Capital Markets PDF

CAPITAL MARKETS A. **Stock Market** - [Where the P of firm's stocks are established] - Goal of financial manager: [maximize their firm's stock P] - Physical Location Stock Exchange - [formal orgs having tangible physical locations that conduct auction markets] in designated/[li...

CAPITAL MARKETS A. **Stock Market** - [Where the P of firm's stocks are established] - Goal of financial manager: [maximize their firm's stock P] - Physical Location Stock Exchange - [formal orgs having tangible physical locations that conduct auction markets] in designated/[listed securities] - Physical location exchanges are tangible entities - Each of larger exchanges occupies its own building, allows a limited no. of people to trade on its floor, & has elected governing body = Board of Governors - Over-the-counter (**OTC**) - [Large collection of brokers & dealers], connected [electronically by telephones & computers], that provides for trading in [unlisted securities] - Dealers Markets - [Includes all facilities needed to conduct security transactions], but transactions are [not made on the physical location exchanges] - Relatively [few dealers] ([hold inventories of these securities & who are said to make the market)] - [Thousands of brokers] ([act as agents in bringing dealers together w/ investors)] - [Computers, terminals, & electronic networks] that provide communication link b/n dealers & brokers B. **Equity Valuation** - Main purpose: [estimate value of firm/its security] - Key assumption of any fundamental value technique: Value of security (equity/stock) is [driven by fundamentals of firm's underlying business] at the end of the day 1. Comparables approach - Company's equity value should bear some [resemblance to other equities in similar case] - [Comparing a company's equity to competitors/others firms in same sector] 2. Discounted cash flow - Company's equity value is determined by [future cash flow projections using net present value] - Most useful if the [company has strong data to support future operating forecasts] 3. Precedent transactions - Company's equity value depends on [historical P for completed M&A transactions] involving similar companies - Only relevant if [similar entities have been recently valued/sold] 4. Asset-based valuation - Company's equity value is determined based on the [fair market value of net assets owned by company] - Used for [entities w/ a going concern, emphasizes outstanding liabilities determining net asset value] 5. Book-value approach - Company's equity value is determined based on its [previous acquisition cost] - Only relevant for [companies w/ minimal growth that might have undergone a recent acquisition] C. **Capital Structure** - Capital - [Investor-supplied funds] (debt, deferred stock, common stock, & retained earnings) - AP & accruals are [not included] because they are not provided by investors, they come from suppliers, workers, & taxing authorities as result of [normal operations] - Capital structure - [% of each type of investor-supplied capital], w/ total being 100% - Optimal capital structure - [Mix of debt, preferred stock, & common equity] that [maximizes the stock's intrinsic value] also [minimizes the weighted average cost of capital] (**WACC**) BEHAVIORAL FINANCE - [Study of various psychological factors that can affect financial markets] - Mental accounting - Propensity for people to [allocate money for specific purpose] - Herd behavior - [People tend to mimic financial behaviors of the majority of the herd] - Notorious in the *[stock market]* as the cause behind dramatic rallies & sell-offs - Emotional gap - Decision-making based on [extreme emotions/emotional strains] - Emotions are [key reason why people do not make rational choices] - Anchoring - [Attaching a spending level to a certain reference] - Spending consistently based on budget level - Self-attribution - Tendency to make choices based on [overconfidence in one's own knowledge/skill] - Stems from an intrinsic knack in a particular area - Indivs tend to rank their knowledge higher than others, even when it objectively falls short **Emotion & Investing** a. Confirmation bias - Investors have a bias toward [accepting info that confirms their already-held belief] in an investment - If info surfaces, investors accept it readily to confirm that they're correct about their investment decision even if the info is flawed b. Experiential bias - When investors' money of [recent events makes them biased/leads them to believe that the event is far more likely to occur again] - Recency bias/availability bias c. Loss aversion - When [investors place a greater weighting on the concern for losses than the pleasure from market gains] - They're far more likely to try to assign a higher priority to avoiding losses than making investment gains - As a result, [investors might want a higher payout to compensate for losses] d. Familiarity bias - Investors tend to [invest in what they know] (domestic companies of locally owned investments) - As a result, [investors are not diversified across multiple sectors & types of investment], which can induce risk - Investors tend to go w/ investments that they have a history/familiarity w/ **Behavioral Finance & Investment Strategy** Market Timing & Technical Analysis - Asset bubbles & market crashes are largely a matter of timing - To time events precisely, you would constantly have to watch for new info, & even then, the info from different sources may be contradictory - Marketing timing -- [asset allocation strategy] **Behavioral Finance & Capital Markets** Efficient Market Hypothesis (**EMH**) - [Any given time in a highly liquid market, stock P are efficiently valued to reflect all valuable info] - Long-term historical phenomena in securities markets that contradict the efficient market hypothesis & cannot be captured plausibly in models based on perfect investor rationality - Based on belief that market participants view stock P rationally based on all current & future intrinsic & external factors - When studying stock market, behavioral finance takes the view that [market are not fully efficient] INTEREST RATES - Companies raise capital in 2 main forms: debt & equity - [P that lenders receive, & borrowers pay for debt capital] - Equity investors expect to receive dividends & capital gains, sum of which represents cost of equity **Determinants of Market Interest Rates** - Real risk-free rate of interest (R\*) - Rate of interest that would [exist on default-free US treasury] if no inflation were expected - Nominal/quoted risk-free rate of interest - RoI on [security that is free of all risk] - Proxied by the T-bill/T-bond rate - Includes an [inflation premium] - Inflation premium (IP) - [Premium equal to expected inflation that investors] add to real risk-free rate of return - Default risk premium (DRP) - [Difference b/n interest rate on US treasury bond & corp bond] of equal - Liquidity premium (LP) - [Premium added to the equilibrium interest rate on a security] if that security cannot be converted to cash on short notice & at close to its fair market value - Interest rate risk - [Risk of capital losses to which investors are exposed] because of changing interest rates - Maturity rate premium - [Premium that reflects interests rate risk] - Reinvestment rate risk - [Risk that decline in interest rates] will lead to [lower income] when bonds mature & funds are reinvested **COST OF MONEY** 4 Most Fundamental Factors affecting Cost of Money: 1. Production opportunities -- [investment opportunities in productive] (cash-generating) assets 2. Time preferences for consumption -- [preferences of consumers for current consumption] as opposed to saving for future consumption 3. Risk -- [chance that an investment will provide low/negative return] 4. Inflation -- [amount by which P increase over time] - People use money as [medium of exchange] - The [higher the rate of inflation], the [larger the required dollar return] Interest rate paid to savers depends on: - Rate of return that producers expect to earn on invested capital - Savers' time preferences for current vs future - Riskiness of loan - Expected future rate of inflation - Producers' (borrowers) expected returns on their business investments set an [upper limit to how much they can pay for savings], while consumer's time preferences for consumption establish how much consumption they are willing to defer & how much they will save at different interest rates - [Higher risk & higher inflation = higher interest rate]s **Interest Rate Levels** - Short-term rates -- responsive to [current economic conditions] - Long-term rates -- [reflect long-run expectations] for inflation - Term structure of interest rates -- [relationship b/n long-term & short term rates] **Term Structure of Interest Rates** - Relationship b/n bond yields & maturities - Relationship b/n long & short-term rates - [Important to corporate treasures] deciding whether to borrow by issuing long/short-term debt & to investors who are deciding where to buy - Yield curve -- [graph showing relationship b/n bond yields & maturities] - What determines its shape: because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds - Normal yield curve -- [upward-slopping yield curve] - Inverted (abnormal) yield curve -- [downward-slopping yield curve] - Humped yield curve -- [yield curve where interest rates on intermediate-term maturities are higher] than rates on both short&long-term maturities **INTEREST RATE RISK** - Interest rate risk -- [risk of capital losses to which investors are exposed] of changing interest rates - Maturity risk premium (MRP) -- [premium that reflects interest rate risk] - Reinvestment rate risk -- [risk that a decline in interest rate = lower income] when bonds mature & funds are reinvested **INTEREST RATE DERIVATIVES** 1. Real risk-free rate of interest - [Exist on risk-less security] if no inflation were expected - [Rate of interest on short-term US treasury securities] in an inflation-free world - Not static, [changes over time] depending on economic conditions 2. Nominal/quoted risk-free rate of interest - Interest rate on a [totally risk-free security] (one that has no default risk, maturity risk, no liquidity risk, no risk of loss if inflation increases - [Includes inflation premium] equal to average expected inflation rate over remaining life of security 3. Inflation premium (IP) - [Premium equal to expected inflation] that investors add to real risk free rate of return 4. Default risk premium (DRP) - [Risk that a borrower will default], means that [borrower will not make scheduled interest/principal payments] - The [greater the bond's risk of default, the higher the market rate] 5. Liquidity premium (LP) - Liquid asset can be converted to cash quickly at a fair market value - [Real assets are less liquid] than financial assets **MONETARY POLICY** - [Set of tools used by nation's central bank to control overall money supply] & promote economic growth - Contractionary - [Increases interest rates] & [limits outstanding money supply] to [slow growth & decrease inflation] - Prices of goods & services rise & reduce purchasing power of money - Expansionary - During times of slowdown/recession, it [grows economic act] - By [lowering interest rates], saving becomes less attractive, & consumer spending & borrowing increase - [Decreases unemployment ] Goals of Monetary Policy - Inflation - Unemployment - Exchange rates -- w/ increase in money supply, domestic currency becomes cheaper than its foreign exchange Tools of Monetary Policy a. Open market operations - Federal reserve bank [buys bonds from investors/sells additional bonds to investors] to change no. of outstanding govt securities & money avail to economy - [Adjust level of reserve balances to manipulate short-term interest rates] & that affect other interest rates b. Interest rates - Central bank may change interest rates/required collateral that it demands - US, this rate is discount rate - Banks will loan more/less freely depending on this interest rate c. Reserve requirements - [Authorities can manipulate] this, funds that banks must retain as proportion of the deposits made by their customers to ensure that they can meet their liabilities - *Lowering this* = [releases more capital] for the banks to offer loans/buy other assets - *Increasing this* = [curtails bank lending & slows growth] **INFLATION & INTEREST RATES** - [Interest rates tend to move in same direction as inflatio]n but w/ lags, because IR are primary tool used by central bank to manage inflation - US, federal Reserves targets average inflation rate of **2%** over time by setting a range of its benchmark federal funds rate, interbank rate on overnight deposits - *Higher interest rates* are policy [response to rising inflation] - When *inflation is falling* & economic growth slowing, central banks [lower interest rates to stimulate economy] How changes in interest rates affect inflation? - *Rising interest rates* [curb inflation] while *declining interest rates* tend to [speed inflation] - *Interest rates decline* = [consumers spend more] as cost of goods & services is cheaper = increased consumer spending means increase in demand & increases in demand increases P - *Interest rate rise* = [consumer spending & demand decline], money-flows reverse, & inflation is tempered How do interest rates affect stocks? - [Rising interest rates hurt performance of stocks] - *Interest rates rise* = [indivs will see a higher return on their savings]; removes the need for indivs to take on added risk by investing in stocks, resulting in less demand for stocks - Interest rates influence stocks, bond interest rates, consumer & business spending, inflation, & recessions - Relationship b/n interest rates & stock market is [indirect], two tend to [move in opposite directions] - Federal Reserve *cuts interest rates* = [stock market go up] - Federal Reserve *raises interest rates* = [stock market go down] INCOME & BUSINESS TAXATION **CORPORATION TAXATION** - Corporate tax - [collected by govt as source of income] - based on taxable income after expenses have been deducted Corporate Tax Deductions - corps are permitted to reduce taxable income by certain necessary & ordinary business expenditures - [all current expenses] required for the operation of the business are [full tax-deductible] - [investments & real estate] purchased w/ intent of generating income for the business are [deductible] - corp can deduct employee salaries, health benefits, tuition reimbursement, & bonuses - corp can reduce its taxable income by deducting insurance premiums, travel expenses, bad debts, interest payments, sales taxes, fuel taxes, & excise taxes - tax preparation fees, legal services, bookkeeping, & ad costs can be used to reduce business income Special Considerations (Double Taxation) **Advantages of Corporate Tax** - [more beneficial for business owners] than paying additional indiv income tax - easier for corp [to deduct losses] - corp may deduct the entire amount of losses - profit earned by corp may be left within the corp, allowing for tax planning & potential future tax advantage Corporate Tax rate - tax levied on corp's profits, collected by govt as source of income - applies to company's income (revenue -- expenses) - US, federal corp tax rate is a flat rate of **21%** **INDIVIDUAL TAXATION** Individual Income Tax - Personal income tax - Levied on [indivs wages, salaries] - Tax that the state imposes - Tax credit [reduces income tax obligation] - Tax credit help [reduce the taxpayer's tax] obligation/amount owed; created primarily for [middle & lower-income households] What percent of income is taxed? - \% of income that is taxed depends on how much you earn & your filing status - The [more you earn, the more you pay] How can I calculate income tax? - Add up all sources of taxable income earned in yr - Calculating your adjusted gross income - Subtract any deductions for which you are eligible from you adjusted gross income - All taxpayers pay federal income tax - US have progressive income tax system -- the [higher the income, the higher tax rate] **TAX PLANNING & OPTIMIZATION** Tax Planning - [Analysis of financial situation/plan] to ensure that all elements work together to allow you to pay the lowest tax possible - Plan that [minimizes how much you pay taxes] (tax efficient) - Covers several considerations: timing of income, size & timing of purchases, & planning for expenditures - Selection of investments must complement the tax filing status & deductions to create the best possible outcome Tax Gain-loss harvesting - Another [form of tax planning/management relating to investments] - Helpful because it can [use a portfolio's losses to offset overall capital gains] - [Short & long-term capital losses must first be used to offset capital gains] - Long-term losses offset long-term gains before offsetting short-term gains Basic tax planning strategies - Reducing overall income, by contributing to retirement plans, making tax deductions, & taking advantage of tax credits How do high-income earners reduces taxes? - Contributing to retirement accounts, health savings accounts, investing in stocks w/ qualified dividents, buying municipal bonds, & planning where you live based on favorable tax treaments - Tax planning involves utilizing strategies that lower taxes that you need to pay FINANCIAL ANALYSIS & REPORTING FINANCIAL STATEMENTS ANALYSIS - [Process of analyzing a company's financial statements] for decision-making purposes - External stakeholders use it to [understand overall health of an org & to eval financial performance] & business value - Internal constituents use it as [monitoring tool for managing finances] How to Analyze Financial Statements - Financial statements of company [record important financial data on every aspect of business acts] - Centered around *accepted accounting principles* (**GAAP**) in US - GAAP -- [require a company to create & maintain 3 financial statements]: balance sheet, income statement, & cash flow statement - [Public companies have stricter standards] for financial statement reporting - They must follow GAAP, which requires accrual accounting - [Private companies have greater flexibility] in their financial statement prep & have option to use either accrual/cash accounting - Horizontal analysis - [compares data horizontally], by [analyzing values of line across 2/more yrs] - Detect [growth trends] across different time periods - Vertical analysis -- looks at [vertical effects that line items have on other parts of business] & business' proportions - Ratio analysis - uses important [ratio metrics to calculate statistical relationshi]ps - price-to-earnings ratios, earnings per share, dividend yield A. **Balance Sheet** - [Report of company's financial worth] in terms of book value - Assets, liabilities & shareholders equity - Balance assets & liabilities to equal shareholder's equity - Short-term assets - Cash & AR - Tell a lot of [company's operational efficiency] - Liabilities - Company's [expense arrangements & debt capital] - Shareholder equity - Details on [equity capital investments & retained earnings] from periodic net income B. **Income Statement** - Breaks down the [revenue that a company earn against the expense involved] in its business to provide a bottom line (net profit/loss) - Profit margin -- helps to [show where company costs are low/high] at different points of operations C. **Cash Flow Statement** - [Overview of company's cash flow] from operating, investing, & financing acts - [How much cash a company has avail] - Net income is carried over here, where it included as top line item for operating acts - Investing acts = [firm-wide investments] - Financing acts = both [debt & equity] financing Free Cash Flow & other valuation Statements - [Analyze value of company] - Arrive at net present value by discounting free cash flow that company is estimated to generate over time - Private companies may keep valuation statement as they progress toward potentially going public Financial Performance - Both internal & external stakeholders use same corporate finance methodologies for maintaining business acts & eval overall finance performance Common ratio metrics +-----------------------------------+-----------------------------------+ | Balance sheet | Asset turnover | | | | | | Quick ratio | | | | | | Receivables turnover | | | | | | Days to sales | | | | | | Debt to assets | | | | | | Debt to equity | +===================================+===================================+ | Income statement | Gross profit margin | | | | | | Operating profit margin | | | | | | Net profit margin | | | | | | Tax ratio efficiency | | | | | | Interest coverage | +-----------------------------------+-----------------------------------+ | Cash flow | Cash & earnings before interest | | | | | | Taxes | | | | | | Depreciation | | | | | | Amortization (EBITDA) | +-----------------------------------+-----------------------------------+ | Comprehensive | ROA | | | | | | ROE | | | | | | DuPont analysis | +-----------------------------------+-----------------------------------+ Advantages of Financial statement analysis - Investors may develop a [more nuanced picture] of company's financial profile RATIO ANALYSIS - Ratios help us [eval financial statements] 1. Liquidity ratios - firm's [ability to pay off debts that are maturing within a yr] - Necessary if firm is to continue operating 2. Asset management ratios - idea of [how efficiently the firm is using its assets] - Firm to [keep its costs low & net income high] 3. Debt management ratios - idea of [how the firm has financed its assets & firms' ability to repay long-term debt] - [how risky the firm] is & how much of its operating income must be paid to bondholders than stockholders 4. Profitability ratios - idea how [profitability the firm is operating & utilizing its assets] - combine asset & debt management & show their effects on ROE 5. Market value ratios - idea of [what investors think about the firm & its future prospects] CASH FLOW ANALYSIS - important aspect of company's financial management because it underscores [cash that's avail to pay bills & make purchases ] - [money it needs to run & grow business] - for [insight into a company's financial stability & health] & to inform decisions about possibly investing in a company - examines the [cash that flows into & out of a company] (where it comes from, what it goes to, & amounts for each) - *ongoing positive cash flow* points to a [company that is operating on strong footing] - continued *negative cash flow* indicate a [company is in financial trouble] - lend [insight into financial vibrancy/financial instability of a company] & its prospect as good investment - presents [past data] - process of examining amount of cash flows into a company & cash that flows out to determine the net amount of cash that is held - cash flow from operations - reports [amount of cash from income statement] that was originally reporting on accrual basis - AR, AP, income taxes payables - Changes in [current assets/liabilities] are recorded - cash flow from investing - records cash flow from [capital expenditures & sales of long-term investments] - fixed assets related to plant, property & equipment - cash flow from financing - [debt & equity transactions] are reported - payment of dividends, repurchase/sale of stocks, bonds - cash received from taking out a loan/cash used to pay down long-term debt - cash flow -- [net cash amounts from each sections] - operating cash flow/net sales - ratio is express as % of company's net operating cash flow to its net sales - tells us h[ow many \$ of cash are generated for every \$ of sales] - free cash flow - [net operating cash flow minus capital expenditures] - shows [how efficient a company is at generating cash] - investors use this to [measure whether a company might have enough cash], after funding operations & capital expenditures, [to pay investors thru dividends & share buybacks] - cash flow avail after paying operating expenses & purchasing needed capital assets - important evaluative indicator for investors - [captures all positive qualities of internally produced cash from company's operations] & monitors use of cash for capital expenditures - comprehensive free cash flow coverage - [dividing free cash flow by net operating cash flow to get % ratio] - higher the %, the better Points when analyzing cash flow: - positive cash flow - [always the goal] - demonstrates a company is [capable of healthy operations & can grow successfully] - negative cash flow - operating cash flow margin - [ratio compares cash from operating acts to sales revenue] in particular period - *positive margin* = company is able to [convert sales to cash & indicate profitability & earnings quality] **Forms of Accounting:** - Accrual Accounting - Used by [most public companies] - Reports *[revenue]* as income when it's [earned rather than when the company receives payment] - *[Expenses]* are reporting [when incurred], even though no cash payments have been made - Cash Accounting - [Payment receipts are recorded] in the period they are [received] - *[Expenses]* are recorded in the period in which they are [paid] - Company's profit is shown as net income (bottom line of company) on income statement FINANCIAL MODELING - [Process of creating summary of company's expenses] & earning in the form of spreadsheet that can be used to calculate impact of a future event of decision - Uses for company executives - Financial analyst use it to [analyze & anticipate how a company's stock performance might be affected by future events/executive decisions] - Financial model is used for [decision-making & financial analysis] by people inside & outside of companies - Reason include need to raise capital, grow business organically, sell/divest business units, allocate capital, budget, forecast, value business - [Set of numerical techniques used to forecast company's future growth] How is a Financial Model validated? - Errors in financial modeling can cause expensive mistakes - It may be [sent to outside party to validate] the info it contains - Banks & other financial institutions, project promoters, corps seeking funds, equity houses may requires model validation to reassure the end-user that the calculations & assumptions within the model are correct FINANCIAL REPORTING & DISCLOSURE - [Process of documenting & communicating financial acts & performance] over specific time periods - Companies use financial reports to [organize accounting data & report on current financial status] - Financial reports are essential in [projections of future profitability, industry position & growth] - Tracking cash flow - Evaluating assets & liabilities - Analyzing shareholder equity - Measuring profitability Importance of Financial reporting - Monitors income & expense - Tracking income & expenses - Necessary for [effective debt management & budget allocation] & provides insight into key areas of spending - Ensures companies track debts regularly to remain transparent in competitive markets - Ensures compliance - [Accurate documentation crucial to ensures all financial reports comply w/ tax regulations] & financial reporting criteria - Simplifies tax, valuation & auditing processes, reducing time to complete necessary financial obligations & further validating financial compliance - Communicates essential data - Key shareholders, executives, investors & professionals all rely on current financial data to make decisions, plan budget & monitor performance - [To support funding, investment opportunities & financial review] - Supports financial analysis & decision-making - Crucial for [performing analysis to support business decisions] - Reporting helps businesses [eval current acts & make decisions for future growth] Who regulates financial reporting - Regulatory entities (SEC, IRS & financial accounting standards board -FASB) [establish standards that outline protocols & required practices relating to financial acts] - SEC - [Overseeing capital markets & sets forth] regulations for investment acts in stock markets - [Requires public companies & market participants to disclose financial info regularly] to investors to review - FASB - [Private regulatory entity that establishes & monitors **GAAP**] ([framework for financial processes that supports efficiency in reporting & ensures regulatory compliance]) BANKING & FINANCIAL INSTITUTIONS **Bank regulation** - [Imposes various requirements, restrictions, & guidelines on banks] - Objective: [reducing systematic risk] by creating unfavorable trading conditions for banks - [Process of setting & enforcing rules for banks ] - Protect consumers, ensure stability of financial system, & prevent financial crime - [Promote safe & sound banking practices] by ensuring banks have enough capital to cover risks - Supervise acts of banks & enforce compliance w/ regulations Who regulates banks? - Regulations come from [both govt agencies & central banks] - **US**: office of comptroller of currency, federal deposit insurance corp insuring deposits, federal reserve system, consumer financial protection bureau - **Canada**: office of superintendent of financial institutions - **UK**: prudential regulation authority, financial conduct authority, division of banking of England - **Germany**: BaFin Regulation importance - [Tool for ensuring stability & efficiency] of banking sector - [Protects consumers] by ensuring banks maintain adequate capital levels, disclose risks inhere in their business acts, & follow sound risk management practices - [Promotes financial stability] by limiting ability of banks to engage in acts that could lead to systematic crisis - Helps to ensure that banks serve as reliable sources of credit for businesses & households - Ensuring [safety & soundness of banking sector] Why are banks regulated? - Banks deal w/ large amounts of money, making them a prime target for crime - Play crucial role in economy - [Act as intermediaries b/n borrowers & lenders], helping to allocate capital to its most productive uses - Reserve requirements -- [how much money bank must keep on hand] - Capital requirements -- [how much money banks can lend] - Liquidity requirements -- [how easily banks can convert their assets into cash] **Risk Management in Banks** - Risk management - [Essential piece of banking operations] Types of Risk Management in Commercial Banks 1. Credit risk - [Chance that a loan recipient does not pay bank that money] can be measured as credit risk - Result in [interruption of cash flows], [increased costs for collection] 2. Market risk - risk of an investment [decreasing in value as result of market factors] - systematic risk 3. Operational risk - [Potential sources of losses] that result from any sort of operational event 4. Reputational risk - [Damage customer relationship], cause a drop in share price, give competitors advantage 5. Liquidity risk - [Unable to pay back its liabilities in timely manner] because of unexpected claims/obligation to sell long-term assets at undervalued P Risk Management Practices in banks - Goes far beyond compliances - Regulatory change is managing regulatory, policy &/procedures applicable to your org for your industry - Regulatory compliance can be [burdensome & costly task for financial institutions ] - Assessing risk - [Hallmark of a healthy risk management system] - [Collect & analyze data] to determine the likelihood of any given risk & subsequently prioritize remediation efforts - Risk mitigation - Process of [reducing risk exposure & minimizing likelihood of an incident] - Top risks & concerns need to be continually addressed to ensure bank is fully protected - Monitor - [Ongoing & proactive process] - Testing, metric collection & incidents remediation to certify that controls are effective - Allows for [addressing emerging trends] to determine whether/not progress is being made - Connect - [Creating relationships] b/n risks, business units, mitigation acts paints a cohesive picture of bank - Allows for [recognition of upstream & downstream dependencie]s, identification of systematic risks, & design of centralized controls - Report - [Presenting info about how risk management program] is going demonstrates effectiveness & can rally support of various stakeholders at bank Enterprise Risk Management (**ERM**) software for banks - Best way to [begin process of developing sound banking risk management plan] FINANCIAL INSTITUTIONS & MARKETS - [Orgs like banks, credit unions, & investment companies] that [help people manage & grow their money] - Financial Markets - [Places where people can buy & sell things] - [Place where buyers & sellers can come together to trade assets] - Essential for smooth functioning of our economy & play a key role in helping businesses & govts raise money - Banks - [Popular choice for people who want to save money] in secure place & earn interest - [Provide loans & credit cards] to help people finance large purchases - [Offer investment products & services] (stock & mutual funds) - Lenders - Institutions that [lend money to people & businesses] - [Charge interest on borrowed amount] (source of income) - Credit unions - Similar to bank, but [member-owned & you have to qualify to become a member] - [Offer better interest rates on savings] & [lower interest rates on loans] - Provide range of financial services - Brokerage firms & investment companies - [Help people invest their money in stocks, bonds] - Charge fees/commissions for their services - Insurance companies - Provide [protection against financial losses] due to accidents, natural disasters - [Collect premiums from policyholders] & [use money to pay out claims when needed] - Financial advisers - [Provide advice to help people make informed decisions] about saving, investing, & managing their money - [Charge fees for their services], or earn commission based products they reco - Stock markets - [Places where people can invest in shares of companies] - [Allow investors to buy & sell stocks], which represent ownership in company, & potentially earn profits as company grows - Bond markets - [Where people can invest in bonds] (loans made to companies/govt) - Investors who buy bonds receive regular interest payments & get their principal amount back when bond matures - Money markets - Financial market where [people can invest in short-term debt securities] (treasury bills & CD) **BANK OPERATIONS & MANAGEMENT** Banking system - [Crucial component of global economy accounting] for trillions in assets worldwide - Banks [stand b/n depositors who supply capital & borrowers] who demand capital Basic Functions - Accept deposits/make loans - Raise capital from investors/lenders & use money to make loans - Provide safety - [Offer customers security] for their money - Act as payment agents - [Issue debit cards] that allow holders to pay for goods w/ swipe of card, they can arrange wire transfers w/ other institutions - Banks [underwrite financial transactions by lending their reputation & credibility] to transaction in form of banking instruments (checks, pay orders, demand draft) - Banks [make commercial transactions much more convenient] Roles of Banks - Settle payments - [Ensuring proper accounts are credited/debited], in the proper amounts & w/ relatively little delay - Credit intermediation - [Collect money from depositors], & concurrently lending it to other borrowers - Maturity transformation - [Borrow short-term but lend long-term] - Banks transforms debt w/ short maturities into credits w/ very long maturities , & collect differences in the rates as profits - Money creation - Achieved thru [fractional reserve banking] - Only a fraction of bank deposits are backed by actual COD & avail for withdrawal - Done to [expand economy by freeing up capital] that can be loaned out to other parties **Role of Central Bank** A. **Primary functions** - Issue notes, regulation & supervision of financial system, bankers bank, lender of last resort, banker to govt, & conduct of monetary policy B. **Secondary functions** - Agency functions (management of public debt, foreign exchange) FUNDAMENTALS OF CORPORATE FINANCE CAPITAL BUDGETING - [Choosing projects that add value to a company ] - Outlining how company's revenue & expenses will shape up over 12 months - [Long-term financial plan for larger financial outlays] - Relies on many of the same fundamental practices as any other form of budgeting - Capital budgets are [exclusively cost centers], they [do not incur revenue during project] & must be [refunded from outside source] - Since it is long-term, there are [more risks, uncertainty ] - Prepared for long-term endeavors, then reassessed as project/undertaking is under way - Companies will periodically reforecast their capital budget as project moves along - To proactively plan ahead for large cash outflows that should not stop unless company is willing to face major potential project delay costs - No single method of capital budgeting - Zero-based budgets are [most appropriate] Why do business need capital budgeting? - It creates [accountability & measurability] - [Outlines expectations] for a project - Process is a measurable way for business to determine long-term economic & financial profitability of any investment project - Need this to assess risks, plan ahead, & predict challenges before they occur Discounted Cash flow analysis - [Assess not only cash flow timing] but also [implications of dollar] - Currencies become devalued as time passes - Incorporates inflows & outflows of a project Payback analysis - [Plan around timing of when certain benchmarks are achieved] - Needing to be especially careful in forecasting cash flows - Any deviation in an estimate from 1 yr to next may substantially influence when a company may hit payback metric - Requires slightly [more care timing] Throughput analysis - [Analyze revenue & expenses across an entire org, not just for specific projects] - Thru cost accounting can be used for operational/noncapital budgeting - Taking the revenue of a company & subtracting variable costs - Results in analyzing how much profit is earned from each sale that can be attributable to fixed costs - Payback period (**PB**) - Calculates [length of time required to recoup the original investment] - Used [when liquidity presents a major concern] - Easy to calculate once cash flow forecasts have been established - [Does not account for time value of money] (TVM) - Both this & discounted payback period ignore cash flows that occur toward the end of project's life (salvage value); payback is not a direct measure of profitability - Possibility that cash investments might be needed at different stages of project - Life of assets that was purchased should be considered - Internal rate of return (**IRR**) - [Discount rate that would result in a net present value of zero] - Benchmark calculation is the actual rate used by firm to discount after-tax-cash flows - [**IRR** that is higher than **WACC**] = capital project is [profitable] - Provides [benchmark figure for every project that can be assess in reference to company's capital structure] - Product same types of decisions as NPV models & allows firms to compare projects based on returns on invested capital - Useful valuation measure when [analyzing indiv capital budgeting projects] - Provides better valuation alternative to payback method - [Does not give true sense of value that a project will add to a firm]; simply [provides benchmark figure] for what projects should be accepted - Does [not allow for an appropriate comparison] of [mutually exclusive projects] - Cash flow streams from project are unconventional; there are additional cash outflows ff the initial investment - Net present value (**NPV**) - [Inversely correlated w/ discount rate] - [Most intuitive & accurate valuation approach] to capital budgeting problems - [Reveal exactly how profitable a project will be in comparison w/ alternatives] - All projects w/ positive NPV should be accepted while those that are negative should be rejected - Overall usefulness - Provides [direct measure of added profitability] - [Allows one to compare multiple mutually exclusive projects simultaneously] - Subject to fair criticism +-----------------------------------+-----------------------------------+ | Capital budgets | Operational budgets | +===================================+===================================+ | - Geared toward | - [Set for 1 yr] | | [long-term] | defined by revenue & expenses | | | | | - Span [multiple | - Track [day-ta-day | | years] | acts] of business | | | | | - Cover different types of acts | | +-----------------------------------+-----------------------------------+ Capital budgets - No necessarily required to prepare - [Internal docs used for planning ] - Used to [support management's strategic decision making] - [Long-term plan that outlines financial demands of an investmen]t, development, or major purchase - Prepared to analyze whether/not long-term endeavor will be profitable - Scrutinized using NPV, IRR, & payback periods to make sure return meets management's expectations COST OF CAPITAL - [Calculation of min. return that would be necessary to justify undertaking a capital budgeting project] - [Eval of whether a projected decision can be justified by its cost] - Key info [used to determine a project's hurdle rate] - Investor, assessment of return that can be expected from acquisition of stock shares - Measures cost that a business incurs to finance its operations - Measures cost of borrowing money from creditors, or raising it from investors thru equity financing - Weighted average cost of capital (**WACC**) - [Overall cost is derived from weighted average cost of all capital sources] - Firm's cost of capital is calculated by this - Considers cost of both [debt & equity capital] Cost of Debt - [Early stage companies] = equity financing default mode of funding - [Less-established companies] w/ limited operating histories pay *higher cost* for capital - Interest rate paid by company on its debt  Cost of Equity - More complicated since [rate of return demanded by equity investors is not as clearly defined as it is by lenders] - Approximated by capital asset pricing model - Beta - [Used in CAPM formula to estimate risk] - Private companies, it is estimated based on [average beta among a group of similar public companies] - Private firm's beta will become the same as industry average beta  - Debt financing is more [tax-efficient]; [interest expenses are tax-deductible] & dividends on common shares are paid w/ after-tax \$ - Too much debt can result in dangerously high leverage levels, forcing company to pay higher interest rates to offset higher default risk **Importance of Cost of Capital** - Businesses & financial analysts use this to [determine if funds are being invested effectively] - If [return on investment is greater than cost of capital] = investment will end up being a [net benefit] to company's balance sheet - Investment whose return are equal/lower than cost of capital = money is not being spent wisely - Can determine a company's valuation Cost of Capital by industry - *Highest*: software internet companies, paper/forest companies, building supply retailers, semi conductor companies - *Lower*: rubber & tire companies, power companies, real estate developers, & financial services companies CAPITAL STRUCTURE - [Particular combination of debt & equity used by company to finance its overall operation & growth] - Mixture of company's long-term debt, short-term debt, common stock, & preferred stock - Debt to equity ratio ([insight into how risky a company's borrowing practices]) - Equity capital - arises from [ownership share] in company & claims to its future cash flows & profits - Debt -- [form of bond issues/loans] +-----------------------------------+-----------------------------------+ | **Debt** | **Equity** | +===================================+===================================+ | - [Tax advantage] | - [Allows outside investors to | | wherein interest payments | take partial | | made as a result of borrowing | ownership] of | | funds are tax-deductible | company | | | | | - Allows company to [retain | - [More expenses] | | ownership] | (interest rates are low) | | | | | - [Abundant & easy to | - Does not need to be paid back | | access] | | | | - Benefit to the company in the | | | case of declining earnings | | | | | | - Claim by the owner on the | | | future earnings of company | +-----------------------------------+-----------------------------------+ | - Both found in [balance | | | shee]t | | | | | | - [Company assets are | | | purchased] w/ | | | debt/equity | | +-----------------------------------+-----------------------------------+ **Optimal Capital Structure** - [Companies use more debt to finance their assets] & fund operating acts have high leverage ratio & aggressive capital structure - Company that pays for assets w/ more equity has [low leverage ratio & conservative capital structure] - [High leverage ratio & aggressive capital structure] = *higher growth sales* - [Conservative capital structure] = *lower growth rates* - Debt -- [capital-intensive industries]: auto manufacture - Equity -- [labor-intensive]/[service-oriented]: software - Too much debt = [credit ris]k - Too much equity = [company is underutilizing growth opportunities]/paying to much for its cost of capital - [Outlines how company will distributed its dividend to its shareholders] - Details specific about [payouts] including how often, when, & how much is distributed - Dividends - [Distribution of portion of company's earnings to its shareholders] - Declared by company's BOD & paid out on a per-share basis to all shareholders who own stock - Paid on regular basis & represents portion of profits of company - Mature companies in stable industries = issue this - Growth-oriented companies in capital-intensive sectors (technology) = hold onto their cash & not issue this 1. Stable - [Easiest & most commonly] used - Provide shareholders w/ [steady & predictable dividend payout] each yr - [Investors receive regardless of whether earnings are up/down] - Align dividend policy w/ long-term growth of company - Gives shareholder more certainty about amount & timing of dividend 2. Constant - [Investors may not see a dividend increase in boom yrs] - Company pays a % of its earnings as dividend per yr - [Investors experience full volatility of company earnings] - Earnings are *up* = investors get [larger dividend] - Earnings are *down* = investors [may not receive] 3. Residual - [Highly volatil]e - [Company pays out what dividends remain after company has paid for capital expenditures & working capital] - Investors do not want to invest in company that justifies its increased debt w/ need to pay dividends 4. No dividend policy - [High-growth industries/early-stage startups] - Companies prioritize reinvestment of earnings into R&D - Company aims to accelerate growth & enhance shareholder value thru higher future stock P 5. Hybrid - [Combines elements of different policies] - Allows [flexibility] so that investors can expect a baseline amount of dividends but also realize they may be awarded higher dividends if operations go well **Importance of Dividend Policies** - Financial guide that helps management issue dividends - [Sets expectation among investors] about what potential income they might get - Enhances [transparency & credibility] - Can [influence company's cost of capital & shareholder value] - Helps set a company's overall corporate strategy MERGERS & ACQUISITIONS - Different ways companies are combine - Divisions of financial institutions that facilitate/manage such acts - Company may: - Purchase & absorb another company outright - Merge w/ it to create a new company - Acquire some/all of its major assets - Make tender offer for its stock - Stage hostile takeover +-----------------------------------+-----------------------------------+ | **Merger** | **Acquisition** | +===================================+===================================+ | - [2 firms join forces to move | - [One company takes over | | forward as single | another & establishes itself | | entity] | as new owner] | | | | | | - [Unfriendly/hostile takeover | | | deals,] which | | | target companies do not wish | | | to be purchased | | | | | | - Done w/ willing participation | | | of both companies | +-----------------------------------+-----------------------------------+ - Mergers - BOD for [2 companies approve combination & seek shareholders' approval] - Boost both brands, allowing each to bring their existing strengths to new company & create bigger piece of the industry pie for the new company - Acquisition - [Acquiring company obtains majority stake in the acquired firm], which [does not change its name/alter its org structure] - [Allows acquiring company to move into new/related industr]y, expanding its offerings by tapping into the acquired company's existing customer base - Consolidation - [2/more companies combine to increase their market share & eliminate competition] - Tender offer - [1 company offers to purchase the outstanding stock of other] firm at specific P than market P - Acquiring company communicates to offer directly to other company's shareholders, [bypassing management & BOD] - Acquisition of assets - [1 company directly acquirees assets of another company] - Company whose assets are being acquired must obtain approval from its shareholders - Purchase of assets is during [bankruptcy] proceedings, - Management acquisitions - Management-led buyout (**MBO**) - [Company's executives purchase a controlling stake in another company], taking it private - Former executives partner w/ financier/former corp officers in an effort to help fund a transaction - Financed disproportionally w/ debt, & majority of shareholders must approve it **How Mergers are Structured** a. Horizontal -- 2 companies that are in [direct competition] & [share same product lines & markets] b. Vertical -- [customer & company/supplier & company] (ice cream maker merging w/ cone supplier) c. Congeneric -- 2 businesses that [serve same consumer base in diff ways] (TV manu & cable company) d. Market-extension -- 2 companies that [sell same products in diff markets] e. Product-extension -- 2 companies [selling diff but related products in same market] f. Conglomeration - 2 companies that have [no common ] - Purchase mergers - [1 company purchases another company] - Purchase is made w/ cash/thru issue of debt instrument - Consolidation mergers - [Brand new company is formed], & [both companies are bought & combined under new entity] - Tax terms are same as purchase merger Competitive strategies that companies use to consolidate their position among competitors +-----------------------------------+-----------------------------------+ | **Vertical acquisition** | **Horizontal acquisition** | +===================================+===================================+ | - Process of acquiring business | - Acquisition of [related | | operations within [same | business] | | production | | | vertical] | - [Company will take over | | | another company] | | - [Company takes complete | that operates at [same level | | control over 1/more stages in | of value chain] | | production/distribution of | in an industry | | product] | | +-----------------------------------+-----------------------------------+ - Reverse merger - Enables [private company to become publicly listed in relatively short time period] - Private company that has strong prospects & eager to acquiring financing buys a publicly listed shell company w/ no legitimate business operations - [Primate company reverses merges into public company ] Price-to-Earnings ratio (**P/E**) - Acquiring company makes an offer that is multiple of the earnings of the target company Enterprise-value-to-sales ratio (**EV/sales**) - Acquiring company makes an offer as multiple of the revenues while being aware of price-to-sales ratio of other companies in the industry Discounted Cash Flow (**DCF**) - Determines a key company's current value, accord to its estimated future cash flows Replacement cost - Acquisition are based on the [cost of replacing target company] Impact on shareholders - After a merger/acquisition officially takes effect = [stock P exceeds value of each underlying company] during its [pre-takeover stage] CORPORATE GOVERNANCE - [System of rules, practices, & processes by which company is directed & controlled] - Balancing the interests of company's many stakeholders - From action plans & internal controls to performance measurement & corp disclosure - [Guiding principles that a company puts in place to direct all of its operations] - Governance - [Set of rules, controls, policies, & resolutions put in place to direct corp behavior] - BOD is pivotal; proxy advisors & shareholders **Benefits of Corporate Governance** - Creates [transparent rules & controls], guides leadership, & aligns interest of shareholders, directors, management & employees - Helps [build trust w/ investors, community & public officials] - Give investors & stakeholders [clear idea of company's direction & business integrity] - Promotes [long-term financial viability, opportunity, & returns] - Facilitate & raising of capital - Translate to rising share P - Reduce potential for financial loss, waste, risk & corruption - Game plan for resilience & long-term success Corporate Governance & BOD - BOD is primary [direct stakeholder influencing corporate governance] - Directors are elected by shareholders/appointed by other board members - Tasked w/ making important decisions - Made up of mix of insiders ([major shareholders, founders, & executives]) & independent members ([do not share ties that insiders have]) - Independents [dilute the concentration of power] & help align shareholder interest w/ those of insiders **Principles of Corporate Governance** - Fairness - BOD must treat shareholders, employees, vendors & communicates fairly & equal consideration - Transparency - BOD should provide timely, accurate & clear info - Risk management - Board & management must determine risks & how best to control them - Must act on those reco to manage risks - Responsibility - Board is responsible for oversight of corp matters & management acts - Must be aware of & support the successful, ongoing performance of the company - Recruit & hire CEO - Accountability - Explain the purpose of a company's acts & results of its products - Must communicate issues of importance to shareholders **Corporate Governance Models** 1. Anglo-american model - [Principal model at present] 2. Shareholder model - [BOD & shareholders are in control] - Stakeholders (vendors & employees) lack control - Management is tasked w/ running the company in a way that maximize shareholder interest - Shareholders provide the company w/ funds & may withdraw that support if dissatisfied - Success depends on ongoing communications among board, company management, & shareholders 3. Continental model - [2 groups represent controlling authority]: - supervisory board -- [outsiders] (shareholders & union rep) - management board -- [company insiders] (executives) - national interest have strong influence on corps - greatly values engagement of stakeholders as they can support & strengthen a company's continued operations 4. Japanese model - Banks, affiliated entities, major shareholders called Keiretsu (who may be invested in common companies/have trading relationships), management, & govt - [Smaller, independent, indiv shareholders have no role/voice] - BOD is made up of [insiders] - [Keiretsu may remove directors from board if profits wane] - [Corp transparency is less likely] because of the concentration of power & focus on interest of those w/ power **4 Ps of Corporate Governance**: people, process, performance, & purpose **Importance of Corporate Governance** - Creates a [system of rules & practices] that determines how a company operates & how it aligns w/ interest of all its stakeholders - [Fosters ethical business practices], which leads to financial viability BONDS & THEIR VALUATION **BONDS BASICS** - Bond - [Long-term contract under which a borrower agrees to make payments of interest & principal ] - [Issued by corp & govt] that are looking for long-term debt capital - Treasury bonds - Govt bonds issued by [federal govt] - Corporate bonds - Issued by [business firms] - Exposed to default risk/credit risk (if issuing company gets into trouble, it may be unable to make promised interest & principal payments & bondholders may suffer losses) - Municipal bonds / munis - Bonds [issued by state & local govts] - Exposed to some default risk - Interest earned on most munis is [exempt from federal taxes & from state taxes if holder is a resident of the issuing state] - [Market interest is lower] than corp bond - Foreign bonds - Issued by [foreign govt/foreign corp] - All foreign corp bonds are [exposed to default risk] **Characteristics of Bonds** - Par value -- [stated face value of bond]; amount of money the firm borrows & promises to repay on maturity date - Coupon payment -- [specified no. of \$ of interest paid] - Coupon interest rate -- [stated annual interest rate on bond] - Fixed-rate bonds -- [interest is fixed on their entire life] - Floating-rate bonds -- [interest rate fluctuates w/ shifts] in general level of interest rates - Zero coupon bonds -- [no annual interest] but [sold at a discount below par] - Original issue discount (**OID**) bond -- originally offered at [P below its par value] - Maturity date -- [specified date on which par value of bond must be repaid] - Original maturity -- [no. of yrs to maturity at time a bond is issued] - Call provision -- provision in bond contract that [gives issuer the right to redeem bonds under specified terms prior to normal maturity date] - Sinking fund provision -- provision in bond contract that [requires the issue to retire a portion of bond issue each yr] - Convertible bond -- [bonds that are exchangeable at the option of holder] for the issuing firm's common stock - Warrants -- [long-term options to buy a stated no. of shares of common stock] at specified P - Putable bond -- [allows investors to sell them back to the company prior to maturity] at prearranged P - Income bond -- [pays interest only it if is earned] - Indexed (purchasing power) bond -- has [interest payments based on inflation index] to protect the holder from inflation BOND VALUATION - Discount bond - [Sells below its par value] - Occurs whenever going [rate of interest is above coupon rate] - Premium bond - [Sells above its par value] - Occurs whenever going [rate of interest is below the coupon rate] BOND YIELDS & PRICES - Varies from day to day - [Estimate of the rate of return we would earn if we purchased the bond today & held it over its remaining life] - Bond is *not* *callable* = [remaining life is its yrs to maturity] - Bond is *callable* = [remaining life is yrs to maturity if it is not called] - Yield to maturity (**YTM**) -- [rate of return earned on bond if it is held to maturity] - Yield to call (**YTC**) -- [rate of return earned on bond when it is called before its maturity date] **BOND RISKS** - Price risk/interest rate risk - Risk of a decline in bond value [due to increase in interest rates] - Interest rates fluctuates over time, when they rise = value of outstanding bonds decline - Higher on bonds that have long maturities - [Longer the maturity, longer before the bond will be paid off] & bondholder can replace it w/ another bond w/ higher coupon - Reinvestment risk - Risk of income decline [due to drop in interest rates] - Increase in interest rate hurt bondholders because it leads to decline in current value of bond portfolio - Interest rates fall, [long-term investors will suffer reduction in income] - Default risk - If issuer defaults, [investors will receive less than the premium promised return] - Higher the probability of default = higher the premium, thus yield to maturity - Treasuries = zero FIXED INCOME PORTFOLIO MANAGEMENT - [Process of building & managing portfolios containing bonds (]fixed-income securities) - Bondholders receive regular coupon payments at specified interest rat until bond matures - [Bonds carry lower risk] - Fixed income assets provide [predictable returns] thru regular coupon payments & offer portfolio diversification benefits - Bond returns are vulnerable to interest rate fluctuations which erode purchasing power - [Higher allocation to fixed income] [lowers overall portfolio risk] Fixed income securities - [Debt-based instruments that offer regular coupon payments to bondholders] (who receive bond's par vale at maturity) - Fixed income assets do not offer opportunity to benefit from share P appreciation - They [offer lower risk] thru more predictable outcome - Bonds are [liquid] **Types of fixed-income securities** - Government bonds - [Issued by sovereign govts] - [Very low-risk] due to their govt backing - Municipal bonds - [Issued by local govt] & [very low risk] - General obligation bonds -- [financing infrastructure & public projects] - Revenue bonds -- [backed by revenue generated from specific project] (toll roads, airports) - Housing authority bonds -- [finance affordable housing initiatives], backed by [rental incomes/state subsidies] - Corporate bonds - [Securities issued by companies ] - [Pay higher rate of interest] - Convertible bonds - [Converted into company stock during pre-determine periods] - Allows bondholder to [exchange their bond for specific no. of issuer's shares] - Offers investors option to benefit from potential share P appreciation - Potential for [higher returns but carry higher risk] - Issuers are companies that have high growth expectations but less than stellar credit rating - Asset-backed securities (**ABS**) - [Instruments backed by various pools of assets] (mortgages) - When investors buy these, their overall return depends on the interest & principal payments accruing to the underlying loans - Collateralized debt obligations (**CDOs**) - [Complex debt securities], [backed by pools of bonds/loans], w/ levels of risk varying based on quality of underlying assets Role of fixed income in portfolio? - [Defensive asset class as bonds are less volatile ] - [Offer source of diversification] that can help reduce volatility & overall portfolio risk **Fixed Income Portfolio Management Strategies** **Laddered portfolio** - Bond ladder investing - Buying fixed-income securities w/ various maturities to achieve high level of diversification - Helps reduce risk - Reinvestment risk -- interest rates could decline, & maturing bonds would be reinvested at lower rates - Liquidity risk -- bonds w/ lower credit ratings may be less liquid, making them difficult to buy/sell in open market - Credit risk -- exposed to credit risk if issuer defaults **Bullet portfolio** - [Buying fixed-income securities that have the same maturity date on different dates] - Suitable for investors [who may need a lump sum payment in the future,] as all bonds in the portfolio will mature on the same date - [Sensitive to interest rate changes] - *Interest rate increase* = [bonds become less attractive ] - *news issues* = bear [higher interest rates] - includes bonds w/ short-term & long-term maturities - achieve optimal risk-reward outcome - yield curve - used by central banks, policymakers, & investors - [indicator of market sentiment & powerful predictor of economic output] & growth that shapes monetary lending rates - [plots interest rates of bonds w/ equivalent credit ratings but diff maturities] - created for municipal bonds/corp issuer Types of Yield Curve a. normal -- [longer-term bonds have higher yields], [upward-slopping yield curve] = [healthy economy] b. steep -- significant [difference b/n short-term & long-term yields] = [anticipated economic growth] c. inverted = [short term yields are higher] = [economic downturn/recession] d. flat -- [short-term & long-term yield are similar] = [uncertain future economic conditions] INVESTMENT & PORTFOLIO MANAGEMENT MODERN PORTFOLIO THEORY (**MPT**) - investment theory that [allows investors to assemble to an asset portfolio that maximizes expected return for given level of risk] - investors are risk-averse; investors will always [prefer less risky portfolio] - investor must be compensated for higher level of risk thru higher expected returns - core idea of diversification ([owning portfolio of assets from different classes is less risky]) - diversification - [portfolio allocation strategy] that [aims to minimize idiosyncratic risk by holding assets that are not perfectly positively correlated] - [cannot lower systematic risk] because all assets carry this risk - correlation coefficient of **-1** = perfect negative correlation b/n 2 assets; [positive movement in one is associated w/ negative movement] - correlation coefficient of **1** = perfect positive; [both assets move in same direction] - systematic risk - risk that is [common to entire market specific to each asset] - portfolio frontier / efficient frontier - [set of portfolios that maximizes expected returns] for each level of standard deviation (risk) - expected return - [expected value of the probability distribution] of possible returns it can provide - standard deviation - [measures level of risk/volatility of asset] - used to [determine how widely spread out the asset movements are over time] - [assets w/ wider range of movements carry higher risk] - depends on: standard deviation of each asset, weights of each asset, correlation b/n each asset Risk-Free rate - [rate of return an investor expects to earn on an asset w/ zero risk] - all assets carry some degree of risk; [assets that have low default risk & fixed returns] are risk-free (3-month govt Treasury bill) Efficient frontier - [upper portion of the curve] - [combination of risky assets that maximizes expected return for given level of SD] - **Point A** -- minimum variance portfolio ([combination of risky assets that minimizes SD]) - **Point B** -- optimal market portfolio ([consists of at least 1 risk-free asset]) Capital allocation line (**CAL**) - [Line that depicts the risk-reward tradeoff of assets that carry idiosyncratic risk] - Slope = Sharpe ratio ([increase in expected return per additional unit of SD]) - *[Rational risk-averse investors]* should hold portfolios that fall on efficient frontier - **MPT** focuses on the [relationship b/n assets in a portfolio] ASSET ALLOCAITON - [How investors divide their portfolios among diff assets] that might include equities, fixed-income assets, & cash & its equivalents Age-based asset allocation - Reco holding stocks for [**5yrs**/longer] - Cash & money market accounts are appropriate for goals [less than a yr] Asset allocation thru life-cycle funds - Provide investors w/ portfolios that address their age, risk appetite & investment goals w/ correlated parts of diff asset classes - Reduces risk in their portfolios as they near the target date, cutting riskier stocks & adding safer bonds to preserve - Bull market -- investors prefer [growth-oriented assets] - Downturn/recession -- investors shift toward more [conservative investments] Asset allocation fund - [Provides investors w/ diversified portfolio] of investments across value asset classes Good asset allocation: **60%** stocks & **40%** bonds (optimal) - Asset allocation is [how investors split up their portfolios among diff kinds of assets] SECURITY ANALYSIS - This & portfolio management = [process that allows investors to identify & analyze securities & create an investment portfolio]; to [determine which securities to buy, sell & hold] - [Process of examining security to estimate its future value] - Portfolio management - Process of [combining diff securities to create an investment portfolio] - Investment portfolio - [Collection of various types of securities] **Different Types of Investment Securities** a. Equity securities -- [own a share in a company] b. Debt securities -- [pays interest] c. Hybrid securities -- [mixture of equity & debt] **Security analysis Tool & Technique** - Financial statements -- [reports that provide an overall snapshot of company's overall financial health] - Financial statement analysis -- [studying company's financial statements] to identify any potential red flags - Fundamental analysis -- [process of examining company's financial statements to predict future performance] & estimate value of company **Security analysis & portfolio management** +-----------------------------------+-----------------------------------+ | Advantages | Disadvantages | +===================================+===================================+ | - Help investors to [make | - [Time-intensive | | better investment | process] | | decisions], | | | diversify their portfolios, & | - Requires [significant amount | | create financial plan | of research] | | | | | | - Requires investors to take on | | | risk | +-----------------------------------+-----------------------------------+ INVESTMENT STRATEGIES - [Set of principles designed to help an indiv investor achieve their financial & investment goals] - [Guides an investor's decisions] based on goals, risk tolerance, & future needs for capital - Styles of investing that help indiv meet their short & long term goals **Type of Investment Strategies** - Conservative -- [safe investments] that come w/ [low risk & provide stable returns] - High aggressive -- [risky investment] (stocks, options, & junk bonds) - Dollar-cost averaging - [Fixed \$ amount of stocks/particular investment] [are acquired on regular schedule regardless of cost/share] P +-----------------------------------+-----------------------------------+ | **Value investing** | **Growth investing** | +===================================+===================================+ | - Investors chooses [stocks | - Investing capital in [stocks | | that look as they though | of] [junior | | trade for less than their | companies that have potential | | intrinsic value] | for earnings | | | growth] | | - [Stocks that the market is | | | underestimating] | | +-----------------------------------+-----------------------------------+ RISK MANAGEMENT - [Process of identifying, assessing & controlling] financial, legal, strategic & security risks to an org's capital & earnings **PERFORMANCE EVALUATION** - Effective performance eval is a middle ground b/n set it & forget it - Annual review can keep you engaged in your holdings while tracking progress of your investment goals **Common ways to Measure performance** Yield -- expressed as **%;** [measure of the income an investment pays during a specific period] a. Yield on bonds -- when you [buy a bond at issue], its yield is the [same as its interest rate] b. Yield on stocks -- calculated by [dividing the yr's dividend by stock's market P] c. Yield on CDs -- [rate remains fixed] CASH & WORKING CAPITAL MANAGEMENT - Cash - [Lifeblood of business] CASH FLOW MANAGEMENT - [Tracking & controlling how much money comes in & out of a business to accurately forecast cash flow needs] - Day-to-day process of monitoring, analyzing, & optimizing net amount of cash receipts minus the expenses **Cash flow Categories** 1. CF Operations - Money flows from [ordinary operations] - Determines [whether/not a company has enough funds coming in to pay bills & operating expenses] - Must be more CFO than outflows to have long-term viability 2. CF Investing - [How much cash has been generated/spent from investment-related acts] in specific time period 3. CF Financing - [Net flows of cash that are used to fund the business & its working capital] - Acts include [issuing debt/equity & paying dividends] - Provides investors w/ insight into an [org's cash position & how will the capital structure is managed] **Relationship b/n AP & Cash flow management** - Company is experiencing *cash flow shortage* = [delay AP to conserve cash]; can damage supplier relationships & affect credit ratings - *Paying AP too quickly* = [negative impact on cash flow]; you're reducing the amount of COD for business needs AP Automation - [Powerful tool for improving cash flow management] - [Use of technology to streamline the entire AP] process, from invoice to approval - Faster invoice processing -- helps business maintain healthy relationships & avoid late fees - Improved control & visibility -- monitor their cash flow & make more informed decisions about paying bills - Reduced mistakes & fraud -- avoid costly mistakes - Cash savings -- frees up cash for other business **Importance of Cash Flow Management** - Investor trust - Staying in business - Utilization of funds **AR & PAYABLE MANAGEMENT** **Importance of AP management** - Stronger vendor relationship - Save money on late fees - Ensure peace of mind w/ better finances - Identify errors & prevent fraud AR Management - [Practices of managing customer payments that are owed to business] - Monitoring unpaid invoices, ff up w/ clients for payments, & account reconciliation **Importance of AR management** - Improved cash flow -- help business receive payments faster - Reduction in bad debt -- ensure timely payment collection - Increased customer satisfaction - Better financial planning - Competitive advantage INVENTORY MANAGEMENT - [Systematic approach to sourcing, storing, & selling inventory] - Optimizing flow of goods within an org, from purchase right thru sale - Inventory -- go[ods handled by business w/ intention of selling], raw materials that they use in production, finished products **Importance** - Outlines how you can run your business, grow sales & serve customers - More accurate figures that are instantly avail - Build good relationships w/ customers - Help your company to grow **Benefits of IM** - Greater cost savings - Better business negotiations - Reduces risk of overselling - Profitable business decisions Inventory financing - [Form of working capital that allows business to purchase inventory on credit], using *purchased stock* itself as [collateral] - Used by medium-sized companies looking to boost their stock reserves in preparation for demand - [Reducing long lead times] by owning goods in-transit, ensuring access to nearby safety stocks SHORT-TERM FINANCING - [Business financing from short-term sources] (less than 1 yr) - Developing money by [online loans, lines of credit, & invoice financing] - Working capital financing - Required in business process because of their uneven cash flow into business/due to their seasonal business cycle **Types of Short-term financing** 1. Trade credit - [Floating time that allows business to pay for goods they have purchased/received] - **28 days** - Helps business manage their cash flows more efficiently & help deal w/ their finances - [How many days the vendor will be allowed before its payment is due] 2. Working capital loans - [Banks/financial institutions extend loans for shorter period] after studying the business nature, working capital, records - Advised to [finance permanent working capital needs] thru these loans 3. Invoice discounting - [Arranging funds against submitting invoices whose payments will be received shortly] - [Receivables invoices are discounted] w/ banks 4. Factoring - [Debtor finance in which business sell their AR to third party] whom we call factor at lower rate than net realizable value 5. Business line of credit - [Best way of financing working capital needs] - [Business can approach bank for approval of certain amount based on their credit line structure] judged thru credit score, business model & projected inflows - [Interest is charged on the utilized amount on daily reducing balance method] - Very cost-efficient mode of financing **Short-term Loans** +-----------------------------------+-----------------------------------+ | **Advantages** | **Disadvantages** | +===================================+===================================+ | - [Less interest] = | - One can get smaller loan & | | paid off in very short period | shorter maturity date | | | | | - [Disbursed | - [Monthly installment will | | quickly] = risk | come very high] | | involved in defaulting loan | | | payment is lesser | | | | | | - Less documentation | | +-----------------------------------+-----------------------------------+ LIQUIDITY MANAGEMENT - [Proactive process of ensuring company has the COD to meet its financial obligations as they come due] - Directly impacts company's working capital (difference b/n company's current asset & liabilities) - Cash forecasting - Managing short-term debt obligations & investments - Assessing lines of credit ([source of funding that can be used in case of emergency]) - Optimizing AR & AP processes **Types of Liquidity** - Asset liquidity - [Can be converted into cash quickly & easily], w/o incurring significant loss - COD & investments in [short-term debt instruments] are [liquid asset]s - Market liquidity - [Lot of buyers & sellers & P of assets are relatively stable] - Accounting liquidity - [Company's ability to meet its day-to-day operational expenses] - Most important type of liquidity as it [directly impacts company's solvency] **Importance of Liquidity Risk management** In supply chain management - [Process of coordinating flow of goods & resources from suppliers to customers] - [Complex process that involves managing multiple moving par]ts - Disruption in supply chain lead to increased costs, decreased sales, & lower profits How to assess liquidity? - Current ratio - [Measures company's ability to pay its short-term obligations w/ current assets] - [Simples & most common way of calculating company's liquidity] which is dividing company's current assets by current liabilities - Quick ratio - [Excludes inventory from calculation of current assets] - Current assets (**cash + securities + AR**) - Cash ratio - [Measures company's ability to pay its short-term obligations w/ its most liquid assets] (cash & cash equivalents) - [Dividing company's cash & cash equivalents by its current liabilities] **Factors that Impact Liquidity Risk** - Inventory - *Too much inventory* = [tie up working capital] - *Too little inventory* = [production delays & lost sales] - Uncollected receivables - [Money owed to company by its customers for goods] that have been delivered - Outstanding payables - [Money that a company owes its suppliers] - Business take advantage of early payment discounts/extended payment returns on current & future debts - Reduced credit limits - [Companies are forced to pay cash for inventory] which can put strain on working capital - Seasonality - *Spike in demand* = [increase in AR] & [decrease in inventory levels]