Chapter 1:
4 major types of firms:
1. sole proprietorship: owned/run by 1 person, few employees. Personally liable, life
limited to life of owner
2. partnership: >1 owners, all liable for firm’s debt, ends when a partner dies
a. limited partnerships: when certain partners only have limited liability, but
cannot manage the company
3. limited liability company (LLC): all owners have limited liability, but can manage the
company.
4. Corporations: legal entity, separate from its owners. Can enter into contracts.
Ownership is based on stocks, whose owners are entitled to dividends.
a. Double taxation: the firm pays taxes and then the dividend receivers do too (S
Corps prevent this)
b. Shareholder elect the board of directors. BoD determines how company is run
& compensation for top managers.
c. CEO runs the company using rules and policies set by BoD.
Financial Managers: responsibilities
1. Investment decisions: weigh costs and benefits of investments
2. Financing decisions: how to pay for said investments (sell shares / borrow)
3. Cash management: ensure that firm has enough cash to pay for day-to-day
obligations
Goal of the firm: should be determined by the firm’s owners. Shareholders may have
different priorities, but most want the value of their shares to increase
Firm and society: mostly, what is good for the firm is good for society. Not if pollution / 2008
crash.
Ethics and incentives in corporations: managers may have conflicts of interest
- Agency problems: managers may put their own interest before firm’s interest. How
to solve?
- Limit the # decisions where self-interest and firm-interest conflict.
- Tie firm performance to manager compensation (however not too much,
otherwise too much risk taking)
- Shareholders can pressure BoD to fire CEO if the CEO underperforms.
- Firms with good management’s stock price rises and bad firm’s drops.
- Threat of hostile takeover may help discipline bad managers
- When some stakeholders in the corporation benefit and others lose from a decision
- Keeping a badly-running factory open to provide jobs in a small town, against
the interest of shareholders
,hostile takeover: when someone can purchase a large fraction of stocks and get enough
votes to replace the BoD & CEO.
- New management team may be better → increase in stock price → profit for the
corporate raider
Corporate bankruptcy: when a firm fails to repay its debts, the end result is a change in
ownership of the firm, with control passing from equity holders to debt holders.
- Doesn’t necessarily lead to selling all the assets (liquidation). May be in best interest
of debt holders to let the firm run as profitably as possible.
public companies’ shares are traded on stock exchanges.
- The exchange provides liquidity (how quickly you could sell it close to buying price)
- Liquidity important for investors, provides flexibility for timing and duration of their
investment.
primary market: when the firm issues new shares and sell to investors
secondary market: trading between investors without involvement of the firm
market makers: match buyers and sellers on an exchange
- bid/ask: the price at which they’re willing to buy and willing to sell
- bid/ask spread: how they made money, difference in buy/sell price, compensation
for the liquidity they provide
- Would buy a stock even if they didn’t have another one to sell to immediately →
provide liquidity
limit order: an order to buy or sell a set amount at a fixed price (makers of liquidity)
- determines the bid-ask spread:
- Ask = limit sell order with the lowest price
- Bid = limit buy order with highest price
- You earn the bid-ask spread, but risk have your order become ‘stale’ (news changes
price of stock)
market order: orders that trade immediately at the best outstanding limit order (takers of
liquidity)
High frequency traders: buy and sell stocks really fast to adjust to new news and take
advantage of ‘stale’ orders.
dark pools: alternative trading system in which the limit order book is invisible.
- Offer ability to trade at a better price (e.g., the average of the bid and ask, thus
saving the bid-ask spread), with the tradeoff being that the order might not be filled if
an excess of either buy or sell orders is received.
- Thus, attractive to traders who do not want to reveal their demand and who are
willing to sacrifice the guarantee of immediacy for a potentially better price.
,Chapter 2: Intro into Fin Statement
Analysis
Balance sheet: shows assets and liabilities of a firm
- Assets: cash, inventory, PP&E, and other investments the company has made
- Liabilities: obligations to creditors
- Stockholders’ equity, the difference between the firm’s assets and liabilities, an
accounting measure of the firm’s net worth..
- Assets = Liabilities + Stockholders’ Equity
Current assets: cash/assets convertible to cash within a year
- Accounts receivable / inventories / pre-paid expenses
Long-term assets: net PP&E, accumulated depreciation decreases the value of the assets
- book value = asset - accumulated depreciation
- goodwill: the amount extra paid over book-value of other firm when buying that firm
- amortization: decreasing value of intangible assets over time.
Current liabilities: satisfied within one year
- Accounts payable / short-term debt, deferred / unearned revenue
Long-term liabilities:
- long-term debt / capital leases / deferred taxes
net working capital: CA - CL. Capital available to run the business
True value of a company is not captured on a balance sheet
- Based on historical cost, not on actual value to the company
- Company may have very good employees with a lot of human capital, which is not
captured by the balance sheet
- Therefore: market value =/= book value
market cap: shares outstanding * share price
market-to-book Ratio: market cap / book value of equity (stockholders equity)
- if low → value stock, if high → growth stock
Enterprise value: the cost to take over the business.
- Enterprise Value = Market Value of Equity + Debt - Cash
Income statement: firm’s revenues and expenses over a period of time
- Gross profit: difference between revenues and costs (Revenue - COGS)
- Operating expenses: expenses related to running business but not COGS
- Operating income = gross profit - operating expenses
- EBIT: Earnings Before Interest and Taxes, includes sources of income/expenses not
related to core business of company (investments)
- Pretax income: EBIT - interest expenses
, - Net income: subtract taxes as well
Earnings per share (EPS) = Net Income / shares outstanding
- stock options: give the holder the right to buy a certain number of shares
by a specific date at a specific price → may increase # shares outstanding
- dilution: NI divided by a higher # of shares → report diluted EPS (takes
possible increase of shares into account)
- convertible bonds: debt convertible to shares → may increase # shares outstanding
Statement of Cash flows: uses info from the IS and BS to determine how much cash the
firm has generated, has been allocated, during a set period.
- Income statement does NOT indicate the amount of cash generated, because
1. there are non-cash entries of the CFS (depr, amor)
2. Certain uses of cash are not reported on CFS (buying a building)
CFS, divided into three sections:
1. operating activities: starts with Net Inc from IS, adds back all non-cash entries from
operating activities (add back depr, deferred taxes, stock-based compensation)
a. Deduct increases in Accounts Receivable (b/c cash not received yet)
b. Add increases in Accounts Payable (b/c cash did not yet leave)
c. Deduct increases in Inventory (is a cash expense not factored into NI)
2. investment activities: lists cash used for investments
a. Subtract capital expenditures (purchases of PP&E, assets, long-term
investments)
3. financing activities: flow of cash between the firm and its investors (dividends)
a. Retained Earnings = Net Income - Dividends
statement of stockholders’ equity: breaks down the stockholders’ equity computed
on the balance sheet into the amount that came from issuing shares (par value plus paid-in
capital) versus retained earnings
- not useful in assessment of value of company
management discussion and analysis (MD&A): management discusses the recent year
(or quarter), providing a background on the company and any significant events that may
have occurred.
- Must also mention off-balance sheet transactions: things not on balance sheet but
are material to company’s future
Ratios
Profitability ratios:
Gross margin = Gross Profit / Sales (revenues)
Operating margin = Operating Income / Sales
EBIT margin = EBIT / Sales
Net profit margin = Net Income / Sales
