Goal of the Firm

Shareholder (Stockholder) Wealth Maximization

This is the same as A) Maximizing the Firm Value B) Maximizing Stock Price

Note: Goal of the firm is NOT profit Maximization because it ignores A) timing of returns (time value of money) B) Uncertainty of returns (risk)

Sole Proprietor

A business owned by a single individual

General Partnership

A partnership in which all partners are fully liable for the indebtness incurred by the partnership

Limited Partnership

A partnership, in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership

Corporation

An entity that legally functions separate and apart from its owners

Gross Profit

Sale or revenue minus the Costs of Goods Sold

Operating Income

Sales less the Cost of Goods Sold less Operating Expense

Also known as: Earnings Before Interest and Taxes (EBIT)

Taxable Income

Gross income from all sources, except from allowable exclusions, less any tax deductable expense

Dividend Exclusion

70% of all dividend income (dividends received) is exempt from federal taxation (30% is taxable)

Depreciation

The means by which an asset's value is expensed over its useful life for federal income tax purposes

Capital Gain

As defined by the revenue code, gain resulting from the sale or exchange of a capital asset

Capital Loss

As defined by the revenue code, loss resulting from the sale or exchange of a capital asset

Net Capital Loss Carry Back/Carry Forward

May be carried back 3 years or forward up to 5 years and is applied to net capital gains

Operating Loss Carry Back/Carry Foward

May be carried back 2 years or carried forward up to 20 years

Financial Markets

Ways for corporations to raise funds by selling securities (stocks and debt) and in return, once the corporation/assets thrive, money is given back to the investor in the form of dividends or interest payments

Allows people to easily buy and sell (trade) financial securities (stocks and bonds), commodities (metals and agricultural goods) and other items of value at low transaction costs

Real Asset

Asset that is tangible or physical in nature such as land, machinery and livestock

Financial Asset

An asset that derives value because of a contractual claim. Stocks, bonds, and bank deposits are all examples of financial assets

Underwriting

The purchase and subsequent resale of a new security issue. The risk of selling the new issue at a satisfactory (profitable) price is assumed (underwritten) by the investment banker

Secondary Market

A market where current outstanding securities are traded

Ex: Used Car market, sales from investor to investor

Indirect Securities

(Over-the-Counter markets)

Include all security markets except the organized exchanges.

Ex: The Money Market is an over-the-counter market because it doesn't occupy a physical location

Most corporate bonds are traded in this market

Direct Securities

(Organized Securities Exchange)

Tangible entities, that is, they physically occupy space (such as a building or part of a building), and financial instructments are traed on their premises

Formal organizations that facilitate the trading of securities

Example: New York Stock Exchange, American Stock Exchange

3 Ways to Transfer Savings to a Business

1) Direct transfer of funds

2) Indirect transfer using investment banker

3) Indirect transfer using a financial intermediary

Public Offering

An offering of securities where all investors have the opportunity to acquire a portion of the financial claims being sold

Private Placement

A security offering limited to a small number of potential investors

Primary Market

A market where securities are being offered for the first time for sale to potential investors

Example: New Car Market

It's the only time the issuing firm ever gets any money for the securities, and it is the type of transaction that introduces new financial assets (stocks, bonds) into the economy

Money Market

All institutions and procedures that facilitate transactions for short-term (maturity periods of 1 year or less) instruments issued by borrowers with very high credit ratings

Example: US treasury bills, various federal agency securities, bankers' acceptances, negotiable certificates of deposit, and commercial paper

Capital Market

All institutions and procedures that facilitate transactions for long-term (maturity periods that extend beyond 1 year) finaincial instructments

Example: Term loans, financial leases, and corporate stocks and bonds

Exchange

To provide goods or services and receive goods or services of approximately equal value in return

Investment Banker

Financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds

Investment Banker Functions

Underwriting: assuming the risk of selling a security issued at a satisfactory price (one that generates profit for the investment-banking house).

Distributing: Once they own the new securities they must get them into the hands of the ultimate investors. The syndicate is almost viewed as the security wholesalers and the dealer organization can be viewed as the security retailer

Advising: Investment banker as an expert in the issuance and marketing of securites finds the ideal time for the exchange between client and public

Negotiated Purchase

1. Firm that needs funds gets in contact with an investment banker

2. Method is negotiated for determining the price the investment banker and the syndicate will pay for the securities

-Most prevalent method of securities distribution in the private sector

-Generally thought to be most profitable technique for investment bankers

Competitive Bid Purchase

An offering procedure in which underwriters submit sealed bids for the new issue from the corporation and the underwriter with the best terms is chosen by an auction process (not by the Corporation itself)

Confined to 3 situations: railraod issues, public utility issues and state and municipal bond issues

A Commission or Best Efforts Biases

An underwriting in which an investment bank, acting as an agent, agrees to do its best to sell the offering to the public (in return for a fixed commission on each), but does not buy the securities outright and does not guarantee that the issuing company will receive any set amount of money, less common than a firm commitment offering

Used for more speculative issues

Benefits the issuer because it's less costly for them

A Privileged Subscription

The process of marketing a new security issue to a select group of investors

3 target markets are typically involved: current stockholders, employees, and customers of the firm

Investment banker may only act as a selling agent

Direct Sales

The issuing firm sells the securities directly to the investing public without involving an investment banker

This procedure is relatively rare

Floatation Cost

The transaction cost incurred when a firm raises funds by issuing a particular type of security

Underwrite's Cost: the difference between the gross and net proceeds from a given securuity issue expressed as a percent of the gross proceeds

Issue Costs: The printing and engraving of the security certificates, legal fees, accounting fees, trustee feeds, etc

-Mirror the risk of the relationship (Common Stocks have more than Corporate Bonds)

-Larger the security, less fees because they're fixed

Securities Act of 1933

First Congressional Law regulating the securities industry. Required registration and disclosure and included measures to discourage fraud and deception

Regulated the primary market (original issues)

Securities Act Amendments of 1975

Congressional law amending the Securities Act of 1933 to enable the establishment of a National Market System, and to encourage fair and efficient handling of security transactions

Shelf Registration

A registration of a new issue which can be prepared up to 2 years in advance, so that the issue can be offered quickly as soon as funds are needed or market conditions are favorable

Opportunity Cost of Funds

The next-best rate of return available to the investor for a given level of risk

The higher the risk, the higher the expected returns

All securities are risky, except for treasury bills and bonds

Maturity Premium

The additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes

Liquidity Premium

The additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price

Nominal Rate of Interest

The interest rate paid on debt securities without an adjustment for any loss in purchasing power (inflation)

Real Rate of Interest

The nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment (inflation)

Term Structure of Interest Rates

The relationship between interest rates and the term to maturity, where the risk of default is held constant

Unbiased Expectations Theory

The theory that the shape of the term structure of interest rates is determined by an investor's expectations about future interest rates

Liquidity Preference Theory

The theory that the shape of the term structure of interest rates is determined by an investor's additional required interest rate in compensation of additional risks

Market Segmentation Theory

The theory that the shape of the term structure of interest rates implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity. This rate is independent of the demand and supply for securities having different maturities

There are separate markets for short and long-term investments

Yield to Maturity

The rate of return a bondholder will receive if the bond is held to maturity

Securities Exchange Act of 1934

The act which created the SEC, outlawed manipulative and abusive practices in the issuance of securities, required registration of stock exchanges, brokers, dealers, and listed securities and required disclosure of certain financial information and insider trading

Regulates secondary trading

Income Statement

Profit and loss statement

Sales - Expense = Profit

A basic accounting statement that measures the results of a firm's operations over a specific period, commonly 1 year. The bottom line of the income statement shows the firm profit or loss for the period.

Balance Sheet

A statement that shows a firm's assets, liabilities, and shareholder equity at a given point in time. It is a snap shot of the firm's financial position on a particular date

Current Assets

Consist primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses

Fixed Assets

Assets such as equipment, buildings, and land. Long term in nature.

Debt

Liabilities consisting of such sources as credit extended by suppliers or a loan from a bank

Equity

Stockholders' investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.

Retained Earnings

Cumulative profits retained in a business up to the date of the balance sheet

Liquidity

A firm's ability to pay its bills on time.

Liquidity is related to the ease and quickness with which a firm can convert its noncash assets into cash, as well as the size of the firm's investment in noncash assets relative to its short-term liabilities