FINANCIAL MARKETS

Finance is defined by Webster’s Dictionary as “the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking
facilities.”

Areas of finance: (1) financial management, (2) capital markets, and (3) investments.

Financial management, also called corporate finance, focuses on decisions relating to how
much and what types of assets to acquire, how to raise the capital needed to purchase
assets, and how to run the firm so as to maximize its value.

Capital markets relate to the markets where interest rates, along with stock and bond
prices, are determined.

Investments relate to decisions concerning stocks and bonds and include a number of
activities:

(1) Security analysis deals with finding the proper values of individual securities (i.e.,
stocks and bonds).

(2) Portfolio theory deals with the best way to structure portfolios, or “baskets,” of
stocks and bonds.

(3) Market analysis deals with the issue of whether stock and bond markets at any
given time are “too high,” “too low,” or “about right.”

Sarbanes-Oxley Act -A law passed by Congress that requires the CEO and CFO to certify
that their firm’s financial statements are accurate.

Proprietorship- An unincorporated business owned by one individual.

Partnership- An unincorporated business owned by two or more persons.

Corporation- A legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability.

S Corporations -A special designation that allows small businesses that meet qualifications
to be taxed as if they were a proprietorship or a partnership rather than a corporation.

Limited Liability Company (LLC) -A popular type of organization that is a hybrid between
a partnership and a corporation.

Limited Liability Partnership (LLP) -Similar to an LLC but used for professional firms in
the fields of accounting, law, and architecture. It provides personal asset protection from
business debts and liabilities but is taxed as a partnership.

Intrinsic Value -An estimate of a stock’s “true” value based on accurate risk and return
data. The intrinsic value can be estimated, but not measured precisely.
Market Price- The stock value based on perceived but possibly incorrect information as
seen by the marginal investor.

Marginal Investor -An investor whose views determine the actual stock price.

Equilibrium -The situation in which the actual market price equals the intrinsic value, so
investors are indifferent between buying and selling a stock.

Corporate Governance- Establishment of rules and practices by Board of Directors to

ensure that managers act in shareholders’ interests while balancing the needs of other key
constituencies.

Compensation packages- should be sufficient to attract and retain able managers, but
they should not go beyond what is needed.

Shareholder Wealth Maximization- The primary financial goal for managers of publicly
owned companies implies that decisions should be made to maximize the long-run value of
the firm’s common stock.

Physical asset markets - (also called “tangible” or “real” asset markets) are for products
such as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the
other hand, deal with stocks, bonds, notes, and mortgages.

Spot Markets- The markets in which assets are bought or sold for “on-the-spot” delivery.

Futures Markets -The markets in which participants agree today to buy or sell an asset at
some future date.

Money Markets- The financial markets in which funds are borrowed or loaned for short
periods (less than one year).

Capital Markets- The financial markets for stocks and for intermediate- or long-term debt
(one year or longer).

Primary Markets -Markets in which corporations raise capital by issuing new securities.

Secondary Markets -Markets in which securities and other financial assets are traded
among investors after they have been issued by corporations.

Private Markets- Markets in which transactions are worked out directly between two or
more parties.

Public Markets -Markets in which standardized contracts are traded on organized

exchanges.

Derivatives -Any financial asset whose value is derived from the value of some other
“underlying” asset.
Investment Bank- An organization that underwrites and distributes new investment
securities and helps businesses obtain financing.

Commercial Bank -The traditional department store of finance serving a variety of savers
and borrowers.

Financial Services -Corporation A firm that offers a wide range of financial services,
including investment banking, brokerage operations, insurance, and commercial banking.

Credit unions- are cooperative associations whose members are supposed to have a
common bond, such as being employees of the same firm.

Pension funds- are retirement plans funded by corporations or government agencies for
their workers and administered primarily by the trust departments of commercial banks or
by life insurance companies.

Life insurance- companies take savings in the form of annual premiums; invest these
funds in stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries
of the insured parties.

Mutual Funds- Organizations that pool investor funds to purchase financial instruments
and thus reduce risks through diversification.

Money Market Funds- Mutual funds that invest in short-term, low-risk securities and
allow investors to write checks against their accounts.

Physical Location Exchanges -Formal organizations having tangible physical locations

that conduct auction markets in designated (“listed”) securities.

Over-the-Counter (OTC) Market- A large collection of brokers and dealers, connected

electronically by telephones and computers, that provides for trading in unlisted securities.

Dealer Markets- Include all facilities that are needed to conduct security transactions not
conducted on the physical location exchanges.

Publicly Owned Corporation- A corporation that is owned by a relatively large number of

individuals who are not actively involved in the firm’s management.

Going Public- The act of selling stock to the public at large by a closely held corporation or
its principal stockholders.

Initial Public Offering (IPO) Market -The market for stocks of companies that are in the
process of going public.

Annual Report -A report issued annually by a corporation to its stockholders. It contains

basic financial statements as well as management’s analysis of the firm’s past operations
and future prospects.
Four basic financial statements:

1) The balance sheet, which shows what assets the company owns and who has
claims on those assets as of a given date—for example, December 31, 2018.
2) The income statement, which shows the firm’s sales and costs (and thus
profits) during some past period—for example, 2018.
3) The statement of cash flows, which shows how much cash the firm began the
year with, how much cash it ended up with, and what it did to increase or
decrease its cash.
4) The statement of stockholders’ equity, which shows the amount of equity the
stockholders had at the start of the year, the items that increased or decreased
equity, and the equity at the end of the year.

Stockholders’ Equity -It represents the amount that stockholders paid the company when
shares were purchased and the amount of earnings the company has retained since its
origination.

Stockholders’ equity= Paid-in capital + Retained earnings

Retained Earnings- They represents the cumulative total of all earnings kept by the
company during its life.

Stockholders’ equity= Total assets -Total liabilities

= $1,000 - $310=$690 million

Net Operating Working Capital (NOWC) -Operating current assets minus operating
current liabilities.

Net operating working capital (NOWC) = Operating current assets - Operating

current liabilities.

= (Current assets - Excess Cash) - (Current liabilities - Notes payable)

= ($1,000 - $0) - ($310 2 $110) = $800 million

Income Statements Reports -summarizing a firm’s revenues, expenses, and profits during
a reporting period, generally a quarter or a year.

Operating Income -Earnings from operations before interest and taxes.

Operating income (or EBIT) = Sales revenues - Operating costs

=$3,000.0 - $2,716.2

= $283.8 million

Depreciation -The charge to reflect the cost of assets depleted in the production process.
Depreciation is not a cash outlay.
Amortization -A noncash charge similar to depreciation except that it represents a decline
in value of intangible assets

EBITDA- An acronym for earnings before interest, taxes, depreciation, and amortization.

Statement of Cash Flows- A report that shows how items that affect the balance sheet and
income statement affect the firm’s cash flows.

Operating activities- This section deals with items that occur as part of normal ongoing
operations.

Net income- The first operating activity is net income, which is the first source of cash.

Depreciation and amortization-The first adjustment relates to depreciation and

amortization

Increase in inventories-To make or buy inventory items, the firm must use cash.

Increase in accounts receivable- If Allied chooses to sell on credit when it makes a sale, it
will not immediately get the cash that it would have received had it not extended credit.

Increase in accounts payable-Accounts payable represent a loan from suppliers.

Increase in accrued wages and taxes- The same logic applies to accruals as to accounts
payable.

Net cash provided by operating activities- All of the previous items are part of normal
operations—they arise as a result of doing business.

Investing activities-All activities involving long-term assets are covered in this section.

Additions to property, plant, and equipment- Allied spent $230 million on fixed assets
during the current year.

Net cash used in investing activities-Because Allied had only one investment activity, the
total on this line is the same as that on the previous line.

Financing activities-Allied’s financing activities are shown in this section

Increase in notes payable-Allied borrowed an additional $50 million from its bank this
year, which was a cash inflow. When Allied repays the loan, this will be an outflow.

Increase in bonds (long-term debt) - Allied borrowed an additional $170 million from
long-term investors this year, issuing bonds in exchange for cash. This is shown as an
inflow. When the bonds are repaid by the firm some years hence, this will be an outflow.

Payment of dividends to stockholders- Dividends are paid in cash, and the $57.5 million
that Allied paid to stockholders is shown as a negative amount.
Summary- This section summarizes the change in cash and cash equivalents over the year.
Net decrease in case- The net sum of the operating activities, investing activities, and
financing activities is shown here.

Cash and equivalents at the beginning of the year-Allied began the year with
$80 million of cash, which is shown here.

Cash and equivalents at the end of the year- Allied ended the year with $10 million of
cash, the $80 million it started with minus the $70 million net decrease that occurred
during the year. Clearly, Allied’s cash position is weaker than it was at the beginning of the
year.

Statement of Stockholders’ Equity -A statement that shows by how much a firm’s equity
changed during the year and why this change occurred.

Free Cash Flow (FCF) -The amount of cash that could be withdrawn without harming a
firm’s ability to operate and to produce future cash flows.

Net Operating Profit After Taxes (NOPAT) - The profit a company would generate if it
had no debt and held only operating assets.

FCF = [EBIT (1 - T) + Depreciation and amortization] - [Capital expenditures + Net

operating working capital]

Market Value Added (MVA) - The excess of the market value of equity over its book value.

Economic Value Added (EVA) -Excess of NOPAT over capital costs.

Progressive- A tax system where the tax rate is higher on higher incomes. The personal
income tax in the United States, which ranges from 0% on the lowest incomes to 39.6% on
the highest incomes, is progressive.

Marginal Tax Rate -The tax rate applicable to the last unit of a person’s income.

Average Tax Rate -Taxes paid divided by taxable income.

Capital Gain- The profit from the sale of a capital asset for more than its purchase price.

Capital Loss-The loss from the sale of a capital asset for less than its purchase price.