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# System prepended metadata

title: 'Financial management, midterm'

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# Financial Management

[TOC]

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# Introduction

This Online note is brought to you by Kevin Zhou, BIBA class of 2024. All of the contents are from the textbook and online websites (Investopedia, The balance, Financial times). 

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# Chapter 1: The Role and Objective of Financial Management
## 1.1 The primary goal of the firm
* **Shareholder value:** The **most widely** accepted objective of the firm is to maximize **shareholder wealth**
        
    (**Shareholder wealth** = Number of shares outstanding x Market price per share)

    Management should seek to **maximise** the present value of the expected future returns to the shareholder from the firm.
    
* **Two important values:** Present value and market value.
    1. **Present value:** The value today of some future payments, evaluated at 'n' appropriate discount rate.
    2. **Market value:** The price at which the stock trades in the market place.

* **Stakeholder concerns:**
    1. **Stockholders:** Stockholders typically want to see a **return on their investment**, which means they are concerned with the company's financial performance and profitability. They may also be concerned with the company's strategy for growth, divident payouts, and mangement effectiveness.
    
    2. **Customers:** Customers are concerned with the quality of the products or services offered by the comapny, as well as the **price and availability**. They may also be concerned with the company's reputation, social responsibility, and customer service.
    
    3. **Employees:** Employees are concerned with fiar compensation, job security, a safe and healthy work environment, opportunities for career development, and good management practices.
    
    4. **Suppliers:** Suppliers are concerned with being paid fairly and on time having a reliable and steady source of business, and being treated with respect and fairness.
    
    Overall, each stakeholder group has unique concerns that are crucial to their relationship with the company, and addressing these concerns is critical to maintaining **positive relationships** with all stakeholders.
    
* **A divergent objective**

    A divergent objective refers to a situation where **two or more individuals or groups have conflicting goals or interests**, which means that achieving one objective may make it more difficult or impossible to achieve the other. This can create **tension and conflict**, as each party tries to achieve its own objective at the expense of others.
    
    For example, a **company** may have a goal to **increase profits by cutting costs**, while **employees** may have a goal to **increase wages and benefits**. These two objectives can be divergent because achieving one goal may make it more difficult to achieve the other. If the company cuts costs to increase profits, it may mean that employees will have to accept **lower wages or fewer benefits**, which can lead to dissatisfaction, low morale, and even possible strikes or other forms of protests.
---
## 1.2 Agency

* **Agency problems:** The existence of divergent objectives between **shareholders(owners)** and **managers** is one example of problems arising from agency relationships. 

* **Agency relationship:** 
    1. **Principle(Owner):** The owner refers to the principal who hires an agent to perform certain tasks on their behalf.
    2. **Agent(Manager):** The manager refers to the agent who is hired by the owner to perform these tasks.

* **Agency problems**
    1. **Stockholders and creditors:**
        When a company **borrows** money from creditors, such as banks or bondholders, the stockholders' interests may conflict with those of the creditors. **Stockholders** may **prioritize investments** that increase the value of their equity, such as risky projects or dividends, whereas **creditors** may **prioritize the repayment** of their loans with interest. This can lead to conflicts between the two parties, particularly in times of financail distress when the company's ability to repay its debts may be in doubt.
    
    2. **Stockholders and managers:**
        As mentioned earlier, agency problems can arise between stockholders and managers when managers priortize their own interests over those of the stockholders. Managers may **pursue personal goals**, such as maximizing their own compensation or job security, at the expense of the stockholders. This can lead to **suboptimal decisions** for the company, such as underinvestment in profitable projects or excessive risk-taking.
        
        >***suboptimal decision** refers to a situation where there are other better options available but the chosen option is not the most ideal or effective one

* **One way of reducing agency problems**
    * Corporate governance 

        1. **Definision:** Refers to the set of **processes, principles, and values** that guide the management and control of a company. It encompasses the relationships between the board of directors, management, shareholders, and other stakeholders, and the framework that defines the responsibilities and accountability of each party.
    
        2. **Components:** The key components of corporate governance include the board of directors, executive management, shareholders, and other stakeholders. The board of directors is responsible for **providing oversight and guidance** to the company's management, while the management team is responsible for implementing the board's decisions and managing the day-to-day operations of the company.
    
        3. **Shareholders power:** Shareholders have a key role in corporate governance, as they elect the board of dirctors and have the power to **influence the direction** of the company through voting on key decisions. Other stakeholders, such as employees, customers, and the broader community, also have a stake in the company's success and may have input into the corporate governance process.

    * Managerial Compensation
        
        1. **Stock options:** Stock options give employees the right to buy company stock at a **set price** (known as the "exercise price") for a set period of time. The hope is that the value of the company's stock will **increase** during that time, allowing the employee to purchase the stock at a lwoer price and sell it for a profit. This type of compensation incentivizes employees to work to increase the company's stock price.
        
        2. **Restricted stock:** Restricted stock is stock that is **granted** to employees, but the employee **cannot sell or transfer** the stock until certain conditions are met (such as vesting period or achieving certain performance goals.) Restricted stock is often used as a retention tool to encourage employees to **stay with the company for a longer period of time**.
        
        3. **Performance shares:** Performance shares are stock awards that are **tied to specific performance metircs or goals**. If the comapny achieves the goals, the employee receives that shares；**if not**, the shares may be **forfeited**. This type of compensation incentivizes employees to work towards specific goals are aligned with the company's overall strategy.
    
* **Conclusion for agency problems:**

    In both cases, the **interests of the principal** may not align with those of the agent, leading to agency problems. To mitigate these issues, **various mechanisms** can be put in place, such as performance-based compensaiton, monitoring mechanisms, and clear contractual agreements that specify the goals and responsibilities of the different parties.
---
## 1.3 Maximization of Shareholder Wealth: Managerial Strategies

### **Profit maximizing**

1. Mazimizing profits is typically **not the same** as maximizing shareholder wealth
        
    >**Maximizing profits** is often seen as a **short-term** goal that may not align with the long-term interests of shareholders. For example, a company may focus on **increasing profits** by cutting costs and reducing investment in research and development, marketing, or employee development, which may lead to a decline in the company's long-temr value and growth opportunities. In contrast, maximizing shareholder wealth considers the long-term value.
    
2. Profit maximization lacks a **time dimension** (long-term versus short-term)
    
    >Profit maximization may focus solely on **short-term** gains and **ignores the long-term impact** of a company's decisions. In contrast, maximizing shareholder wealth considers the long-term value of a company's shares and may require investment in areas that **may not show immediate profit gains** but will create long-term value for shareholders.
    
3. Generally accepted accounting principles result in hundreds of definitions of profits (or earnings or income)
    
    >Accounting principles allow for various methods of calculating profits, which can lead to different definitions of profits. For example, a company may use **aggressive accounting methods** to show higher profits in the short term, which may not reflect the true long-term value of the company. In contrast, maximizing shareholder wealth considers the long-term value of a company's shares, which may require a more conservative approach to accounting to reflect the true value of the company.
    
4. Profit maximization ignores risk
        
    >Profit maximization may lead companies to take on more risk in order to **achieve higher profits**. However, this may not always be in the best interest of shareholders, who may **value stability and consistent returns**. In contrast, maximizing shareholder wealth takes into account the risk associated with a company's decisions and seeks to create **sustainable long-term growth and value** for shareholders.
---
### **Book Value vs Market Value**

1. **Book value:** (Book value = Assets - Liabilities)
    
    The value recorded in the company's accounting books as the equation shown above. It represents the **amount of equity that would be left** if a company were to liquidate all of its assets and pay off all of its debts.
    
2. **Market value:**
    
    Is the current value of a company as determined by the **stock market**. It is the price at which a company's stock is currently trading in the stock market and is determined by the **supply and demand for the stock**. Market value takes into account factors such as investor sentiment, the company's future growth prtential, and its earnings potential.
    
3. **Differences:**
    
    In general, market value tends to be **higher than book value** because it takes into account the company's potential for future earnings and growth. A company with a **strong growth potential** will have a higher market value than its book value, while a company with a **weak growth potential** will have a lower market value than its book value.
    
* **Conclusion:**

    Investors use both book value and market value to evaluate a company's worth, but the importance of each measure depends on the investor's **investment style and goals**. **Value investors** tend to focus more on **book value**, looking for companies that are undervalued relative to their book value. **Growth investors**, on the other hand, tend to focus more on **market value**, looking for companies with strong growth potential that will increase their market value over time.
---
### **Determinants of Value**

1. **Cash flow:**

    The cash flow refers to the amount of cash that a business or investment generates over a **specific period**. It is an important determinant of value because it reflects the ability of the business or investment to generate revenue and pay expenses. In general, higher cash flows are considered more valuable because they provide a stronger foundation for future growth and profitability.
    
2. **Timing of Cash Flows:**

    The timing of cash flows is another important determinant of value. Cash flows that occur sonner rather than later are generally more valuable because they can be **invested or reinvested** to generate additional returns. This is known as the time value of money, whcih means that money today is worth more than the same amount of money in the future.
    
3. **Risk:**

    Risk refers to the potential for an investment to **lose value or fail to generate expected returns**. Higher risk investments generally require a higher rate of return to compensate investors for the additional risk. Therefore, the level of risk associated with an investment is an important determinant of its value.
    
4. **Market Conditions:**

    The state of the market can also have a significant impact on the value of an investment. For example, during a **recession**, investors may be more **risk-averse and demand higher rates of return** to compensate for the uncertain economic conditions. Coversely, during times of economic growth and stability, investors may be willing to accept lower rates of return.
    
Overall, these determinants of value are interdependent and must be considred in combination to accurately assess the economic value of an investment or business.

---
### **Managerial Actions to Influence stock price**

1. **Products and services offered for sale:** 

    If a company introduces **new products or services** that are well received by consumers, this can lead to increased sales and revenue, which can positively impact the company's stock price.

2. **Production technology:** 

    Implementing more efficient and cost-effective production technology can **increase profit margins**, which can lead to a higher stock price.

3. **Marketing and distribution network:** 

    Effective marketing and distribution can increase brand awareness, **expand the company's customer base**, and ultimately lead to increased sales and revenue, which can positively impact the company's stock price.

4. **Investment strategies:** 

    Investing in profitable ventures or divesting from unprofitable ones can positively **impact the company's financial position**, which can lead to a higher stock price.

5. **Employment policies and compensation packages:** 

    A company's employment **policies and compensation packages** can impact employee satisfaction and motivation, which can impact productivity and ultimately affect the company's bottom line and stock price.

6. **Ownership form:** 

    A change in ownership structure, such as a merger or acquisition, can impact the company's future prospects and growth potential, which can affect the stock price.

7. **Capital structure:** 

    Adjusting the company's capital structure, such as issuing or repurchasing shares or changing the debt-to-equity ratio, can impact the company's financial position and future prospects, which can affect the stock price.

8. **Working capital management policies:** 

    Effective management of working capital, such as **optimizing inventory levels and collecting receivables**, can improve the company's cash flow and financial position, which can affect the stock price.

9. **Dividend policies:** 

    A company's dividend policy can **impact investor perceptions** of the company's financial health and growth prospects, which can affect the stock price.

Overall, investors closely monitor a company's managerial actions to assess its financial health and future prospects, which can impact the company's stock price.

![](https://i.imgur.com/zlygSxO.png)

---
## 1.4 Forms of Business Organization



### Sole proprietorship
    
1. **Definision:** 
        
    A Sole Proprietorship is a type of business structure where **one individual owns and manages the entire business**. It is the simplest and most common form of business organization, representing 72 percent of all U.S. businesses. However, despite its prevalence, it accounts for only 4.1 percent of total U.S. business revenues.
    
2. **Advantage:**
        
    One advantage of a Sole Proprietorship is that it is **easy and inexpensive to establish**. The owner has complete control over the business and can **make decisions quickly** without consulting anyone else.
            
3. **Disadvantage:**
        
    Although it seems nice, there are also several disadvantages to this business structure. The owner has **unlimited liability**, meaning that they are personally **responsible for all the debts and obligations** of the business. This means that if the business fails, the owner's personal assets can be used to pay off any outstanding debts.
            
    Another disadvantage is that it can be **difficult to raise funds to finance growth**. Sole Proprietorships are limited in their ability to raise capital through external sources, such as **loans or investments**, because they do not have the legal entity status that corporations and partnerships have. This can make it challenging to expand the business or take advantage of opportunities for growth.
    
### Partnership

1. **Definition:**
        
    A partnership is a type of business structure in which **two or more individuals** share ownership and management of the company. Each partner contributes to the business in terms of capital, labor, or expertise, and **they share the profits and losses** of the business based on their ownership stake. 
            
    It's a common form of business ownership in the United States, representing around 10 percent of all businesses. However, they tend to account for a relatively small share of total business revenues, typically less than 15 percent.
            
    Partnerships can be classified into two main types, general partnerships and limited partnerships.
    1. General partnership: All partners share **equal responsibility** for the management of the business and are personally liable for its debts and obligations.
    
    2. Limited partnership, there are two types of partners:
    > (1) General partners: Who have unlimited liability and control over the business.
    > 
    > (2) Limited partners: Who contribute capital but have limited involvement in management and are only liable for the amount of their investment.

2. **Advantage:**

    The advantage of having limited partners in a partnership is that their **liability is limited** to the amount they have invested in the business, as specified in the partnership agreement. This means that if the business incurs debts or obligatios that exceed the investment of the limited partner, they are **not personally responsible for the excess amount**. It helps to protect the limited partner's personal assets from being seized to pay off the partnership's debts.
        
3. **Disadvantage:**
    > Partnerships have several disadvantages, which may include the following:
    > 1. Partnership dissolves upon change of makeup in general partners:
    > In a partnership, the business is owned and managed by two or more people who share the profits and losses. However, if one or more of the general partners decide to leave the partnership or pass away, the partnership may be dissolved. This can be a major disadvantage of a aprtnership as it can disrupt the continuity of the business an dresult in the loss of customers, suppliers, and employees.
    > 
    > 2. Unlimited liability for general partners: 
    > Another significant disadvantage of partnerships is that the general partners have unlimited personal liability for the debbts and obligations of the partnership. It means that if the partnership incurs debts or obligations that exceed the assets of the business, the general partners can be held personally responsible for the excess amount. This can put the personal assets of the general partners, such as their homes, savings, and investments, at risk.
        
### Corporation
1. **Definision:**

    A corporation is a type of business entity that is considered a **"legal person"** under the law. This means that it is treated as a separate legal entity from its owners, with its own rights and responsibilities. A corporation can be composed of **one or more actual individuals or legal entities**, such as other corporations or partnerships.
    
    In the United States, corporations represent less than **18%** of all business, but they account for a **large portion of the country's business revenues and profits**. In fact, corporations generate around 81% of business revenues in the States and about 61% of business profits.
    
2. **Advantage:**

    (1) Limited liability:
    
    One of the most significant advantages of a corporation is that it offers **limited liability protection** to its owners or shareholders. This means that the personal assets of the owners are generally not at risk if the corporation itself are at risk. This can be a **valuable safeguard for entrepreneurs and investors**, as it can protect their personal savings, homes, and other assets from potential losses.
        
    (2) Permanency:
    
    Another advantage of a corporation is that it has a **perpetual existence**, which means that it can continue operating even if it owners or management changes. This allows for a level of **continuity and stability** that is not available to other forms of business entities, such as partnerships or sole proprietorships, which can be dissolved or terminated if a key member leaves or dies.
    
    (3) Fliexibility:
    
    Corporations are also **highly flexible** in terms of ownership structure, management, and operations. They **can be owned by multiple shareholders**, with varying levels of ownership and control. They can also be managed by a board of directors, with officers and managers appointed to run day-to-day operations. Additionally, corporations can choose from a wide range of business activities, such as **manufacturing, retail, or service-based operations**.
    
    (4) Ability to raise capital:
    
    Corporations have the ability to **raise large amounts of capital** through the sale of stocks and bonds. Because the ownership of a corporation is divided into shares of stock, it can be **easier to attract investors** who are willing to buy shares in the corporation in exchange for a stake in its ownership. This can allow corporations to **raise significant amounts of capital for growth, expansion, or new ventures**. Additionally, corporations can issue debt **through bonds or other financial instruments**, which can provide additional funding for operations or investments.
    
3. **Disadvantage:**

    One major disadvantage of a corporation is that ownership is often **separated from management**. In a corporation, the owners or shareholders own the company, but they **do not necessarily manage it directly**. Instead, the management of the company is delegated to a board of directors and executive officers who are appointed or hired by the shareholders.
    
    This separation between ownership and management can lead to **conflicts of interest** and a **lack of accountability**. Shareholders may have different goals and priorities than the management team, which can lead to **disagreements and a lack of alignment** on the direction of the company.

Since the following sections do not need to be expained further more, so the sections will be presented by two pictures featuring the organization chart and the impact of other disciplines on financial management.

![](https://i.imgur.com/gPmzFtE.png)

![](https://i.imgur.com/TXEpnJK.png)

---
# Chapter 5: The Time Value of Money
## 5.1 Key words and notations
* In finance, as a general rule, lowercase letters are used to denote percentage rates and lengths of time, whereas capital letters are used to denote money or dollar amounts.

* Five basic time value of money notations:
1. **PMT:** Cash Payment
2. **PV:** Present Value
3. **FV:** Future Value
4. **t:** Time
5. **n:** Number of Periods

* Calculator Solution:
    There are five keys on any financial calculator regardless fo which you use, the same steps are involved for solving any time value of money problems. Think of each key as a specific variable, while the location and specfic notation may vary between calculators, usually the five keys are grouped together.
    
    ![](https://hackmd.io/_uploads/SkdusVPrh.jpg)
    
    Texas BA II plus financial calculator
---
## 5.2 Interest 
* **Definition:** The return earned by or the amount paid to someone who has forgone current consumption or alternative investment opportunities and rented money in a creditor relationships.

* **Principal:** The amount of money borrowed or invested.

* **Rate of interest:** The percentage on the principal that borrower pay the lender

### Simple Interest
* Interest paid on the principal sum only.
    1. I = PV~0~ x i x n
    2. FV~n~ = PV~0~ + (PV~0~ x i x n)
    > Example1: You agree to invest $1,000 in a venture that promises to pay 6 percent simple interest each year for two years. How much money will you have at the end of the second year?
    >> Sol: FV~2~ = $1,000+(1000 x 0.06 x 2)= $1,120
    >
    > Example2: If Gomez borrows $1,000 for 9 months at a rate of 8 percent per annum. How much will he have to repay at the end of the 9-month period?
    >> Sol: FV~3/4~ = $1,000+(1,000 x 0.08 x 3/4)= $1,060

### Compound Interest:
* Interest paid on the principal and on prior interest that has **not been paid or withdroan**
    1. FV~n~ = PV~0~ x (1+i)^n^
    > Example1: You agree to invest $1,000 in a venture that promises to pay 6 percent compound interest each year for two years. How much money will you have at the end of the second year?
    >> Sol: FV~2~ = $1,000 (1+0.06)^2^= $1,123.60

### Simple vs Compound
![](https://hackmd.io/_uploads/rJrklHDH3.png)
* Solving for the Interest Rate
    **FVIF~i,n~= FV~n~/PV~0~**
* Solving for the Number of Compounding Periods
    **FV~n~= PV~0~(FVIF~i,n~)**
>FVIF: Future Value Interest Factors
---
## 5.3 Present Value
* **Definition:** Financial decision maker often faced with another type of problem: Given some **future value (FV~n~)**, what is its equivalent value today? In other words, what is its **present value (PV~0~)**? The solution requires *present value* calculations, which are used to determine the dollar amount today.
* PV~0~ = FV~n~[1/(1+i)^n^]
    > Example: Suppose your banker offers to pay you $255.20 in five years if you deposit X dollars today at an annual 5 percent interest rate. What is the present value of the $255.20?
    >> Sol1: PV~0~ = FV~5~(1/FVIF~0.05,5~)= $255.20(1/1.276)= $200.00
    >> Sol2: PV~0~ = FV x **PVIF**= 255.2*0.784= 200.076
---
## 5.4 Annuities
* **Annuity:** The payment or receipt of equal cash flows per period for a specified time
* **Ordinary annuity:** The payments or receipts occur at the end of each period.
![](https://hackmd.io/_uploads/Hywk0rwr2.png)

* **Annuity due:** The payment or receipt occur at the beginning of each period.
![](https://hackmd.io/_uploads/S1gxRHwS2.png)

* **Difference:** The difference between ordinary annuity and annuity due is **the time of each payment or receipts occurs**. The timming distinction affects the calculation of the **present and future values** of the annuity. In general, as **annuity due** has a **higher** ++present value and future value++ compared to an **ordinary annuity due to** the time value of money and the earlier receipt of payments in the annuity due.

### Future value of an Ordinary annuity
* **FV~n~= PMT~n~(1+i)^t^**

    >Example: Suppose you receive a 3-year ordinary annuity of $1,000 per year and deposit the money in a savings account at *++the end++* of each year. The account earns interest at a rate of 6 percent compounded annually. How much will your account be worth at the end of the 3-year period?
    >> Sol: FVAN~3~ = FV~3rd~ + FV~2nd~ + FV~1st~
    >> = $1,000(1+6%)^0^ + $1,000(1+6%)^1^ + $1,000(1+6%)^2^
    >> = $1,000 + $1,060 + $1,124= $3,184

### Future value of an Annuity due
* **FVAND~n~= PMT[PVIFA~i,n~(1+i)]**
    
    > Example: Suppose you receive a 3-year annuity due of $1,000 per year and deposit the money in a savings account at *++the beginning++* of each year. The account earns interest at a rate of 6 percent compounded annually. How much will your account be worth at the end of the 3-year period?
    >> Sol: FVAND~n~= PMT [FVIFAi,n(1+i)]
    >>FVAND~3~ = $1,000(3.375) = $3,375

### Present value of an Ordinary annuity
* **PV~Ordinary~ ~annuity~= PMT x {1-[1/(1+i)~n~]}/i**
    
    > Example: Suppose you receive a 4-year ordinary annuity of $1,000 per year and deposit the money in a savings account at the end of each year. The account earns interest at a rate of 6 percent compounded annually. How much is this annuity worth to you today?
    >> Sol: PVAN~0~ = PMT(PVIFA~0.06,5~)
            PVAN~0~= $1,000(4.212)= $4,212
            
### Present value of an Annuity due
* **PVAND~t~= PMT[PVIFA~i,n~(1+i)]**
    
    > Example: Suppose you receive a 4-year annuity due of $1,000 per year and deposit the money in a savings account at the beginning of each year. The account earns interest at a rate of 6 percent compounded annually. How much is this annuity worth to you today?
    >> Sol: PVAND~t~= PMT[PVIFA~i,n~(1+i)]
    >> PVAND~0~= $1,000(4.465) = $4,465

### Perpetuities
* **PV~Perpetuities~= PMT/i**
    
    > Example: Determine how much you would be willing to pay for a bond that pays $85 annual interest indefinitely and never matures, assuming you require an 6.5 percent RoR(rate of return) on this investment.
    >> Sol: PV~PER~= PMT/i
    >> PV~PER~= 85/0.065= 1,308

### Present value of an uneven payment stream
* **PV~0~= [PMT~1~/(1+i)^1^]+[PMT~2~/(1+i)^2^]+[PMT~3~/(1+i)^3^]+...+[PMT~n-1~/(1+i)^n-1^]+[PMT~n~/(1+i)^n^]**

---
## 5.5 Compounding Periods and Effective Interest Rates
* **Definition:** The frequency with which interest rates are compounded affcts **both the present values of cash flows** as well as the **effective interest rates** being earned or charged.

* **Normal interest rate:** A normal interest rate refers to the **prevailing rate** in an economy under stable conditions. It is determined by factors like central bank policy, inflation expectations, and supply/demand for credit. Normal rates **encourage borrowing and investment** while keeping inflation in check. Lower rates stimulate economic activity, while higher rates curb inflation and attract savings. 

* **Effective interest rate:** It is a measure of the **true cost or return** on a financial product. It takes into account not only the nominal interest rate but also the compounding effect over a specified period. The effective interest rate reflects the **total amount of interest earned or paid**, including any fees or charges, **over a year**. It allows for accurate comparisons between different financial products and helps consumers evaluate the true cost or return on their investments or loans. The effective interest rate provides a more comprehensive understanding of the financial impact than just the nominal rate.

* **Effect of compounding periods on present and future values:**
![](https://hackmd.io/_uploads/B1mE72sr2.png)
![](https://hackmd.io/_uploads/rkOVX2sH2.png)

### Effective rate calculation
* **i~eff~= (i~nom~/m)^m^-1**
    
    > Example: What is the effective rate if the nominal rate is 15%, compound semi-annually?
    >> Sol: i~eff~= [1+(0.15/2)]^2^-1= 0.155625
---
## 5.6 Net Present Value Rule
* **Definition:** The Net Present Value (NPV) rule is a financial decision-making principle that states that an investment or project should be accepted if its NPV is positive and rejected if its NPV is negative. NPV considers the time value of money and helps assess the profitability of an investment.

* NPV= (Present value of future cash flows)-(Initial outlay)
    
    > Example: An investment offers the following ++year end++ cash flow:
    > | End of year | Cash flow |
    > |-------------|-----------|
    > |      1      |  $20,000  |
    > |      2      |  $30,000  |
    > |      3      |  $15,000  |
    >
    > Using a 15% interest rate, convert this series of irregular cash flows to an equivalent 3 year annuity.
    >
    >> Sol: (step by step)
    >> 1. Calculate the equivalent cash flows for the counting three years, using PV(table 2)
    >> First year: 20,000 x PVIF~15%,1~= 17,400
    >> Second year: 30,000 x PVIF~15%,2~= 22,680
    >> Third year: 15,000 x PVIF~15%,3~= 9,870
    >> Then you will get the total amount of 49,950
    >> 
    >> 2. You convert the 49,950 into a three year annuity payment using  PVAN(table 4)
    >> PVAN= PMT x PVIFA~15%,3~
    >> 49,950= PMT x 2.283
    >> Therefore PMT= 21,879
---
# Chapter 6: Fixed-Income Securities: Characteristics and Valuation
## 6.1 Characteristics of long-term debt
* **Fixed-Income Securities:**

    * **Definition:** Fixed-income securities are investment instruments that generate a fixed stream of income for investors over a specific period. They are typically issued by governments, municipalities, corporations, and other entities to raise capital. Fixed-income securities can be categorized based on several factors:
        1. **Debt versus Equity:**
            Fixed-income securities represent a **debt obligation**, whereas equity represents **ownership in a company**. When you invest in fixed-income securities, you are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount at maturity. In contrast, equity represents ownership in a company, entitling the investor to a share of its profits and potential capital gains.
        
        2. **Tax-Deductibility of Interest:**
            The interest payments received from certain fixed-income securities may be **tax-deductible**, depending on the jurisdiction and the purpose of the investment. For example, in some countries, interest income from government bonds ma be tax-exempt or subject to reduced taxation, while interest from corporate bonds may fully taxable.
        
        3. **Par Value:**
            The par value, also known as the **face value or principal value**, represents the **nominal value of a fixed-income security**. It is the amount the issuer promises to repay to the investor at maturity. Par value is typically set at $1,000 or $100 for bonds, but it can vary depending on the issuer and the market.
        
        4. **Maturity Date:**
            The maturity date is the date on which the issuer is **obligated to repay** the par value of the fixed-income security to the investor. It signifies **the end of the investment period**. Maturity dates can range from a few months to several decades, depending on the type of ifxed-income security. Short-term securities are referred to as money market instruments, while longer-term securities are known as bonds.
        
        5. **Coupon Rate:**
            The coupon rate, also called the **interest rate**, is the fixed annual percentage rate of interest that the issuer agrees to pay the investor on the par value of the security. It determines the regular income the investor will receive throughout the investment period. For example, if a bond has a $1,000 par value and a coupon rate of 5%, the investor will receive $50 in annual interest payments.
        
        6. **Coupon Payment:**
            The coupon payment refers to the **periodic interest payments** made by the issuer to the investor. These payments are typically made **semiannually or annually**, depending on the items of the fixed-income security. The coupon payment is calculated by multiplying the coupon rate by the par value of the security. Using the example above, the investor would recerive two $25 coupon payments per year on a bond with a 5% coupon rate.

* **Types of Long-Term Debt:**
    * **Definition:** Long-term debt refers to **financial obligations or liabilities** that extend beyond a year and are typically used by companies, governments, or individuals to finance investments or operations. It represents borrowed fund that are expected to be repaid over an extended period, often with a fixed interest rate and a maturity date. The followings are some examples of types of long-term debt.
        1. **Mortgage Bonds:**
            Mortgage bonds are secured by a **specific property or real estate**. They are backed by a mortgage on the property, which serves as collateral for the bondholders. In case of default, the bondholders have a claim on the property. Mortgage bond typicall have a **fixed interest rate and a maturity date**.
    
        2. **Debentures:**
            Debentures are **issued by corporations or governments**. Unlike mortgage bonds, debentures are not backed by any specific collateral. INstead, they rely on the general creditworthiness and repayment ablility of the issuer. Debentures often have a fix interest rate and a specific maturity date.
    
        3. **Senior Debt:**
            Senior debt refers to a category of debt that has **priority** over other types of debt in the event of **liquidation or bankruptcy**. It has a higher claim on the assets of the borrower, meaning that in case of default, senior debt holders are paid before other creditors. Senior debt is considered **less risky** than other forms of deb since it has a higher chance of being fully repaid.
    
        4. **Unsubordinated Debentures:**
            Unsubordinated debentures are a type of debenture that is not subordinated to any other debt. They hold the **smae priority** as other unsecured debts of the issuer. In the event of liquidation or bankruptcy, unsubordinated debentures are paid **after** any secured debts but before any subordinated or junior debts.
    
        5. **Equipment Trust Certificates:**
            Equipment trust certificates are secured by specific pieces of equipment, such as airplanes, ships, or machinery. These certificates represent an **ownership interest in the equipment** and provide collateral to the bondholders. In case of default, the bondholders have a claim on the equipment and can seize or sell it to recover their investment.
    
        6. **Collateral Trust Bonds:**
            Collateral trust bonds are secured by financial securities, such as stocks or bonds, which are held in a trust. The issuer pledges these securities as collateral to provide additional security to the bondholders. If the issuer defaults, the collateral can be sold to repay the bondholders.

* **Features of Long-Term Debt:**
    * **Definition:** Long-term debt refers to a **financial obligation that extends beyond one year** and is typically used by companies to finance their operations, acquisitions, or capital expenditures. It is an important component of a company's capital structure and has several features that distinguish it from short-term debt. Let's explore some of the key features of long-term debt and the categories mentioned below.
        1. **Indenture:**
            An indenture is a **legal contract** that outline the terms and conditions of the long-term debt issuance. It specifies details such as **the principal amount, intereset rate, maturity date, repayment terms, and any special provisions or covenants associalted with the debt**.
        
        2. **Trustee:**
            A trustee is a **third-party entity** appointed to represent the interests of the bondholders or lenders. The trustee ensures that the terms of the indenture are followed, monitors the issuer's compliance with covenants, and protects the rights of the bondholders.
        
        3. **Call Feature and Bond Refunding:**
            A call feature allows the issuer to redeem the bonds before their maturity date at a specified call price. This feature provides **flexibility to the issuer** but can be **diasdvantageous to bondholders** if interest rates decline and the issuer decides to refinance the debt at lower rates. Bond refunding refers to the process of issuing new debt at lower interest rates to retire existing higher-interest-rate debt.
        
        4. **Sinking Fund:**
            A sinking fund is a provision in the indenture that requires the issuer to set aside money periodically to **retire a protion of the lon-term debt**. The sinking fund reduces the issuer's **default risk and providesadditional security** to bondholders.
        
        5. **Equity-Linked Debt:**
            Equity-linked debt, also known as **convertible bonds or convertible debt**, gives bondholders the option to convert their bonds into a specified number of the issuer's common shares at a predetermined conversion price. This feature allows bondholders to participate in the potential upside of the issuer's stock while still receiving interest payments.
        
        6. **Typical Sizes of Debt issues:**
            The size of long-term debt issues can vary significantly depending on the issuer's financial needs, creditworthiness, and market conditions. Debt issues can range from a few million dollars for small companies to billions of dollars for large corporations or governments. The **size of the debt** issue is determined based on the **issuer's funding requirements and investor demand**.

* **Information on Debt Financing Activities:**
    * **Definition:** Debt financing activities involve raising capital by borrowing funds from external sources, typically through the issuance of debt instruments. These activities are common in both corporate finance and government financing. Let's explore the information related to debt financing activities and the categories mentioned below.
        1. **Coupon Rates:**
            Coupon rates represent the **interest rate** paid on a debt instrument, such as bonds or loans. They are usually expressed as a **percentage of the face value** of the debt. Coupon rates are determined at the time of issuance and remain **fixed or may be variable** based on a specified benchmark interest rate. These rates determine the **periodic interest payments** made to the lenders or bondholders. The coupon rate is influenced by factors such as prevailing market interest rates, the creditworthiness of the issuer, and the term of the debt.
        
        2. **Maturity:**
             Maturity refers to the **time period or duration** until a debt instrument reaches its repayment date. It signifies **the end of the contractual** agreement between the borrower and the lender. Debt instruments have a specified maturity date at the time of issuance, and the borrower is expected to **repay the principal amount** by that date. Maturity can range from short-term (less than a year) to long-term (several years or even decades).
        
        3. **Corporate Bonds:**
             Corporate bonds are **debt instruments** issued by corporations to raise capital. They are typically sold to investors and carry a **fixed or variable coupon rate**. Corporate bonds offer a predetermined maturity date and provide regular interest payments to bondholders. The creditworthiness of the issuing corporation affects the interest rate and the overall risk associated with the bonds.
        
        4. **Government Debt Securities:**
            Government debt securities are debt instruments issued by **national governments or governmental entities** to finance their activities. These securities include **treasury bonds, treasury notes, and treasury bills**. They are considered relatively **low-risk investments** because they are backed by the government's ability to tax or print money. The interest rates on government debt securities are **influenced by various factors**, including economic conditions and the credit rating of the government.
        
        5. **Users of Long-Term Debt:**
            The users of long-term debt can include **both corporations and governments**. In the corporate sector, companies may use long-term debt to fund capital expenditures, business expansions, research and development initiatives, acquisitions, or debt refinancing. Governments utilize long-term debt to finance infrastructure projects, public services, and budget deficits. The users of long-term debt vary in size and creditworthiness, ranging from small businesses to large multinational corporations and from local governments to national governments.

* **Advantages and Disadvantages:**
    * **Advantages:**
        1. **Lower interest rates:** 
            Long-term debt often comes with lower interest rates compared to short-term debt or other forms of financing. This can result in lower overall borrowing costs for businesses, especially if they have a good credit rating.
        
        2. **Fixed repayment schedule:** 
            Long-term debt usually has a fixed repayment schedule, allowing businesses to plan and budget their cash flows more effectively. The predictable repayment structure provides stability and helps with financial planning.
        
        3. **Capital availability:** 
            Long-term debt enables businesses to access a significant amount of capital to finance large-scale projects, expansions, or acquisitions. It allows companies to make long-term investments and take advantage of growth opportunities that may not be feasible with internal funds alone.
        
        4. **Tax advantages:** 
            In some cases, the interest payments on long-term debt may be tax-deductible, reducing the overall tax liability for the business. This can provide a financial advantage and improve the company's cash flow.
    
    * **Disadvantages:**
        1. **Interest costs:**
            While long-term debt may offer lower interest rates, the total interest costs over the life of the debt can be higher due to the extended repayment period. Businesses need to carefully assess their ability to make regular interest payments over an extended timeframe.
        
        2. **Debt service obligations:**
            Long-term debt creates ongoing obligations for businesses to make regular interest and principal repayments. These obligations can limit financial flexibility and restrict the company's ability to allocate funds to other priorities, such as investments or dividends.
        
        3. **Risk of default:**
            Taking on long-term debt introduces the risk of default if the business faces financial difficulties or is unable to meet its debt obligations. Defaulting on long-term debt can have serious consequences, such as damaging the company's credit rating, impacting future borrowing capacity, and potentially leading to bankruptcy or insolvency.
        
        4. **Financial constraints:**
            The presence of long-term debt on a company's balance sheet can create certain financial constraints. It can affect the company's ability to raise additional funds or secure favorable terms for future borrowing, as lenders may consider the existing debt burden when evaluating creditworthiness.
        
        5. **Potential loss of control:**
            In some cases, taking on long-term debt may require providing collateral or granting lenders certain rights or claims on company assets. This can result in a loss of control or limit the company's flexibility in making business decisions.
---
## 6.2 Valuation of Assets
* **Definition:** The value of any asset, whether physical or financial, is determinded by various factors, including the expected future cash flows they are anticipated to generate.

    1. **The value of asset:** 
        The value of an asset is **fundamentally linked to the cash flows** it it expected to generate in the future. Investors and market participants assess the **potential income or benefits** that can be derived from owneing the asset over a specific time period. THese expected future cash flows can come in the form of revenue, rental income, interest payments, dividends, or **any other financial benefits associated with the asset**.
    
    2. **Physical asset:**
        A physical asset refers to a **tangible object or property** that possesses value in the **real world**. Examples of physical assets include real estate properties, machinery, equipment, vehicles, inventory, and commodities. The value of a physical asset is primarily derived from its ability to **generate cash flows or provide economic benefits** through its utilization or sale.
    
    3. **Financial asset:**
        A financial asset represents a **claim or ownership** of an underlying entity that holds financial value. Examples of financial assets include **stocks, bonds, mutual funds, derivatives, and bank deposits**. The value of a financial asset, such as a stock or bond, is primarily based on the **expected cash flows** it will generate for the owner during the holding period.

### Capialization of cash flow method
* $$V_0=\displaystyle\sum_{t-1}^{n}\dfrac{CF_t}{(1+i)^t}$$

### Market Value of Assets and Market Equilibrium
1. **Supply and demand:** 
    In a market economy, the price of an asset, such as a stock, bond, or commodity, is determined by the **forces of supply and demand**. When demand for an asset exceeds its supply, the price tends to increase, and when supply exceeds demand, the price tends to decrease. The market price(**the equilibrium price**) is the point at which buyers and sellers agree to transact, based on their assessment of the asset's value and their willingness to buy or sell at a partiucular price.

2. **Marginaly satisfied buyer:** 
    A marginally satisfied buter refers to an **individual or entity** that is willing to purchase an asset at the **prevailing market price but would not be willing to pay a higher price**. This buyer is satisfied with the price and sees the asset's value **as equal to or greater than the market price**. They are willing to enter the market and make a purchase at the current price level.

3. **Marginally satisfied seller:** 
    A marginally satisfied seller refers to an **individual or entity** that is willing to sell an asset at the prevailing market price but would **not be willing to accept a lower price**. This seller is satisfied with the price and believes that the asset's value is **equal to or less** than the market price. They are willing to enter the market and make a sale at the current price level.

4. **Market equilibrium:** 
    Market equilibrium occurs when the quantity of an asset demanded by buyers equals the quantity supplied by sellers at a specific price level. In other words, it is the point where the **demand curve intersects the supply curve**. At this equilibrium price, the intentions of both buyers and sellers align, and there is **no ingerent pressure for the price to change**. The market is said to be in a **state of balance**, with **no excess demand or supply**.

5. **Market disequilibrium:** 
    Market disequilibirum refers to a situation where the quantity demanded **does not equal the quantity supplied at the prevailing market price**. It occurs when there is a **temporary imbalance between supply and demand**. If the quantity demanded exceeds the quantity supplied, a **shortage** occurs, leading to upward pressure on prices. Conversely, if the quantity supplied exceeds the quantity demanded, a **surplus** occurs, resulting in downward pressure on prices. In either case, the market is not in equilibrium, and there is a **tendency for prices to adjust to restore balance**.
    ![](https://hackmd.io/_uploads/Sy5e30zD3.png)
* **Book Value of an Asset:**
    **The book value of an asset** refers to the accounting value assigned to it on a company's balance sheet. It is calculated by **subtracting any accumulated depreciation** from the historic acquisition cost of the asset.

    > The historic acquisition cost represents the original cost incurred to acquire the asset, including any expenses directly attributable to its acquisition, such as purchase price, transportation costs, and installation charges.
    >
    > Accumulated depreciation, represents the total depreciation expense allocated to the asset over its useful life. Depreciation is a method used in accounting to allocate the cost of an asset over its estimated useful life, reflecting its gradual wear and tear, obsolescence, or deterioration. By subtracting the accumulated depreciation from the historic acquisition cost, the book value of the asset is obtained.

    It is important to note that **the book value of an asset does not necessarily bear any relationship to its market value**. Market value refers to the price at which an asset could be bought or sold in the open market, based on the forces of supply and demand. Market value takes into account factors such as **current market conditions, supply and demand dynamics, and investor sentiment**.

    The book value of an asset is based on **historical cost and reflects the asset's value** as recorded in the company's accounting records. However, market value is influenced by **various external factors** and can fluctuate significantly over time. Therefore, it is **possible for an asset's market value to be higher or lower than its book value**, depending on market conditions and other relevant factors.
---
## 6.3 Bond Valuation
* $$P_0=\displaystyle\sum_{t=1}^{n}\dfrac{I}{(1+k_d)^t}+\dfrac{M}{(1+k_d)^n}$$
    > Example: Suppose Bell Company (BCC) issued $3billion of 6% bonds maturing on March 15, 2023. The bonds were issued in $1000 denominations (par value). The bond pays interest on Mar15 every year. An investor considers to purchase one of these BCC on March 2016 and requires an 8% of return.
    >>  
    >> Sol: P~0~= 60(PVIFA~0.08,7~)+1,000(PVIF~0.08,7~)
    >> = 60(5.206)+1,000(0.583)
    >> = 895.36

* **Maturity Dates:** Bonds with finite maturity dates can be issued by companies, government, or other entities to raise capital. These bonds have specific characteristics associated with their pricing, including premium, par value, and discount.
    > 1. Premium: When a bond is issued at a premium, its purchase price is higher than its par value. This happens when the bond's coupon rate is higher than the market interest rates.
    > 2. Par: The par value, also known as the face value, is the nominal value of the bond. It represents the amount that will be repaid to the bondholder at maturity.
    > 3. Discount: If a bond is issued at a discount, its purchase price is lower than its par value. This occurs when the bond's coupon rate is lower than the market interest rates.
    >> 
    >> These pricing terms reflect the relationship between the bond's coupon rate and the prevailing interest rates, determining whether the bond is issued at a premium, par, or discount.

![](https://hackmd.io/_uploads/H1YsE3nDn.png)
![](https://hackmd.io/_uploads/Byb2Nhnv2.png)
* **Two Major Risks:**

    1. Interest rate risk: 
        This is the risk of investment losses due to changes in interest rates. Rising rates can lower bond values, while falling rates can increase bond values.
    
    2. Reinvestment rate risk: 
        This refers to the risk of not being able to reinvest cash flows at the sma erate of return. If interest rates decline, future reinvestments may generate lower returns.
        
### Semiannual Interest Payments
* **$$P_0=\displaystyle\sum_{t=1}^{2n}\dfrac{I/2}{(1+k_d/2)^t}+\dfrac{M}{(1+k_d/2)^2n}$$**
    > Example: Suppose Bell Company (BCC) issued $3billion of 6% bonds maturing on March 15, 2023. The bonds were issued in $1000 denominations (par value). The bond pays interest semiannually. An investor considers to purchase one of these BCC on March 2016 and requires an 8% of return.
    >>
    >> Sol: P~0~=60(PVIFA~0.04,14~)+1,000(PVIF~0.04,14~)
    >> = 60(10.563)+1,000(0.577)
    >> = 893.89

### Pepertual Bonds
* $$P_0=\dfrac{I}{k_d}$$
* **Definition:**
    Perpetual bonds are fixed-income securities with no maturity date. They pay interest indefinitely without the need for repayment of principal. They offer stable income to investors, but the principal amount is never repaid. This creates a perpetual obligation for the issuer to make interest payments.
    
    > Example: Determine the value of a $1000 Canadian Pacific Ltd perpetual 4% bond at the required rates of return 4% 
    >
    >> Sol: I= 1,000 x 4%= 40
    >> P= 40/4%= 1,000
### Yield-to-Maturity of a Bond
(This section of all calculations requires a finanical calculator in order to finish the quest. Since you cannot dissolve the 't' and 'n' power)
* **$$P_0=\displaystyle\sum_{t=1}^{n}\dfrac{I}{(1+k_d)^t}+\dfrac{M}{(1+k_d)^n}$$**

    > Example: Suppose Bell Company (BCC) issued 6% bonds maturing on March 15, 2023. The bonds were issued in $1000 denominations. The interest is paid annually. The bonds are selling for 987.5 on March 15, 2016.  What is the YTM(Yield to Maturity) rate?
    >> Sol: Simply type [N=7, PMT(payment)=60, P0=987.5, M=1000] in the calculator, then solve the question with 6.5%.

## 6.4 Characteristics of Preferred Stock 
* **Features**
    1. **Selling price and par value:** 
        Preferred stock has a selling price, which is the market price at which it is currently being traded, and a par value, which is the predtermined face value of the stock.
    
    2. **Adjustable rate preferred stock:**
        Some preferred stocks hae adjustable or floating rates of divident payments. These rates can change over time based on specific factors such as market conditions or benchmark interest rates.
    
    3. **Cumulative feature:** 
        Cumulative preferred stock guarantees that if any divident payments are **missed** they accumulate and must be paid out to shareholders before common stock dividends can be distributed. This feature helps protect the interests of preferred stockholders.
        
    4. **Participation:**
        Participating preferred stock allows shareholders to receive additional dividends alongside **common stockholders**. If the company preforms well and common stockholders receive extra dividends, participating **preferred shareholders** will also receive their regular dividends plus an additional amount. 
        
        Some might ask: What is the difference between common stockholders and preferred stockholders? Let's use some easy examples to demonstrate them! 
        [Link:(https://hackmd.io/@Kevin-Zhou/ryO1IJwu3)]

    5. **Maturity:** 
        Preferred stock typically does not have a specified maturity date. It is considered a perpetual security, meaning there is no obligation for the issuer to redeem the stock at a specific time.

    6. **Call Feature:** 
        Preferred stock may have a call feature, which allows the issuer to redeem the stock before its maturity date. This enables the issuer to retire the stock and potentially replace it with a lower-cost or more advantageous security.

    7. **Voting Rights:** 
        Preferred stock generally does not carry voting rights. However, some classes of preferred stock may have limited or special voting rights, such as the ability to vote on specific matters that directly affect the preferred shareholders' interests.
        
And that will be all for the midterm. Good luck on your exam.