma imum return or a given level o ris".

$is o a Port olio: Port olio $eturn an! Stan!ar! 2eviation


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'he return on a port olio is a weighted average o the returns on the individualassets rom which it is ormed.

9here!

w N proportion o the port olios total dollar value represented by asset

r N return on asset

$is o a Port olio: Correlation

Correlation is a statistical measure o the relationship between any twoseries o numbers.

Positivel* correlate! describes two series that move in the samedirection.

@egativel* correlate! describes two series that move in oppositedirections.

'he correlation coe3cient is a measure o the degree o correlationbetween two series.

Per ectl* positivel* correlate! describes two positively correlatedseries that have a correlation coe:cient o S@.

Per ectl* negativel* correlate! describes two negatively correlatedseries that have a correlation coe:cient o *@.

'o reduce overall ris", it is best to diversi y by combining, or adding to theport olio, assets that have the lowest possible correlation.

#ombining assets that have a low correlation with each other can reduce theoverall variability o a port olios returns.

8ncorrelate! describes two series that lac" any interaction and there orehave a correlation coe:cient close to /ero.


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,nternational 2iversifcation

'he inclusion o assets rom countries with business cycles that are not highlycorrelated with the ;.0. business cycle reduces the port olios responsivenessto mar"et movements.

+ver long periods, internationally diversifed port olios tend to per orm better(meaning that they earn higher returns relative to the ris"s ta"en) than purelydomestic port olios.

owever, over shorter periods such as a year or two, internationallydiversifed port olios may per orm better or worse than domestic port olios.

#urrency ris" and political ris" are uni-ue to international investing.

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