Chapter 1:
THE FIRM AND THE FINANCIAL MANAGER
Organizing a Business
Sole Proprietorship
- is the simplest business form under which one can
operate a business. It does not have a separate legal
entity. It simply refers to a person who owns the
business and is personally responsible for its debts.
- is an individual entity that is separate and distinct
from the owner.
Partnerships
- is form by two or more persons binding themselves to
contribute money, property or industry to a common
fund, with the intention of dividing the profits among
themselves.
- The partnership is an individual entity that is
separate and distinct from each of the partners.
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- Two or more persons may also form a partnership for the
exercise of profession.
- Partnership Agreement set out how management decisions are
to be made and the proportion of the profits that each
partner is entitled to.
Corporation
is an artificial being created by operation of law,
having the right of succession and the powers,
attributes and properties expressly authorized by law
or incident to its existence.
Articles of incorporation set out the purpose of the business
and how it is to be financed, managed and governed.
Corporations have limited liability - corporate
creditors have claims against corporate assets only
which means that the owners are not personally
responsible for the corporation’s debt.
Separation of ownership and management is one distinctive
feature of corporations.
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Characteristics of business organizations
Who owns the business?
Are managers andowner(s) separate?
What is the owner’sliability?
Are the owner andbusiness taxed separately?
Main Role of a Financial Manager
Financial activities of a firm is one of the most important
and complex activities of a firm. Therefore in order to take
care of these activities a financial manager performs all
the requisite financial activities.
REAL ASSETS are assets used to produce goods and
services.
FINANCIAL ASSETS - Claims to the income generated by
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Themanager Partners
Shareholders
No No Usually
Unlimited Unlimited Limited
No No Yes
real assets. Also called securities.
A financial manger is a person who takes care of all the
important financial functions of an organization. The person
in charge should maintain a farsightedness in order to
ensure that the funds are utilized in the most efficient
manner. His actions directly affect the Profitability,
growth and goodwill of the firm.
a. Capital Budgeting Decision is the planning process used to
determine whether an organization's long term
investments such as new machinery, replacement
machinery, new plants, new products, and research
development projects are worth the funding of cash
through the firm's capitalization structure (debt,
equity or retained earnings). It is the process of
allocating resources for major capital, or
investment, expenditures.
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Chief Financial Officer (CFO)
Responsible for:Financial Policy
Corporate Planning
TreasurerResponsible for:Cash ManagementRaising Capital
Banking Relationship
ControllerResponsible for:Preparation of
Financial StatementsAccounting-Taxes
b. Financial Decision is concerning the liabilities and
stockholders' equity side of the firm's balance
sheet, such as a decision to issue bonds.
Who is The Financial Manager?
Financial Manager refers to anyone responsible for a
significant corporate investment or financing decision. They
hold the most important ingredient of a company in the palm of
their hands, management of cash flow of a company. Since
financial managers can be found in almost every organization,
it is important to understand their role in an organization.
Financial manager faces two basic problems.
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TreasurerResponsible for:Cash ManagementRaising Capital
Banking Relationship
ControllerResponsible for:Preparation of
Financial StatementsAccounting-Taxes
Goals of Corporation
Maximize Profit - A company's most important goal is to make
money and keep it. Profit-margin ratios are one way to
measure how much money a company squeezes from its total
revenue or total sales.
Minimize cost- Companies use cost controls to manage and/or
reduce their business expenses. By identifying and
evaluating all of the business's expenses, management can
determine whether those costs are reasonable and affordable.
The cost-control process seeks to manage expenses ranging
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from phone, internet and utility bills to employee payroll
and outside professional services.
Shareholders want managers to maximize market value-
Companies are always looking to expand their share of the
market, in addition to trying to grow the size of the total
market by appealing to larger demographics, lowering prices
or through advertising. Market share increases can allow a
company to achieve greater scale in its operations and
improve profitability.
Chapter 2:
THE FINANCIAL ENVIRONMENT
A financial environment is a part of an economy with the
major players being firms, investors, and markets. Essentially,
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this sector can represent a large part of a well-developed
economy as individuals who retain private property have the
ability to grow their capital. Firms are any business that offers
goods or services to consumers. Investors are individuals or
businesses that place capital into businesses for financial
returns. Markets represent the financial environment that makes
this all possible.
FINANCIAL MARKETS
Stock Market
Financial Market is a market in which people and entities
can trade financial securities, commodities, and other fungible
items of value at low transaction costs and at prices that
reflect supply and demand. Securities include stocks and bonds,
and commodities include precious metals or agricultural goods.
Primary Market is the part of the capital market that deals
with issuing of new securities. Companies, governments or public
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sector institutions can obtain funds through the sale of a new
stock or bond issues through primary market.
Secondary Market is a market where investors purchase
securities or assets from other investors, rather than from
issuing companies themselves.
Other Financial Market
Fixed-income market is market for debt securities.
Capital Market is a part of a financial system concerned with
raising capital by dealing in shares, bonds, and other long-term
investments.
Money Market is the trade in short-term loans between banks
and other financial institutions.
Financial Intermediaries
It is an entity which acts as a middleman between two
parties in a financial transaction. While a commercial bank is a
typical financial intermediary, this category also includes other
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financial institutions such as investment banks, insurance
companies, broker-dealers, mutual funds and pension funds.
Financial intermediaries offer a number of benefits to the
average consumer including safety, liquidity and economies of
scale.
A financial intermediary is an organization that raises money
from investors and provides financing for individuals, companies,
and other organizations. For corporations, intermediaries are
important sources of financing. Intermediaries are a stop on the
road between savings and real investment.
Mutual funds raise money by selling shares to investors. The
investors’ money is pooled and invested in a portfolio of
securities. Investors can buy or sell shares in mutual funds as
they please, and initial investments are often $3,000 or less.
Mutual funds offer investors low-cost diversification and
professional management. For most investors, it’s more efficient
to buy a mutual fund than to assemble a diversified portfolio of
stocks and bonds.
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Issue debt (borrower)
There are other ways of pooling and investing savings and
one is the pension plan. The most common type of plan is the
defined-contribution plan. In this case, a percentage of the
employee’s monthly paycheck is contributed to a pension fund.
Contributions from all participating employees are pooled and
invested in securities or mutual funds. The balance in the plan
can be used to finance living expenses after retirement. Pension
funds are designed for long-run investment. They provide
professional management and diversification. They also have an
important tax advantage: Contributions are tax-deductible, and
investment returns inside the plan are not taxed until cash is
finally withdrawn.
Financial Institutions
An establishment that focuses on dealing with financial
transactions, such as investments, loans and deposits.
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COMPANY INVESTORS
Invest 2.5M
Conventionally, financial institutions are composed of
organizations such as banks, trust companies, insurance companies
and investment dealers. Almost everyone has deal with a financial
institution on a regular basis. This includes the financial
institution (such as a bank, credit union, finance company,
insurance company, stock exchange, and brokerage.
Functions of Financial Markets and Intermediaries
Transporting Cash across Time
Individuals need to transport expenditures in time. If you
have money now that you wish to save for a rainy day, you
can (for example) put the money in a savings account at a
bank and withdraw it with interest later. If you don’t have
money today, say to buy a car, you can borrow money from the
bank and pay off the loan later. Modern finance provides a
kind of time machine. Lenders transport money forward in
time; borrowers transport it back.
Liquidity
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The degree to which an asset or security can be bought or
sold in the market without affecting the asset's price.
Liquidity is characterized by a high level of trading
activity. Assets that can be easily bought or sold are known
as liquid assets.
The Payment Mechanism
Think how inconvenient life would be if you had to pay for
every purchase in cash or if Boeing had to ship truckloads
of hundred-dollar bills around the country to pay its
suppliers. Checking accounts, credit cards, and electronic
transfers allow individuals and firms to send and receive
payments quickly and safely over long distances.
Reducing Risk
The chance that an investment's actual return will be
different than expected. Risk includes the possibility of
losing some or all of the original investment. Different
versions of risk are usually measured by calculating the
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standard deviation of the historical returns or average
returns of a specific investment.
Provide information
In well-functioning financial markets, you can see what
securities and commodities are worth, and you can see—or at
least estimate—the rates of return that investors can expect
on their savings. The information provided by financial
markets is often essential to a financial manager’s job.
Here are three examples of how this information can be used.
Chapter 3
ACCOUNTING and FINANCE
A financial statement (or financial report) is a formal record of
the financial activities of a business, person, or other entity.
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It is a summary report that shows how a firm has used the
funds entrusted to it by its stockholders (shareholders) and
lenders, and what is its current financial position. The three
basic financial statements are the (1) balance sheet, which shows
firm's assets, liabilities, and net worth on a stated date; (2)
income statement (also called profit & loss account), which shows
how the net income of the firm is arrived at over a stated
period, and (3) cash flow statement, which shows the inflows and
outflows of cash caused by the firm's activities during a stated
period.
Types of Financial Statements
- Balance Sheet or Statement of Financial Position
- Income Statement or Statement of Financial Performance
- Statement of Cash Flow
- Statement of Changes in Shareholder’s Equity
- Statement of Comprehensive Income
- Notes and Supporting details
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BALANCE SHEET OR FINANCIAL POSITION
- An accountant’s snapshot of the firm’s accounting value
on a particular date, as though the firm stood
momentary still.
- States what the firm owns and how it is financed.
- A summary of a management's performance as reflected in
the profitability (or lack of it) of an organization
over a certain period. It itemizes the revenues and
expenses of past that led to the current profit or
loss, and indicates what may be done to improve the
results.
Assets = Liabilities + Stockholders’ equity
Sections of the balance sheet:
Assets - resources of the firm that are expected to increase
or cause future cash flows (everything the firm owns)
Liabilities - obligations of the firm to outsiders or claims
against its assets by outsiders (debts of the firm)
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Owners’ Equity - the residual interest in, or remaining
claims against, the firm’s assets after deducting
liabilities (rights of the owners)
INCOME STATEMENT
- Measures performance over a specific period of time,
say, a year.
- It is composed of the following two elements:
Income: What the business has earned over a period
(e.g. sales revenue, dividend income, etc)
Expense:The cost incurred by the business over a
period (e.g. salaries and wages, depreciation
rental charges, etc)
The accounting definition of income is:
Revenue – Expenses = Income
STATEMENT OF CASH FLOWS
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- One of the quarterly financial reports any publicly
traded company is required to disclose to the SEC and
the public. The document provides aggregate data
regarding all cash inflows a company receives from both
its ongoing operations and external investment sources,
as well as all cash outflows that pay for business
activities and investments during a given quarter.
- Reports the sources and uses of cash by operating activities,
investing activities, financing activities, and certain supplemental
information for the period specified in the heading of
the statement. The statement of cash flows is also
known as the cash flow statement.
Classification of Cash flow Activities
1. Operating Activities – key indicator of the extent to
which the operations of the enterprise have
generated sufficient cash flows to repay loans,
maintain the operating capability of enterprise, pay
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dividends and make new investments without recourse
to external sources of financing.
2. Investing Activities –cash flow which extent to which the
expenditures have been made for resources intended
to generate future income and cash flow. It includes
acquiring and selling, or otherwise disposing of (a)
securities that are not cash equivalents and (b)
productive assets that are expected to benefit the
firm for long term periods of time; and lending
money and collecting on loans.
3. Financing Activities is important in predicting claims on
future cash flows by providers of capital to the
enterprise. It include borrowing from creditors and
repaying the principal; and obtaining resources from
owners and providing them with a return on the
investment.
STATEMENT OF CHANGES IN SHAREHOLDER’S EQUITY
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- Often referred to as Statement of Retained Earnings in
U.S. GAAP, details the change in owners' equity over an
accounting period by presenting the movement in
reserves comprising the shareholders' equity.
- Statement of changes in equity helps users of financial
statement to identify the factors that cause a change
in the owners' equity over the accounting periods.
Whereas movement in shareholder reserves can be
observed from the balance sheet, statement of changes
in equity discloses significant information about
equity reserves that is not presented separately
elsewhere in the financial statements which may be
useful in understanding the nature of change in equity
reserves
STATEMENT OF COMPREHENSIVE INCOME
- is the change in equity (net assets) of a business
enterprise during a period from transactions and other
events and circumstances from non-owner sources.
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- It illustrates the financial performance and results of
operations of a particular company or entity for a
period of time.
NOTES and SUPPORTING DETAILS
Additional information provided in a company's financial
statements. Footnotes to the financial statements report the
details and additional information that are left out of the main
reporting documents, such as the balance sheet and income
statement. This is done mainly for the sake of clarity because
these notes can be quite long, and if they were included, they
would cloud the data reported in the financial statements.
THE MARKET VALUE VERSUS BOOK VALUE
Book Value literally means the value of the business
according to its "books" or financial statements. In this case,
book value is calculated from the balance sheet, and it is the
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difference between a company's total assets and total
liabilities.
Market Value is the value of a company according to the stock
market. Market value is calculated by multiplying a company's
shares outstanding by its current market price.
There are three basic generalizations about the relationships
between book value and market value:
Book Value Greater Than Market Value: The financial market
values the company for less than its stated value or net
worth. When this is the case, it's usually because the market
has lost confidence in the ability of the company's assets to
generate future profits and cash flows.
Market Value Greater Than Book Value: The market assigns a
higher value to the company due to the earnings power of the
company's assets.
Book Value Equals Market Value: The market sees no compelling
reason to believe the company's assets are better or worse
than what is stated on the balance sheet.
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Chapter 4:
The Time Value of Money
Time Value of Money (TVM) is an important concept in financial
management. It can be used to compare investment alternatives and
to solve problems involving loans, mortgages, leases, savings,
and annuties.
Future Values
Future Value - Amount to which an investment will grow after
earning interest.
Compound Interest - Interest earned on interest.
Simple Interest - Interest earned only on the original
investment.
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Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Interest Earned Per Year = 100 x0 .06 = $ 6
Present Values
Present Value
- Value today of a future cash flow.
Discount Factor
- Present value of a $1 future payment.
Discount Rate
- Interest rate used to compute present values
of future cash flows.
Example:
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PV F V r t 1
1( )PV= Future Value after t periods(1+r)t
You just bought a new computer for $3,000. The payment terms are 2 years
same as cash. If you can earn 8% on your money, how much money should you set
aside today in order to make the payment when due in two years?
The PV formula has many applications. Given any variables
in the equation, you can solve for the remaining variable.
PV of Multiple Cash Flows
Your auto dealer gives you the choice to pay $15,500 cash now, or make three
payments: $8,000 now and $4,000 at the end of the following two years. If your cost of
money is 8%, which do you prefer?
PVs can be added together to evaluate multiple cash flows.
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PV= 3000(1.08 )2
=$2,572
Immediate payment 8,000.00PV1=
4,000(1+.08)1
=3,703.70
PV2=4,000
(1+.08)2=3,429.36
Total PV = $15,133.06
PV=C1
(1+r )1+
C2
(1+r)2+....
Perpetuities & Annuities
Perpetuity- A stream of level cash payments that never
end.
Annuity- Equally spaced level stream of cash flows for a
limited period of time.
PV of Perpetuity Formula
C = cash payment r = interest rate
Example:
In order to create an endowment, which pays $100,000 per year, forever, how much
money must be set aside today in the rate of interest is 10%?
If the first perpetuity payment will not be received until three years from today, how
much money needs to be set aside today?
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PV=Cr
PV=100 ,000.10 =$1,000,000
PV of Annuity Formula
C = cash payment
r = interest rate
t = Number of years cash payment is received
PV Annuity Factor (PVAF)
- The present value of $1 a year for each of t
years.
Inflation
- Rate at which prices as a whole are increasing.
Nominal Interest Rate
- Rate at which money invested grows. 27 | P a g e
PV=1,000,000(1+.10 )3
=$751,315
PV=C [ 1r− 1r(1+r )t ]
PVAF=[ 1r− 1r (1+r )t ]
Real Interest Rate
- Rate at which the purchasing power of an
investment increases.
Example
If the interest rate on one year govt. bonds is 5.0% and the inflation rate is 2.2%,
what is the real interest rate?
Effective Annual Interest Rate
- Interest rate that is annualized using compound
interest.
Annual Percentage Rate
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1+real interest rate= 1+nominal interest rate1+inflation rate
Real int. rate≈nominal int. rate-inflation rate
- Interest rate that is annualized using simple
interest.
Chapter 5:
Bond Valuation
Valuation Fundamentals
A bond is an IOU issued by a corporation, government, or
governmental agency to cover money the bondholder has lent. If
you own stock in a company, you are a part owner of the company.
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Valuation
As a bondholder, you are a creditor.Although less exciting than
stocks, bonds play a critical role in our economy and an
important role in every well-balanced portfolio.
Returns from bonds are generally lower than stocks; however,
they're a much safer investment. Bonds' safety and stability act
as a counter to the fluctuations common to stocks.
Most investors should have a mix of stocks and bonds in their
portfolio. The more risk you are able and willing to take the
higher percentage of stocks in your portfolio. The more
conservative investor will want a higher percentage of bonds.
Look at my article on the basics of asset allocation.
Bonds are debt instruments used by business and governmentto raise large sums of money
Most bonds share certain basic characteristics.
First, a bond promises to pay investors a fixed amountof interest, called the bond’s coupon.
Second, bonds typically have a limited life, ormaturity.
Third, a bond’s coupon rate equals the bond’s annualcoupon payment divided by its par value.
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Fourth, a bond’s coupon yield equals the coupon paymentdivided by the bond’s current market price.
Corporations issue bonds as a way to borrow large sums of money.
Companies have two basic ways to raise money for expansion,
acquisitions, or other uses. They can issue stock or borrow the
money.Corporate bonds usually come in 1,000 denominations and
have maturities ranging up to 40 years, but are usually shorter.
Municipal governments also issue bonds, which they often use to
build roads or perform other infrastructure projects.
BOND MARKETS
1. Issuing Market (Primary market): The period starts from
issuer's planning stage to passes a series of procedures and
finally until bond is handed to subscribers.
2. Trading Market (Secondary Market): The market for investors to
trade bonds or for bondholders to sell bonds for cash. Recently,
bond tradingmainly deals in the OTC market, only a few bond
trading prosecutes onthe main market. In order to make bond
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trading more smoothly and safely, GTSM sets up all kinds of
regulations to standardize the market.
TYPES OF BONDS
GovernmentBonds
In general, fixed-income securities are classified according to
the length of time before maturity. These are the three main
categories:
Bills - debt securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.
Municipal Bonds
Municipal bonds, known as "munis", are the next progression in
terms of risk. Cities don't go bankrupt that often, but it can
happen. The major advantage to munis is that the returns are free
from federal tax. Furthermore, local governments will sometimes
make their debt non-taxable for residents, thus making some
municipal bonds completely tax free. Because of these tax
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savings, the yield on a muni is usually lower than that of a
taxable bond. Depending on your personal situation, a muni can be
a great investment on an after-tax basis.
Corporate ]Bonds
A company can issue bonds just as it can issue stock. Large
corporations have a lot of flexibility as to how much debt they
can issue: the limit is whatever the market will bear. Generally,
a short-term corporate bond is less than five years; intermediate
is five to 12 years, and long term is over 12 years.
Corporate bonds are characterized by higher yields because there
is a higher risk of a company defaulting than a government. The
upside is that they can also be the most rewarding fixed-income
investments because of the risk the investor must take on. The
company's credit quality is very important: the higher the
quality, the lower the interest rate the investor receives.
Convertible Bonds
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Other variations on corporate bonds include convertible bonds,
which the holder can convert into stock, and callable bonds,
which allow the company to redeem an issue prior to maturity.
Zero-Coupon bonds
This is a type of bond that makes no coupon payments but instead
is issued at a considerable discount to par value. For example,
let's say a zero-coupon bond with a $1,000 par value and 10 years
to maturity is trading at $600; you'd be paying $600 today for a
bond that will be worth $1,000 in 10 years.
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV of lump sum
Remember, as interest rates increase, the PVs decrease
So, as interest rates increase, bond prices decrease and viceversa
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P0 = Price of asset at time 0 (today)
CFt = cash flow expected at time t
r = discount rate (reflecting asset’s risk)
n = number of discounting periods (usually years)
Bonds: Premiums & Discounts
The bond's value will differ from its par value
Yield to Maturity (YTM)
- Rate of return investors earn if they buy the bond at P0 and
hold it until maturity.
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- The YTM on a bond selling at par will always equal the
coupon interest rate.
- YTM is the discount rate that equates the PV of a bond’s
cash flows with its price.
Chapter 6:
Stock Valuation
Debt
Debt securities represent a legally enforceable claim.
Debt securities offer fixed or floating cash flows.
Bondholders don’t have any control over how the companyis run.
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R < Coupon Interest Rate
Equity
Common stockholders are residual claimants
• No claim to earnings or assets until all senior claimsare paid in full
• High risk, but historically also high return
Stockholders have voting rights on important companydecisions.
Debt and equity have substantially different marginal benefits andmarginal costs.
Two Main Types Of Stocks
CommonStock
Common stock is, well, common. When people talk about stocks they
are usually referring to this type. In fact, the majority of
stock is issued is in this form. We basically went over features
of common stock in the last section. Common shares represent
ownership in a company and a claim (dividends) on a portion of
profits. Investors get one vote per share to elect the board
members, who oversee the major decisions made by management. Over
the long term, common stock, by means of capital growth, yields
higher returns than almost every other investment. This higher
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return comes at a cost since common stocks entail the most risk.
If a company goes bankrupt and liquidates, the common
shareholders will not receive money until the creditors,
bondholders and preferred shareholders are paid.
PreferredStock
Preferred stock represents some degree of ownership in a company
but usually doesn't come with the same voting rights. (This may
vary depending on the company.) With preferred shares, investors
are usually guaranteed a fixed dividend forever. This is
different than common stock, which has variable dividends that
are never guaranteed. Another advantage is that in the event of
liquidation, preferred shareholders are paid off before the
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Share
s issued and outstandin
g
Number of shares owned by
stockholders
common shareholder (but still after debt holders). Preferred
stock may also be callable, meaning that the company has the
option to purchase the shares from shareholders at anytime for
any reason (usually for a premium).
Preferred stock is a hybrid having some features similar to debtand other features similar to equity.
Claim on assets and cash flow senior to common stock As equity security, dividend payments are not tax
deductible for the corporation. For tax reasons, straight preferred stock held mostly
by corporations.
Valuing Preferred Stock
• Because preferred stock pay a constant dividend, they areeasy to value because the dividends are perpetuity.
• Recall the present value of a perpetuity is:
• Where : D1 is the constant dividend whose first payment is one period from today
Example:
You purchase a preferred stock with a $12 per year dividend. Fora 10% market rate, what is its value?
Book value
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PV=PMTi =
D1i
Price=PV=D1i =
$120.10
=$120.00
Net assets per share available to common stockholdersafter liabilities are paid in full
Net worth of the firm according to the balance sheet
Liquidation value
Actual net amount per share likely to be realized uponliquidation & payment of liabilities
Net proceeds that could be realized by selling thefirm’s assets and paying off its creditors.
More realistic than book value, but doesn’t considerfirm’s value as a going concern
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