Financial Management Theory and Practice Chapter 1

An unincorporated business owned by one individual
Easily and inexpensively formed, few government regulations, not subject to corporate taxation
Advantages of a proprietorship
Difficult to obtain capital, unlimited personal liability, limited to life of its founder
Limitations of a proprietorship
Exists whenever two or more persons or entities associate to conduct a noncorporate business for profit
Limited Partnership
wherein certain partners are designated general partners and other limited partners
Limited Partners
In a limited partnership, can lose only the amount of their investment in the partnership, but typically have no control
General Partners
In a limited partnership, have unlimited liability and typically control rests solely with
Limited Liability Partnership (or limited liability company)
All partners enjoy limited liability with regard to the business’s liabilities, and their potential losses are limited to their investments in the business
A legal entity created under state laws, and it is separate and distinct from its owners and managers.
Advantages of a corporation
Unlimited life, easy transferability of ownership interest, limited liability
Disadvantages of a corporation
Double taxation (earnings, and earnings paid out as dividends)
complex to set up.
Includes information such as the name of the proposed corporation, types of activities it will pursue, amount of capital stock, number of directors, and names and addresses of directors. Filed with Secretary of State. Once started, must file annual/quarterly employment/financial/tax reports w/ state and Fed.
A set of rules drawn up by the founders of the corporation. Election of directors, if existing stockholders have first right to new shares, procedures for changing by-laws.
Professional Corporation (or professional association)
Has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability
S Corporations
A small corporation that, under Subchapter S of the Internal Revenue Code, elects to be taxed as a proprietorship or a partnership yet retains limited liability and other benefits of the corporate form of organization
Initial Public Offering
Occurs when a closely held corporation or its principal stockholders sell stock to the public at large
Agency Problem
Occurs when mangers act in their own best interests, rather than in the best interests of the stockholder/owners
Corporate Governance
The set of rules that control a company’s behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community
Market Price
The stock price that we observe in the financial markets
Intrinsic/Fundamental Price
The market price when it reflects all relevant information
Free Cash Flows (FCF)
The cash flow actually free (available) for distribution to all investors/creditors/stockholders after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations.
Weighted Average Cost of Capital
The rate of return required by investors.

To determine this rate, one needs managerial finance decisions, interest rates in the economy, risk of firms operations, stock market investor’s overall attitude towards risk.

Investment Banking House
Organization in which indirect transfers of securities may go through, these organizations underwrite the issue and basically serves as a middleman and facilitates the issuance of securities. Pg 14
Financial Intermediary
Middle Man that buys securities with funds that it obtains by issuing ITS OWN securities. An example is a common stock mutual fund that buys common stocks with funds obtained by issuing shares in the mutual fund. Pg14
Paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values.
Debt Instruments
contractual agreements that have specified payments and maturity.
Capital Market Security
Debt that matures in more than a year
Money Market Security
Debt that matures in less than a year
Equity Instruments
A claim upon a residual value. For example, a company’s stockholders are entitled to cash flows after bondholders and other debts have been paid.

Remember: since stock has no maturity, it goes for over a year and is considered a capital market security.

Securities whose claims (value) depends on what happens to the value of some other asset. Futures and option are two important types, and their values depend on what happens to the prices of other assets. Therefore, the value of these securities comes from the value of an underlying real asset or other security
A process in which some securities are created from packages of other securities
Savings and Loan Associations (S&Ls)
Organization that at one time made most mortgages, took in the vast majority of their deposits from individuals in nearby neighborhoods, pooled these deposits and then lent money to others in the neighborhood in the form of fixed-rate mortgages
Mortgage Securitization
i. Local S&Ls, not allowed to branch (disequilibrium during 1950s East expansion).
ii. Short-term liabilities but long term assets meant S&Ls could not respond to supply/demand/interest rate changes. Money market bankrupted them.
iii. Government allowed branching and long-term debt (to go along with short-term deposits). Managers did not know how to deal and made bad decisions.
iv. Demise of S&Ls meant demand for mortgages was high but supply low, which led to mortgage securitization. Banks, S&Ls, and mortgage firms would originate a mortgage and sell it to an investment bank. The investment bank would bundle several and use them as collateral to sell bonds. The investment bank will use the bundled-funds-payments (from homeowners) to pay interest on the bonds. The bonds are more liquid than the mortgages, which also helps investors.
v. After mortgage securitization, there is more money for aspiring homeowners, mortgage firms have less risk, and there is more opportunity for risk-willing investors to make more money (more liquidity, in this).
Interest Rate
The rate users pay providers for debt
Cost of Equity
The rate users pay providers for equity
Four most fundamental factors affecting the cost of money
Production Opportunities (ability to turn capital into benefits such as the benefits of borrowing for education are higher expected salary, etc), Time Preferences For Consumption (Japan has a lower time consumption rate, so interest rates are higher there to induce lending), Risk, Inflation

Note: economic factors include fed reserve policy, fed budget deficit or surplus, level of business activity, and international factors such as foreign exchange rate, international business climate and foreign trade balance.

Fed Reserve’s Open Market Policy
Fed buys T-bills from bank, bank has more cash, and if demand does not go up, will have to lower interest rate to get rid of it.

Fed reserve is demanding more T-bills, so demand is up. Supply is constant, then prices go up and interest rates go down. ???

Country Risk
The risk that arises from investing or doing business in a particular country and it depends on the country’s economic , political, and social environment
Exchange Rate Risk
Risk associated with the value of an investment depending on what happens to exchange rates
Investment Banks’ Jobs
i. advise corporations regarding design/pricing of new securities (and even things like mergers/acquisitions)
ii. Buy these securities from the issuing corporation
iii. Resell them to investors (remember, this is a primary market transaction b/c same security is being bought and sold)
Mutual Savings Banks (MSBs)
Operate similiar to S&Ls, mostly in northeastern states
Credit unions
Cooperative associations whose members have a common bond, which loans members’ savings only to other members
Commercial Banks
raise funds from depositors and issue stock and bonds to investors
Mutual Funds
Corporations that accept money from thousands of savers and then use these funds to buy financial instruments, they pool funds which allows them to reduce risks by diversification and achieve economies of scale in analyzing securities, managing portfolios, and buying/selling securities. Most traditional mutual funds only allow investor to redeem share at the close of business.
Money Market Funds
Invest in short term, low risk securities, such as Treasury bills and commercial paper
Exchange Traded Fund (ETF)
Allows investors to sell their share in a mutual fund at any time during normal trading hours, usually have very low management expenses and are rapidly gaining in popularity.
Hedge Funds
Raise money from investors and engage in a variety of investment activities, limited to institutional investors and a relatively small number of high net worth individuals. Less regulated than mutual funds due to supposed “sophistication of investors.”
Private Equity Funds
Similar to hedge finds in that they are limited to a relatively small number of large investors, but they differ in that they own stock in other companies and often control those companies, whereas hedge funds usually own many different types of securities. Often turn public companies private.
Life Insurance Companies
Take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and them make payments to beneficiaries
Pension Funds
Retirement plans funded by corporations or government agencies, invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate
Financial Markets
Bring together people and organizations needing money with those having surplus funds
Physical Asset Market
Markets for such tangible products as wheat, autos, real estate and machinery
Financial Asset Markets
markets that deal with stocks, bonds, notes, and other financial instruments
Spot Markets
markets where assets are being bought or sold for “on-the-spot” (within a few days).
Future Markets
Markets where assets are bought and sold and delivered on some future date
Money Markets
Markets for short term highly liquid debt securities
Capital Markets
Markets for corporate stocks and debt maturing more than a year in the future
Mortgage Markets
Markets dealing with loans on residential, agricultural, commercial, and industrial real estate
Consumer Credit Markets
Markets involving loans for autos, appliances, education, vacation, etc
Primary Markets
Markets in which corporations raise new capital
Secondary Markets
Markets in which existing, already outstanding securities are traded among investorsd. The corporations whose securities/stock is being traded does not receive any money from this transaction.
Private Markets
Markets where transactions are worked out directly between two parties. These securities are tailor-made but less liquid.
Public Markets
Markets where standardized contracts are traded on organized exchanges. More liquid but subject to greater standardization, since investors do not have the time to study a new contract for every sale.
example is the CBOT where traders meet in a pit and sellers and buyers communicate with one another through shouts and hand signals
Dealer markets
Markets where market makers keep an inventory of the stock in much the same way that any merchant keeps and inventory, they then list bid and ask quotes which are the prices at which they are willing to buy or sell
Electronic Communications Network (ECN)
participants post their orders to buy and sell and this automatically matches orders
Market Order
An order to buy stock at current market price. “Buy/sell 2000 shares”
Limit Order
An order to buy or sell securities with limitations. “Sell 1000 shares, but at X price.”
Seasoned Equity Offering
After going public, this is when a company decides to sell additional shares to raise new equity after the IPO, this is still a primary market
National Association of Securities Dealers (NASD)
a self regulatory body that licenses brokers and oversees trading practices
Federal Reserve Actions
If our prices fall compared to other countries, our goods will sell better because they are cheaper.

If the Fed lowers interest rates below other countries, then investors will sell our bonds and buy ones that will have higher interest rates. This will bring down our bond price and bring up our interest rates (interest rates in general or just on the bonds??).

If Yen weakens compared to the dollar, then yen will buy fewer dollars. A US investor would have less U.S. money when a Japanese bond matured.

When there are more offers to buy stock/securities than the supply can allow.
Real rate of return
The rate of return you get when adjusted for inflation.
[ (1 + Rate_nominal) / ( 1 + Rate_inflation) ] – 1.0
[ ( 1 + 1.06) / (1 + 1.03) ] – 1.0 = 2.91
Opportunity cost rate
Interest rate offered on another investment/project having a similar risk. Used in TVM (time value of money) equations to find the corresponding present and future values of investment.
NPV of Individual Irregular Cash flows (no lump sum)
1. To get first, CFj0 = 1. Then CFj1 value, interest and NPV
2. To get second, CFj0 = CFj1 = 0, CFj2 value, interest and NPV
3. To get total, put all in starting with CFj0.
Net future value
1. Starting with 0, enter cash flows, interest rate and then [NPV] [D arrow] [SWAP]