• Forecast future financial needs
• through the building of financial models
• End result is a series of pro-forma financial statements (ex. projected income statement, balance sheet, and cash flow statement)
• Helps to answer several questions and provide basis for planning

• Financial Modeling helps to develop each type of plan
• Each type of plan usually contains a financial section
• Finance is also a component of any SWOT analysis

Three Types of Planning

1. Strategic Planning (3 to 5 years)
2. Tactical Planning (for next year to implement Strategic Plan)
3. Operational Plans (day to day planning)

• The revenue forecast is the lynchpin of all financial forecasts
• Many other variables are a function of revenue

• Reasonably accurate (no forecast is ever totally accurate)
• An unbiased forecast (not consistently too high or too low)
• A forecast that yields other important insights into the company

• Extraplorate trends: CAGR (compound average annual growth rate) and Time Regression (assumes linear growth or relationship)
• Problems:Non-linear growth or variable growth.
   
  Forecast might yield fairly accurate results, but doesn’t provide any information. Usually misses
  significant turning points (strategic points).
   

• A causal model is an econometric model where revenue is forecasted as a function of one or more macro - economic variables (or “caused by” this or these variables)
• For example: Revenue = f(# of households, level of disposable income,level of interest rates)
•  Models can be difficult to construct, may miss turning points, and doesn’t provide a lot of important information
   

• A business model is a model of how a company makes revenue (where revenue comes from)
• It helps to identify the key drivers in the revenue forecast
• It is the preferred forecasting method (though the
  other methods may produce forecasts that are as accurate)
   

• An AFN model is a simple financial forecasting method
• Essentially a truncated sources and uses statements
• AFN = Required increase in Assets-Increase in retained earnings-Increase in spontaneous liabilities

• Assets/Revenue is a ratio of capital intensity
• A ratio of 1 also means that for every dollar increase
  in revenue, an additional dollar must be invested in
  assets
• = Capital Intensity * Increase in Revenue
• = (Assets/Revenue) * (Revenue_n+1-Revenue_n)
  

• Source of funds (internal source)
• ∆Retained earnings = Net income n+1 – Dividends n+1
• Net income = Net margin * Revenue
• Dividends = Net income * Payout Ratio
• ∆Retained earnings= Net Income (1–Payout R)
   

• A spontaneous liability is one that increases (or
  decreases) as revenue increases (or decreases)
• Spontaneous liabilities are generally accruals and accounts payable
•  Spontaneous liabilities represent a source
  of funds
• Spontaneous liabilities = [(Payables +Accruals) / Revenue]* ∆Revenue
   

• Revenue forecast may not be very accurate
• Assumes no change in key ratios (such as assets/revenue or net profit margin)
• Ignores such factors as excess production capacity

• Classified and acquired either by Direct or Indirect
• Direct Acquisition: Investors actually own the financial instruments
• Indirect Acquisition: Investors own an equity that, in turn, owns the financial instruments

Three Security Categories

• Debt
• Equity
• Derivative

• Investor lending money to a government or company
• Divided into two types: Money markey instruments and Long-term fixed income securities

• Investor actually owns part of a company

• Value is derived from some financial asset or some real asset (i.e. gold, silver), which is the underlying
• Divided into three types: Stock Options, Future Contracts, and Corporate created derivatives (convertible bonds)
• Classified as riskier stock
• Value depends on the value of the underlying asset: commodity, common stock, stock index, and treasury bond

• Investor owns an equity that, in turn, directly acquires Financial Instruments
• ex. acquiring shares of a mutual fund

• Short-term securities (not money or currencies)
• Size of the "money market" worldwide is in the trillions

• Mature within one year from the date initially sold
• High quality securities
• Discount Securities: sold for less than face value, at maturity for face value, the return is difference between acquisition price and the face value
• Most are large denominations: 1 million or more (US treasury bills are exceptions)

• Treasury Bills: Best known MMI, minimum face value of $10,000, matures 91,181, or 360 days
• Commercial Papers: corporate equivalant of treasury bills, matures in 270 days
• Repurchase Agreements (Repo): u.s. government securities are collateral, one party sells and agrees to buy back at a later date, matures overnight or several months
• Banker's Acceptance: discounted instruments used to finance goods that have not been shipped, matures up to 1 year

• Negotiable Certificates of Deposits (CDs): at maturity both the interest and the principal are returned to the investor, sold at minimum 100k but usually at 1 million, interest paid at a specific rate.
• Short Term Municipal Securities: sold by state and local government, minimum denominations of 25k, exempt from federal income tax
• Foreign Money Market Instruments: sold by other countries, have a foreign exchange risks

• Include all debt instruments with maturities in excess of one year
• Issued by governments and corporations

• A more permanent source of financing allowing issuers to purchase large, long-lived assets
• Include bonds, mortgage pass-through securities, and preferred stock
   

• Most bonds are interest bearing securities
• Interest payments are called coupon payments and is a fixed percentage of face value
• At maturity, the investor receives the bond's face value
• Most are "callable"
• Vary widely in credit risk from low to high
• Can sell at premium or discount over face value
• Most have interest payments twice a year

• U.S. Government: maturities 2-30 years, bought and sold in active markets, sold in denominations as low as 1k
• Municipal Bonds: issued by state and local gov., face values from 5k-25k, not subject to fed. income tax
• Corporate Bonds: mature 5-30 years, face values 1k-5k
• Foreign Bonds: eurobonds denominated in U.S. dollars but sold outside the U.S., have foreign exchange risk. Rate of exchange affects rate of return

• legally not equity that pays a set dividend which does not change
• Practically, preferred stock is more like a bond
• no voting rights

• Represents an ownership claim on a corporation
• As owners, shareholders have voting rights
• Investors acquire stock for two purposes: Share value/capital appreciation, and income generating through dividends

• Blue Chips (GE, WMT): long history of stable earnings and dividends growth
• Growth (Cisco, Lucent): rapid growth and earning growth
• Value (eye of the beholder)
• Cyclical Stock (Home Depot, GM): Sales and profits closely tied to economy

1. Stock Options- the right to buy or sell an individual stock at a fixed price for a fixed period of time.
2. Corporate Created Derivative Securities- convertible security and warrants
3. Future Contracts- contract between parties for future delivery of a commodity at an agreed price, usually within one year

• Call- an option to buy at a price
• Put- an option to sell at a price

• A regular bond or preferred stock issue with an option of exchanging for a fixed number of shares of common stock

• Long- term call option to exchange the warrant
  for a specific number of stock shares at a pre-set price
   

• Historically, returns show that there is a positive relationship between risk and return
• Stocks have been riskier investment than other financial instruments

• A market where financial instruments (stocks and bonds) are bought and sold
• Help to transfer capital from those with a surplus to those with a deficit
• Allow corporations/governments a mean to raise capital at a reasonable cost and help investors get a reasonable return for lending

• Open trading exists
• Price continuity
• Low transaction costs
• Rapid price adjustments

• Primary or secondary (U.S. Treasury) vs secondary sales/purchase (NYSE)
• Money or capital (short-term vs. long-term)
• Debt or equity (bonds vs stocks)
• Organized or over-the-counter rules (NYSE) vs. flexible trading rules (Nasdaq)
• Regional or global (Local, regional, or national in scope vs global in scope)

• To ensure a "good" financial market they are regulated around the world.
• In the US: Securities and Exchange Commissions, as well as by both federal or state government
• Global: uses model established by US

• securities are sold via open auctions: US government sells own securities
• underwritten:initially aqcuired by an investment bank who then turns around and resells the issue to the public
• sold privately: sale of corporate debt issues to large institutional investors

• Provide liquidity (fast sales) and price discovery (what price should be charged
• where most securities are sold
• Secondary bond markets: online trading
• Secondary equity markets: Stock markets and online trading

• individuals must have a brokerage account
• Brokerage provide advice, information, and order execution
• Types of Brokerage firms: Full Service (advice, info, order execution) and Discount (info, and order execution)

• Market orders: broker obtans best possible price
• Limit orders: establishes buyer/seller limit (ceiling/floor)
• Stop-loss orders: sell order that becomes effective at certain price
• Buying on Margin: means borrowing to buy the securities
• Short sale: selling borrowed shares of equity with the hope of buying the equity back at a later date at a lower price
• Cyber orders: acquiring and selling shares over the internet
• Day Trading: watching and estimating trends and buy/sell shares on a momentary basis all day.
   

• Called Intermediaries in the profession
• Help transfer funds between savers and borrowers
• The institution creates several financial products: checking accounts, saving accounts, and various types of loans

• If financial institutions did not exist, savers and borrowers would be forced into direct transfers of funds, creating their own financial products.
• The cost of producing so many financial products, in such small amounts, would be extremely high.

• Economies of scale lowering the cost of transferring funds between savers and borrowers.
• Flexible denominations enhancing the size of transfers
• Flexible maturities enhancing the maturities of transfer instruments
• Diversifying credit risk
• Liquid allowing conversion to cash quickly for small fee.

• Depository institutions: accepts deposits that customers can withdraw on demand. (ex. commercial banks, savings banks and credit unions)
• Non-Depository institutions: no customer deposits (pension funds, mutual fund, and life insurance companies)

• Sources: Deposits and Borrowers
• Uses: Loans and Cash and Reserves

• Accept funds from businesses and individuals which are then invested.
• Have far more predictable cash inflows and outflows which allows investment in long-term securities

• Pension Funds
• Insurance Companies
• Investment Companies

• Transfer of risk to insurance company for a series of payments
• Underwriting
• Process to determine who to insure and what to charge

• Retirement benefits to workers and families generally set up by employers
• Regulated by IRS, SEC and other federal and state governmental agencies

• Raise funds by selling shares to investors
• Pools these funds and purchases investment securities
• Regulated by the SEC
• Detailed annual reports required for investors
  

• Unit investment trusts-fixed number of shares purchasing a fixed portfolioof stocks and bonds
• Closed end funds- fixed number of shares purchasing a managed portfolio
• Mutual funds- actively managed and the largest