Real assets: generate net income to economy

- Natural resources, physical capital, intangibles

Financial assets: specify level, timing, and condition for payment of cash, goods, other financial assets

- Money, debt, equity, derivatives

Divisibility: extent to which fractions of asset can be traded

Liquidity: extent to which asset can be sold quickly

Standardization: units of asset are same

1. Maximize shareholders' wealth

2. Maximize share price

3. Maximize firm value

Definition: relationship between stockholders and managers

Reduce agency problems and agency costs:

Managerial compensation, corporate control

Marginal tax rate

Average tax rate

Marginal rate: rate of last taxable dollar

Average rate: total taxes paid / taxable income

Three steps to get from Income to Cash Flow

(Lecture 2)

Calculate operating cash flow (OCF)

- Adjusted for taxes and depreciation

Calculate net capital spending

- Adjusted for money reinvested for long-term

Calculate change in NWC (CA - CL)

- Adjusted for money reinvested for short-term

OCF = net income + depreciation + interest paid

OCF = EBIT + depreciation - taxes

= (Sales-costs)x(1-t) + depreciation x t

Common-size B/S: compute all accounts as % of total assets

Common-size I/S: compute all line items as % of sales

Easier to compare F/S between companies

Take numerous lines from F/S and interpret in meaningful way; better comparison through time and between companies

Categories:

Short-term solvency (liquidity), long-term solvency (financial leverage), asset management (turnover), profitability, market value

Profit margin: operating efficiency

Total asset turnover: asset use efficiency

Financial leverage: choice of optimal debt ratio

Dividend policy: choice of how much to pay shareholders vs. reinvesting in company

Real Interest Rate (L4)

Inflation

Rate at which all facets of money are valued equally (converted into physical capital, consumption, and medium of exchange)

Inflation: change in purchasing power of money

Nominal rate = [(1+real rate) x (1+inflation)] - 1

R = [(1+r)(1+h)] - 1

FOCUS ON NOMINAL RATE

FV_t = C₀(1+r)^t

C₀ = CF at time t=0

(1+r)^t = FV interest factor

PV0 = C_t / (1+r)^t

1 / (1+r)^t = discount factor

- For a given interest rate, longer t means lower discount factor (present value)

- For a given t, a higher interest rate means a smaller present value

Periodic Rate = Stated rate / # of payments per year

Number of periods = number of years x periods per year

Higher frequency in compounding, greater is the future value

APR: annual rate that is quoted by law

APR = period rate * number of periods per year

To get period rate:

Period rate = APR/number of periods per year

Actual annual rate paid after accounting for compounding that occurs during year

Need to use EAR to compare alternative investments

EAR is the equivalent of period rate

Pure discount: borrower gets money today and repays a single lump sum (principal+interest) in future

Interest-only: interest paid each month, entire principal repaid at some future date

Amortized loans: part of principal repaid over time; usually a single, fixed payment per month