Principles of Finance

• The goal of a firm or its financial managers is to maximize shareholders' wealth, equivalent to maximizing the stock price or market value.
• Maximizing accounting profit (earnings, or EPS) is not the goal, as it ignores timing, cash flows, and risk.
• Maximizing stakeholders' welfare isn't feasible because their priorities are difficult to rank.
• In a competitive market, maximizing shareholder wealth requires considering stakeholders' benefits, which are protected by a healthy legal system.

Financial Managers' Key Decisions

• Financing decisions cover raising short-term and long-term funds.
• Investment decisions concern allocating funds/capital in long-term projects.
• Capital budgeting is focused on selecting projects that maximize shareholder value.
• Working capital decisions involve managing short-term resources for daily operations.

Principles of Managerial Decisions

• Time value of money emphasizes that timing matters in financial decisions.
• Risk-return tradeoff means high risk should be balanced with high return, and low risk with low return.
• "Cash is King" principle focuses on cash flows as a key consideration.
• Competitive financial market requires following market demand/supply and responding to market signals.
• Incentive should be provided to both employees and managers.
• Finance adopts the Marginal cost-Marginal benefit analysis from Economics, advising that all financial decisions should result in MB > MC (marginal benefit is greater than marginal cost).

Finance vs. Accounting

• Financial managers focus on actual cash flows (inflows, outflows, and net flows).
• Accountants prepare financial statements on an accrual basis, recognizing revenue at the time of sale, and expenses when incurred.
• Example firm A: $10,000 sale of goods, $8,000 cost; net profit is $2,000, cash flow is -$8,000.

Principal-Agent Problem

• Owners (principal) and managers (agent) have differing interests, leading to agency costs.
• The firm's owners (stockholders) bear agent costs.
• Corporate governance can solve the problem by aligning managers' interests with owners' through stock options or restricted stocks, linking performance/benefits with stock prices.

Corporate Job Functions

• The board of directors makes strategic decisions.
• The President/CEO is in charge of overall business operations.
• The CFO is in charge of overall financial management.
• The Treasurer manages cash, pension plans, and key risks.
• The Controller is responsible for accounting activities, tax management, and cost control.

Organizational Forms

• Sole proprietorship: unlimited liability, taxed on proprietor's personal tax return.
• Partnership: unlimited liability, owners may cover debts of other partners, taxed on partners' personal tax return.
• Corporation: limited liability, double taxation on firm and individual.

Marginal Tax Calculation

• Calculate tax payments for each applicable taxable income bracket using the corresponding marginal tax rate, then sum these amounts.

Ethical Behavior

• Ethical behavior affects share prices.
• The Sarbanes-Oxley Act of 2002 provides ethical guidelines for firms.

Financial Institutions

• Financial institutions channel savings from fund suppliers (individuals) to fund demanders (firms).

Three Types of Financial Institutions

• Commercial banks receive deposits and make commercial loans.
• Investment banks raise capital for companies, advise on transactions, and engage in security trading and market-making.
• Shadow banking system includes insurance companies, mutual funds, that engage in lending without accepting deposits, and they are not subject to traditional banking regulations.

Money Market vs. Capital Market

• The money market trades securities with maturities of one year or less (e.g., Treasury bills, commercial paper, negotiable certificates of deposit).
• The capital market trades securities with maturities over one year or without maturity (e.g., long-term government securities, corporate bonds and stocks, and financial derivatives).

Primary Market vs. Secondary Market

• In primary market, firms issue new financial securities to raise funds through an Initial Public Offering (IPO)
• In secondary market, investors trade pre-owned securities, such as on the NYSE and Nasdaq

Forms of Firm Owners' Income

• Ordinary income includes income from business operations, such as wages, salaries, and dividends
• Capital gains come from selling the firm's assets, including physical and financial assets.

Broker Market vs. Dealer Market

• Both markets trade pre-owned securities.
• Broker markets has a trading floor (e.g., NYSE), brokers bring buyers and sellers together for a transaction, but do not buy or sell securities themselves, they charge commissions.
• In dealer market (e.g., Nasdaq) dealers provide liquidity as "market makers," buying/selling securities; they charge 1/2 bid/ask spread + transaction fees (commissions), so transaction costs are higher than broker markets.

Over-the-Counter (OTC) Market

• OTC market is a financial market where smaller, unlisted securities are traded; trading volumes are small.

Efficient Market Hypothesis (EMH)

• The Efficient Market Hypothesis says that security prices fully reflect all available information; they are in equilibrium and fairly priced.
• Due to quick market equilibrium, investors cannot easily find mispriced securities or make systematic gains.

Behavioral Finance

• It opposes the Efficient Market Hypothesis, and it suggests that stock prices can deviate, which may lead to predictable patterns and potential profit opportunities.

Glass-Steagall Act of 1933

• It prohibited institutions from high-risk securities activities, separating commercial and investment banks.
• Established FDIC provides deposit insurance and examines banks to ensure safe operations.

Gramm-Leach-Bliley Act of 1999

• This act promotes competition in the banking industry by allowing business combinations between commercial banks, investment banks, and insurance companies.

Ways to Raise Capital

• Private placements are raised by selling firms' new securities directly to investors.
• Public offerings are raised by selling bonds or stocks to the public through investment banks in the capital market.

Venture Capital

• Venture capital finances young, rapidly growing firms through equity.
• Venture capitalists invest private equity capital from individuals and institutions.
• Legal agreements define deal structure, operation strategy, IPO timeline, exit strategy, VC repayment terms, and VC equity ownership, where riskier firms require more equity and pay less.

Initial Public Offering (IPO)

• An IPO is a private firm going public by issuing new common stocks in a primary market, resulting in outstanding stocks traded in secondary markets.
• Prospectus is a security registration statement submitted to SEC and potential investors, describing the issue.
• Underwriting is securities purchased by investment bank(s) from issuing corporation at an agreed-on price.
• IPO offer price, the price at which the firm sells securities to public investors.
• Underwriting syndicate spreads the investment opportunities and risks across investment banks.
• Selling group is a large number of brokerage firms which that sell a portion of a new security issue for commission.
• Total proceeds equals IPO offer price multiplied by the number of IPO shares issued.
• Net proceeds equals total proceeds minus issuing costs paid to investment banks.
• Market price is the price of the firm's shares in the secondary market.
• Market capitalization is the market price of stock multiplied by the number of stock shares outstanding
• IPO market price is the final trading price of the first day in the secondary market.
• IPO underpricing equals (market price – offer price) / offer price

Securitization of Mortgage Loans

• Securitization pools mortgages or other loans to create a financial package, and the selling securities are against the pool in the secondary market.
• Mortgage-backed securities represent claims on cash flows generated by the mortgage pool.

Subprime Mortgages

• Subprime mortgages are given to borrowers with lower incomes and credit histories, leading to higher default risks than prime borrowers.

Equilibrium Rate of Interest

• The equilibrium rate of interest is a general prevailing market interest rate, determined by supply and demand in financial markets.
• Nominal rate of interest (r) is actual charged rate.
• Real rate of interest (r*) is return on an investment measured in purchasing power.
• Expected inflation rate (i) is rate of rising prices.
• r* = r – i; r = r* + i means the nominal interest rate is the real interest rate plus an expected inflation rate premium.

Risk-Free Securities

• Risk-free securities have no default risk.
• An interest rate offered by a risk-free security benchmarks the rate in the absence of risk.
• US federal government securities are risk-free; therefore, nominal interest rate offered by T-bills, T-notes, or T-bonds are a common proxy of risk-free rate (R_f), thus: R_f=r* + i.

Risk Premium

• Corporate issued securities (bonds and stoks) are not risk-free , they have either delinquency or default risk, For investors, in order to compensate the risk for an underline security, risk premium (RP_j) is added to make the risk-free rate (Rf).
• r_j = R_f+RP_j

Kinds of Firm Risks

• All kinds of business risks, financial risk, interest rate risk, liquidity risk, and tax risk, default risk and contractual provision risk must be examined when evaluating a firm.
• Moody's, Standard & Poor's, and Fitch evaluate the creditworthiness of bonds.
• A company that earns low risk should have a low risk premium, and a company rated low risk should have a high risk premium.

Yield to Maturity, Term Structure, Yield Curve

• YTM is a estimated compound return rate earned on a debt security until maturity, and it is an estimate of the market's required return on a partucular bond..
• Term structure of interest rates is the relationshop between the maturity and rate of return.
• Yield curve is a graphic depiction of the term structure of interest rates.

Shapes of Yield Curves

• Normal (upward sloping), flat, and inverted (downward sloping) are the three types of slope.
• The theories to explain shapes of yield curves are expectations, liquidity preference, and market segmentation
• The Expectations theory says expected rate could cause any shape of a yield curve.
• The Liquidity preference theory that long-term rate is higher than short-term rates, so creating an upware sloping yield curve.
• The Market segmentation theory assumes market for loans is segmented on the basis of maturity, and the supply and demand determine the slope. Yield curve affect firms financing and investment decisions.
• Financial managers compare short-term or long-term costs.
• Yield curve predicts the economy.
• A positive slope predicts an economic growth or boom, and a negative slope foreshadows a recession.

Foreign exchange rates (FX rate)

• International trade and investment drives the money supply markets.
• The direct rate is USD/JPY, domestic currency is in the numerator.
• The indirect rate is JPY/USD, domestic is in the denominator. If in America an FX rate rises in it's figure, the numerator falls relative to what is in the denominator.

Currency Value

• Depreciation is that currency values falls.
• Appreciation is that a currency value rises.

Bretton-Woods Monetary System.

• The system was signed and agreed to by the top leaders of the major allied countries, which pegged the exchange rate.
• 1oz of gold = $35, and the US dollars were fixed with each currency of member countries, and could be redeemed with gold from federal banks.
• This system eliminated risks of foreign exchange rates, greatly improved the world economy.
• The US no longer needed gold reserves because it was not obligated to redeem gold, and the system collapsed. Now, rates are determined by market forces. The government now invervenes to maintain rates with a certain currency.

Purchasing Power Parity (PPP)

• States the exchange rates will make the prices of goods and services according to the currencies' purchasing power.

Currency Buying Scenarios

• If you want to “cheap” buy, or "weak currency".
• If you want to sell, you need an expensive of "strong currency" the companies that want weak currencies are: Boeing, Disney, Rice farmers, Japanese company.

Trade Flows

• Countries with trades deficits should be depreciated and should be appreciated for trade surpluses.

Inflation Rates

• Countries with higher inflation depreciated, countries with lower inflation are appreciated.

Interest Rates

• Countries that lower interest rates should is depreciated, and countries with higher rates, the currency should be appreciated.