Chapter 2 Operating cash flow: the amount of cash flow generated by a firm from its operations OCF = EBIT

taxes + depreciation Free cash flow: the net amount of cash flow remaining after the firm has met all operating needs and paid for investments, both long-term (fixed) and short-term (current). Represents the cash amount that a firm could distribute to investors after meeting all its other obligations FCF = OCF Gross FA (CA A/P accruals) Liquidity ratios: measure a firms ability to satisfy its short-term obligations as they come due Current ratio: measures the firms ability to meet its short-term obligations Current ratio = current assets/current liabilities Net working capital = current assets current liabilities Quick (acid-test) ratio = (current assets inventory)/current liabilities Activity ratios: measure the speed with which the firm converts various accounts into sales or cash Inventory turnover: provides a measure of how quickly a firm sells its goods Inventory turnover = cost of goods sold/inventory Average age of inventory = 365/inventory turnover Average collection period (average age of accounts receivable) = accounts receivable/average sales per day Average payment period = accounts payable/average purchases per day Fixed asset turnover: measures the efficiency with which a firm uses its fixed assets Fixed asset turnover = sales/net fixed assets Total asset turnover: measures the efficiency with which a firm uses all its assets to generate sales Total asset turnover = sales/total assets Debt ratios Coverage ratio: focuses more on income statement measures of a firms ability to generate sufficient cash flow to make scheduled interest and principal payments Debt ratio: measures the proportion of total assets financed by the firms creditors Debt ratio = total liabilities/total assets % Assets to equity ratio (equity multiplier): measures the proportion of total assets financed by a firms equity A/E ratio = total assets/common stock equity (no preferred) Debt to equity ratio = long-term debt/stockholders equity (yes preferred) Times interest earned ratio: a measure of the firms ability to make contractual interest payments Times interest earned = earnings before interest and taxes/interest expense Profitability ratios Gross profit margin: measures the percentage of each sales dollar remaining after the firm has paid for its goods Gross profit margin: gross profit/sales % Operating profit margin: measures the percentage of each sales dollar remaining after deducting all costs and expenses other than interest and taxes Operating profit margin = operating profit/sales % Net profit margin: measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted Net profit margin = earnings available for common stockholders/sales %

Earnings per share: represent the number of dollars earned on behalf of each outstanding share of common stock Earnings per share = earnings available for common stockholders/number of shares of common stock outstanding Return on total assets ROA (return on investment ROI): measures the overall effectiveness of management in using its assets to generate returns ROA = earnings available for common stockholders/total assets % Return on common equity (ROE): captures the return earned on the common stockholders (owners) investment in the firm ROE = earnings available for common stockholders/common stock equity % DuPont system ROA = net profit margin x total asset turnover = earnings available for common stockholders/sales x sales/total assets ROE = ROA x A/E = earnings available for common stockholders/total assets x total assets/common stock equity Market ratios: relate the firms market value, as measured by its current share price, to certain accounting values Price/earnings (P/E) ratio: a measure of a firms long-term growth prospects that represents the amount investors are willing to pay for each dollar of a firms earnings P/E ratio = market price per share of common stock/earnings per share Market/book (M/B) ratio: a measure used to assess a firms future performance by relating its market value per share to its book value per share Book value per share = common stock equity/number of shares of common stock outstanding M/B ratio = market value per share of common stock/book value per share of common stock Ordinary corporate income: income resulting from the sale of the firms goods and services Average tax rate = tax liability/pretax income Marginal tax rate: the tax rate applicable to a firms next dollar of earnings Capital gain: the difference between the sale price and the original purchase price resulting from the sale of a capital asset, such as equipment or stock held as an investment Capital loss: the loss resulting from the sale of a capital asset at a price below its book, or accounting, value Chapter 3 FV = PV x (1+r)n PV = FV/(1+r)n FV (mixed stream) = CF1 x (1+r)n-1 + CF2 x (1+r)n-2 + Ordinary annuity: annuity for which the payments occur at the end of each period Annuity due: annuity for which the payments occur at the beginning of each period FV (ordinary annuity) = PMT x (((1+r)n-1)/r) FV (annuity due) = PMT x (((1+r)n-1)/r) x (1+r) FV (annuity due) = FV (ordinary annuity) x (1+r) Perpetuity: a level or growing cash flow stream that continues forever (valuing a business as a going concern, or valuing a share of (preferred) stock with no definite maturity date) PV (mixed stream) = (CF1 x 1/(1+r)1) + (CF2 x 1/(1+r)2) + PV (ordinary annuity) = PMT/r x (1-(1/(1+r)n)) PV (annuity due) = PMT/r x (1-(1/(1+r)n)) x (1+r)

PV (annuity due) = PV (ordinary annuity) x (1+r) PV (perpetuity) = PMT/r PV (growing perpetuity/Gordon growth model) = CF1/(r-g) r>g Cash flow for any specific future year (t) = CF1 x (1+g)t-1 FV = PV x (1+(r/m))m x n FV (continuous compounding) = PV x (er x n) Stated annual rate: the contractual annual rate of interest charged by a lender or promised by a borrower Effective annual rate (EAR) (true annual return): the annual rate of interest actually paid or earned, reflecting the impact of compounding frequency EAR = (1+(r/m))m-1 EAR (continuous compounding) = er-1 Annual percentage rate (APR): the stated annual rate calculated by multiplying the periodic rate by the number of periods in one year Annual percentage yield (APY): the annual rate of interest actually paid or earned, reflecting the impact of compounding frequency; the same as the effective annual rate Deposits needed to accumulate a future sum: PMT = FV/(((1+r)n -1)/r) Loan amortization: a borrower makes equal periodic payments over time to fully repay a loan PMT = PV/(1/r x (1-(1/(1+r)n))) PV for amortization, FV = 0 Chapter 4 The value of any asset equals the present value of future benefits accruing to the assets owner Generally, the greater the uncertainty about an assets future benefits, the higher the discount rate investors will apply when discounting those benefits to the present Required rate of return: the rate of return that investors expect or require an investment to earn given its risk P0 (fundamental valuation) = CF1/(1+r)1 + CF2/(1+r)2 + P0 = assets price today CFt = assets expected cash flow at time t r = required return Plain-vanilla bonds: those that promise a fixed stream of cash payments over a finite time period Par value (bonds): the face value of a bond (principal amount), which the borrower repays at maturity (typically $1000 for corporate bonds) Coupon: a fixed amount of interest that a bond promises to pay investors (yearly, multiply DIVIDE? by 2 for semiannual) Indenture: a legal document stating the conditions under which a bond has been issued (dollar amount of the coupon and when the borrower must make coupon payments) Coupon rate = annual coupon payment/par value Coupon (current) yield = coupon/bonds current market price P0 = C/(1+r)1 + C/(1+r)2 + + M/(1+r)n C = annual coupon payment M = par value Price = PV of coupons + PV of principal P0 = C x [(1-(1/(1+r)n))/r] + M/(1+r)n Premium: a bond that sells for more than its par value Discount: a bond that sells for less than its par value

Yield to maturity (required rate of return): the discount rate that equates the present value of the bonds future cash flows to its current market price Coupon rate > YTM = premium Coupon rate < YTM = discount Make PV negative when calculating YTM P0 (semiannual compounding) =(C/2)/(1+(r/2))1 + (C/2)/(1+(r/2))2 + (C/2)/(1+(r/2))2n + M/(1+(r/2))2n Interest rate = most important factor to change bond prices When the markets required return on a bond changes, the bonds price changes in the opposite direction The higher the bonds required return, the lower its price, and vice versa Bond prices and interest rates move in opposite directions The prices of long-term bonds display greater sensitivity to changes in interest rates than do the prices of short-term bonds Interest rate risk: the risk that changes in market interest rates will cause fluctuations in a bonds price. Also, the risk of suffering losses as a result of unanticipated changes in market interest rates One main factor: inflation Real return: approximately, the difference between an investments stated or nominal return and the inflation rate Nominal return: the stated return offered by an investment unadjusted for the effects of inflation (1+r) = (1+i)(1+rreal) [(1+r)/(1+i)]-1 = rreal r= nominal return, i= inflation rate Default risk: the risk that the corporation issuing a bond may not make all scheduled payments Optimistic: required return falls, price rises Primary market: initial sale of bonds by firms or government entities When corporations and state and local government bodies issue bonds in the primary market, they do so with the help of investment bankers Secondary market: investors trade bonds with each other Note: bond with maturity of one to ten years Municipal bonds: issued by U.S. state and local governments. Interest received on these bonds is exempt from federal tax U.S. government = largest single issuer of bonds Treasury bills: debt instruments issued by the federal government that mature in less than one year Treasury notes: maturities ranging from 1 to 10 years Treasury bonds: maturities of up to 30 years Interest from Treasury securities is subject to federal income tax but not state income tax Agency bonds: bonds issued by federal government agencies. Agency bonds are not explicitly backed by the full faith and credit of the U.S. government. Agencies issue bonds to promote the formation of credit in certain sectors of the economy, such as farming, real estate, and education Floating-rate bonds (variable-rate bonds): bonds that make coupon payments that vary through time. The coupon payments are usually tied to a benchmark market interest rate (one year treasury rate, prime rate, London Interbank Offered Rate)

Prime rate: the rate of interest charged by large U.S. banks on loans to business borrower with excellent credit records London Interbank Offered Rate (LIBOR): the interest rate that banks in London charge each other for overnight loans. Perhaps most common benchmark interest rate for short-term debt Federal funds rate: interest rate U.S. banks charge each other for overnight loans Spread: the difference between the rate that a lender charges for a loan and the underlying benchmark interest rate. Added to benchmark, according to risk of the borrower. Lenders charge higher spreads for less creditworthy borrowers Treasury Inflation-Protected Securities (TIPS): notes and bonds issued by the federal government that make coupon payments that vary with the inflation rate Debentures: unsecured bonds backed only by the general faith and credit of the borrowing company Subordinated debentures: unsecured bond that has a legal claim inferior to other outstanding bonds Senior bonds have a higher priority claim than junior bonds Secured bond: backed by collateral Mortgage bonds: a bond secured by real estate or buildings Collateral trust bonds: a bond secured by financial assets held by a trustee Equipment trust certificates: a bond secured by various types of transportation equipment Pure discount (zero-coupon) bonds: bonds that pay no interest and sell below par value Treasury bill (T-bill): mature in 26 weeks or less, par value of $10,000, distribute cash only at maturity Treasury STRIP: a zero-coupon bond representing one coupon payment or the final principal payment made by an existing Treasury note or bond. Taxable capital gain as bonds price slowly appreciates Convertible bond: a bond that gives investors the option to convert their bonds into the issuers common stock Exchangeable bonds: bonds issued by corporations which may be converted into shares of a company other than the company that issued the bonds Mandatory exchangeable bonds: at maturity, bondholders must accept common stock in the underlying firm Callable bonds: bonds that the issuer can repurchase from investors at a predetermined price known as the call price. Generally offer higher coupon rates than otherwise similar noncallable bonds Putable bonds: bonds that investors can sell back to the issuer at a predetermined price under certain conditions. Can offer lower coupon rates Bond indenture: contract between a bond issuer and its creditors Sinking fund: a provision in a bond indenture that requires the borrower to make regular payments to a third-party trustee for use in repurchasing outstanding bonds, gradually over time Protective covenants: provisions in a bond indenture that specify requirements the borrower must meet (positive covenants) or things the borrower must not do (negative covenants) Most bonds trade in an electronic over-the-counter (OTC) market Bond prices (high, low, last) are quoted as a percentage of par value Yield spread: the difference in yield to maturity between two bonds or two classes of bonds with similar maturities Corporation yield % - Treasury bond yield %

Basis points: 1/100 of 1 percent; 100 basis points equal 1.000 percent The greater the risk that the borrower may default on its debts, the higher the spread that bonds issued by the borrower must offer investors to compensate them for the risk that they take Yield spread rises with maturity and as the bond rating falls Term structure of interest rates: the relationship between time to maturity and yield to maturity for bonds of equal risk Yield curve: shows the term structure of interest rates Usually, long-term bonds offer higher yields than short-term bonds do, and the yield curve slopes up Historically when a yield curve inverts, a recession usually follows Expectations theory: in equilibrium, investors should expect to earn the same return whether they invest in long-term Treasury bonds or a series of short-term Treasury bonds Equilibrium occurs when: (1+r)2 = (1+r1)[1+E(r2)] Expectations theory implies that when the yield curve is sloping upward, investors must expect short-term yields to rise States that the slope of the yield curve is influenced not only by expected interest rate changes, but also by the liquidity premium that investors require on long-term bonds Preferred habitat theory (market segmentation theory): recognizes that the shape of the yield curve may be influenced by investors who prefer to purchase bonds having a particular maturity regardless of the returns those bonds offer compared to returns available at other maturities A bonds price depends on how much cash flow it promises investors, how that cash flow is taxed, how likely it is that the issuers fulfill their promises (i.e. default risk), whether investors expect high or low inflation, and whether interest rates rise or fall over time Chapter 5 Unlike bondholders, common stockholders collectively own the company. Their shares entitle them to vote on important matters Firms usually pay dividends on a quarterly basis Cumulative dividends: if a firm misses any preferred dividend payments, it must catch up and pay preferred shareholders for all the dividends they missed (along with the current dividend) before it can pay dividends on common stock Neither preferred dividends nor common stock dividends can be treated as a tax-deductible expense for the firm; interest payments on debt are tax deductible Preferred shareholders hold a claim that is junior to bonds Preferred stock is most often issued by public utilities Other corporations frequently issue preferred stock as part of a merger or acquisition Corporations, rather than individuals, own much of the preferred stock that is issued in the U.S. Residual claimants: investors who have the right to receive cash flows only after all other claims against the firm have been satisfied. Common stockholders are typically the residual claimants of corporations Majority voting system: system that allows each shareholder to cast one vote per share for each open position on the board of directors Dual class structure: two or more outstanding classes of stock, usually with different voting rights for each class Proxy statements: documents mailed to shareholders that describe the issues to be voted on at an annual meeting

Proxy fight: an attempt by outsiders to gain control of a firm by soliciting a sufficient number of votes to unseat existing directors Shares authorized: the shares of a companys stock that shareholders and the board authorize the firm to sell to the public Shares issued: the shares of a companys stock that have been issued or sold to the public Shares outstanding: the shares of companys stock that are currently held by the public = shares issued - treasury stock Additional paid in capital: the difference between the price the company received when it sold stock in the primary market and the par value of the stock, multiplied by the number of shares sold Market capitalization: the value of the shares of a companys stock that are owned by the stockholders: = total number of shares outstanding x current price per share treasury stock: common shares that have been issued but are no longer outstanding because the firm repurchased them Investment banks: assist firms in the process of issuing securities to investors. Also advise corporations engaged in mergers and acquisitions, and they are active in the business of selling and trading securities in secondary markets Three principal lines of business: corporate finance (generally most profitable), trading (act as dealers, facilitating trade between unrelated parties and earning fees in return); hold inventories of securities and may make or lose money as inventory values fluctuate), asset management (most revenues, managing money for individuals with high net worth, operating and advising mutual funds, managing pension funds) Initial public offering (IPO): a corporation offers its shares for sale to the public for the first time; the first public sale of company stock to outside investors Seasoned equity offering (SEO): an equity issue by a firm that already has common stock outstanding Negotiated offer: the issuing firm negotiates the terms of the offer directly with on IB (most common) Competitively bid offer: the firm announces the terms of its intended equity sale, and IBs bid for the business Lead underwriter: the IB that takes the primary role in assisting a firm in a public offering of securities. Other participating banks are known as comanagers Best efforts: the IB promises to give its best effort to sell the firms securities at the agreed upon price; but if there is insufficient demand for the issue, then the firm withdraws the issue from the market (very small, high-risk companies) Firm commitment: an offering in which the IB agrees to underwrite the firms securities, thereby guaranteeing that the firm will successfully complete its sale of securities Underwriting syndicate: consists of many investment banks that collectively purchase the firms shares and market them, thereby spreading the risk exposure across the syndicate Underwriting spread: the difference between the price at which the banks purchase shares from the firms (the net price) and the price at which they sell the shares to institutional and individual investors (the offer price) (usually IPO = 7%) Underwrite: the IB purchases shares from a firm and resells them to investors

IBs: carrying out the analytical work required to price a new security offering, assisting the firm with regulatory compliance, marking the new issues, developing an orderly market for the firms securities once they begin trading Registration statement: information about the securities being offered, as well as the firm selling them Prospectus (red herring): a document that contains extensive details about the firm and describes the security it intends to offer for sale; circulated among prospective investors Road show: a tour of major cities taken by a firm and its bankers several weeks before a scheduled offering; the purpose is to pitch the firms business plan to prospective investors Oversubscribe: when the investment banker builds a book of orders for stock that is greater than the amount of stock the firm intends to sell (goal) Selling group: consists of investment banks that may assist in selling shares but are not formal member of the underwriting syndicate Green Shoe (overallotment) option: an option to sell more shares than originally planned Price stabilization: purchase of shares by an investment bank when a new issue begins to falter in the market, keeping the market price at or slightly above the offer price Market maker: lead underwriter purchases shares from investors wishing to sell, and sells shares to investors wishing to buy Broker market: a market in which the buyer and seller are brought together on a securities exchange to trade securities (national and regional exchanges) (about 60% of the total dollar volume of all shares traded in the U.S. stock market) Dealer market: a market in which the buyer and seller are not brought together directly, but instead have their orders executed by securities dealers that make markets in the given security (NASDAQ, OTC -40% of all shares traded) (primary market) NYSE big board requirements: at least 2200 stockholders, each owning at least 100 shares; minimum of 1.1 million shares outstanding; $10 million in aggregate pretax earnings over the three years before listing; no loss in previous two years; at least $100 million total market value of outstanding common stock Bid price: the highest price offered by a market maker to purchase a security; the price at which an investor can sell a security Ask price: the lowest price that a market maker offers a security for sale; the price at which one can purchase a security National Association of Securities Dealers Automated Quotation (Nasdaq) System: biggest dealer market, which is considered a listed stock exchange, uses an electronic trading system to facilitate dealer transactions Stocks must have at least two market makers to be listed Over-the-counter (OTC) market: the dealer market, separate from Nasdaq, that includes small companies that either cant or dont wish to comply with Nasdaq requirements OTC Bulletin Board: links market makers that trade shares of small companies, regulated by SEC Pink Sheets: unregulated, minimal/almost nonexistent liquidity PS0 (PV of preferred stock)= Dp/rp (dividend/rrr) If dividend payments arrive annually and if the next dividend payment comes in one year r = (D1 + P1 P0)/P0 P0 (current stock price)= (D1 + P1)/(1+r)1 P0 = D1/(1+r)1 + D2/(1+r)2 +

Zero growth model: the simplest approach to stock valuation that assumes a constant dividend stream P0 = D/r Constant (Gordon) growth model: values a share of stock under the assumption that dividends grow at a constant rate forever P0 = D1/(r-g) Variable growth model: assumes that the dividend growth rate will vary during different periods of time, when calculating the value of a firms stock P0 = [D0(1+g1)1)/(1+r)1 + [D0(1+g1)2)/(1+r)2 + + [1/(1+r)N x DN+1/(r-g2) Also works for FCF with WACC for r and P0 = enterprise value N = number of years in initial growth period D0 = last or most recent per-share dividend paid g1 = initial (fast) growth rate of d g2 = stable growth rate of d Retention rate (rr): the fraction of the firms earnings that it retains Return on common equity (ROE): the rate of return that new investments will generate ROE = earnings available for common stockholders/book value of common stock equity g = rr x ROE Free cash flow (FCF): the net amount of cash flow remaing after the firm has met all operating needs and paid for investments, both long-term (fixed) and short-term (current). Represents the cash amount that a firm could distribute to investors after meeting all its other obligations Weighted average cost of capital (WACC): the after-tax, weighted average required return on all types of securities issued by a frim where the weights equal the percentage of each type of financing in a firms overall capital structure WACC = (% of debt financing x return on debt) + (% of equity financing x investors required return) Forecasts of FCFs discounted at WACC = estimate of the total value of the firm (VF) VS = VF VD - VP VS: worth of firms shares VF: total enterprise value VD: value of firms debt VP: value of firms preferred stock Book value: the value of a firms equity as recorded on the firms balance sheet Historical cost of the firms assets, adjusted for depreciation, net of the firms liabilities Usually less than market value Liquidation value: the amount of cash that remains if the firms assets are sold and all liabilities paid P/E ratio: estimate of stock price by multiplying the earnings forecast times the average or median P/E ratio for comparable firms Either an increase in the dividend payout or a decrease in the required rate of return increases the P/E ratio Study balance sheet and income statement Page 207- steps in IPO process Bond ratings: Page 173