What are the four major types of firms?

1) sole proprietorship

2)partnership

3) limited liability company

4) corporation.

What is the most common type of firm in the world?

sole proprietorship

What are the key characteristics of a sole proprietorship?

1) Straightforward to set up. Used by many new businesses

2) No separation between the firm and the owner.  Only one owner. Other investors may not hold ownership stake in the firm.

3) Owner has unlimited liability for any firm debts

4) Life of the firm limited to the life of the owner

What are the key characteristics of a partnership?

1) It has more than one owner

2) All owners are liable for the firm's debt

3) Partnership ends on the death or withdrawal of any single partner

4) Personal tax on profits

What types of businesses typically organize as partnerships?

Doctors, accounting firms, law firms

What is a limited partnership?

A firm with general owners (who have the same rights as partners) and limited partners (whose liability is limited to their investment)

What types of businesses typically organized as limited partnerships?

Private equity funds & venture captial funds

What is a limited liability company (LLC)?

All the owners have limited liability and all can run the business.

What is a corporation?

1) A legal entity (citizen of the state in which it is incorporated) that can enter into contracts, acquire assets,  and incur obligations.  Has Constitutional protection from property seizure

2) The owners of a corporation are not liable for any obligations the corporation enters into

3) The corporation is not liable for the personal obligations of its owners

4) Corporate tax on income

5) Personal tax on dividends

What are the three responsibilities of financial managers?

1) Making investment decisions

2) Making financing decisions

3) Managing the firm's cash flows

What are the goals of the financial manager?

1) Maximize firm value

2) Maximize shareholder value

3) Maximize share price

What is the agency problem? 

A belief that separation of ownership & control in a corporation gives financial managers little incentive to work in the interests of shareholders.  To overcome, shareholders often tie top-tier compensation to performance.

Book Value

Acquisition cost

- Accumulated Depreciation

________________________

Goodwill & Intangible Assets

Price Paid for Firm

- Book Value of Tangible Assets

_______________________________

If a corporation fails to satisfy __________ claims, debt holders may ______________ of the firm.  A corporate bankruptcy is best thought of as a _____________ of the corporation, and not necessarily a ____________of the underlying business.

If a corporation fails to satisfy debt holders' claims, debt holders may take control of the firm.  A corporate bankruptcy is best thought of as a change in ownership of the corporation, and not necessarily a failure of the underlying business.

In the stock market, _____ prices exceed _____ prices. Customers always buy at the _____ (________) price and sell at the ______ (lower) price. The ___________ is the ___________investors have to pay in order to trade.

In the stock market, ask prices exceed bid prices. Customers always buy at the ask (higher) price and sell at the bid (lower) price. The bid-ask spread is the transaction cost investors have to pay in order to trade.

Amortization or Impairment Charge

Reductions in the value of intangible assets as it declines over time.*

*Not a cash expense

Net Working Capital

Current Assets

-Current Liabilities

______________________

Book Value of Equity or Stockholders' Equity

Assets 

-Liabilities

_______________

*Inaccurate measurement of assessment of actual value of firm's equity because it does not measure the quality of the managment team, employee expertise, reputation, customer relationships & thevvalue fo future R&D innovations.

 Market Capitalization

Market price per share

X number of shares

________________________

*Not based on historical cost of firm's assets but what investors expect those assets to produce in the future.

Enterprise Value of a firm

Market Value of Equity+Debt-Cash

*Measures value of business assets unensumbered by debt & separate fromcash and marketable securities.

Gross Margin

=Gross Profit/Sales

Operating Margin

=Operating Income/Sales

Net Profit Margin

=Net Income/Total Sales

Statement of Cash Flows

Information from the income statement & balance sheet used to determine how much cash the firm has generated, and how that cash has been allocated during a set period.

NPV Decision Rule

When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.

Net Present Value (NPV)

The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. 

=PV(Benefits)-PV(Costs)

=PV(Benefits-Costs)

=PV(All project cash flows)

Law of One Price

In competitive markets, securities or portfolios with the same cash flows must have the same price.

Future Value of a Cash Flow

FV_n=C X (1+r)ⁿ

*Compounding-moving a cash flow forward in time

Present Value of a Cash Flow

(received in n years)

PV=C/(1+r)ⁿ

*Discounting-moving a cash flow back in time

Efficient Portfolio

Cannot be diversified further.  There is no way to redue the risk of the portfolio without lowering its expected return.  Should be a  large portfolio, containing many different stock, as a market portfolio of all stocks & securities traded in the capital markets.  Use S&P 500 as a proxy.

Present Value of a Perpetuity

PV(C in perpetuity)=C/r

Present Value of an Annuity

(at the end of the annuity)

PV(annuity of C for N periods with interest rate r)=

C X 1/r (1-1/(1+r)^N

Future Value of an Annuity

FV(annuity)=PV X (1+r)^N

C X 1/r {(1+r)^N-1)}

*First payment does not grow

Present Value of a Growing Perpetuity

PV(growing perpetuity)=C/r-g

Present Value of a Growing Annuity

PV=C X 1/r-g {1-(1+g)^N/(1+r)}

Internal Rate of Return (IRR)

Interest rate that sets the NPV of cash flows equal to zero.

*With 5 or more periods and general cash flows, there is no formula to solve for r.  Use trial and error.

Beta of the Security

The sensitivity of the security's return to the return of the market portfolio (S&P 500 by proxy).  The beta of a security is the expected % change in its return given a 1% change in the return of the market portfolio.

What are the 3 rules of cash flow time travel?

1) Only cash flows that occur at the same point in time can be compared or combined.

2) To move a cash flow florward in time, you must compound it.

3) To moe a cash flow backward in time, you must discount it.

What is the Rule of 72?

The number of years it will take for an investment to double in value is approximately equal to 72 divided by the interest rate earned.

Capital Asset Pricing Model (CAPM)

The most important method for estimating the cost of capital.

Risk-free interest rate+Beta X Market Risk Premium

Alpha

Difference between a stocks expected return and its required return (above or below the market line).

Future Value

The Future Value of a cash flow represents the amount, at some time in the future, that an investment made today will grow to if it is invested to earn a specific interest rate.