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Accrual accounting recognizes revenues as earned when sales are

transacted, regardless of when the company actually receives

payment. Likewise, expenses are recognized when they are incurred
rather than when the actual payment is made. In contrast, cash
accounting recognizes revenues as earned only when payment is
received and recognizes expenses as costs only when cash is actually
paid out.
Net sales = Gross sales - (Returns and Allowances)
Some firms also offer sales discounts for large volume purchases - in
such cases, these are also netted out of gross sales. ften returns and
allowance num!ers are estimates. If actual returns turn out to !e less
than estimated returns, a credit is made to net sales during the next
accounting period. If, however, actual returns turn out to !e greater
than estimated returns, the allowance account should !e increased
during the next accounting period to reflect this fact.
"ost of goods sold - #henever a product is manufactured or sold,
certain direct costs are incurred. $hese costs are designated on the
income statement as cost of goods sold, or "%S. &or a retail
company, direct costs are simply the cost of materials purchased for
resale. &or a manufacturing company, direct costs can also include
la!or costs, manufacturing overhead, and depreciation expenses
associated with production. Since service companies incur few direct
costs, their income statements usually do not include cost of goods
Cost of goods sold = Beginning inventory + Materials purchases - Ending inventory.
Operating expenses - perating expenses are expenses other than
cost of goods sold that a company incurs in the normal course of
!usiness. $hese include items such as management salaries,
advertising expenditures, repairs and maintenance costs, research and
development expenditures, lease payments, and general and
administrative expenses. $his latter category includes everything from
salaries of office staff to paper clips. As mentioned a!ove, for a
manufacturer, depreciation expense is considered as a cost of goods
sold' for a retailer, depreciation is included in operating expenses.
$he top line refers to a company(s gross sales or revenues.
)et income divided !y the num!er of common shares outstanding is
referred to as earnings per share, or *+S. $his value represents the
profit earned for each share of stock. $he current market price of the
stock divided !y *+S is called a +,* ratio. Analysts often consider *+S
and +,* ratios to !e important indicators of a firm-s current and
potential future performance.
11. What is your investing strategy?
Different investors have different strategies. Some look for undervalued
stocks, others for stocks with growth potential and yet others for stocks with
steady performance. A strategy could also be focused on the long-term or
short-term, and be more risky or less risky.
12. o! has your portfolio perfor"ed in the last five years?
If you dont have a portfolio, start a mock one using ahoo! "inance. Also, if you think you are
going to say it has outperformed the S#$ each year, you better be well prepared to e%plain why
you think this happened.
1#. $f you read that a given "utual fund has achieved %& percent returns
last year' !ould you invest in it?
ou should look for more information, as past performance is not
necessarily an indicator of future results. &ow has the overall market done'
&ow did it do in the years before' (hy did it give )* percent returns last
year' +an that strategy be e%pected to work continuously over the ne%t five
to ,* years'
1(. )ou are on the *oard of directors of a co"pany and o!n a significant
chun+ of the co"pany. ,he CE-' in his annual presentation' states that
the co"pany.s stoc+ is doing !ell' as it has gone up 2& percent in the last
12 "onths. $s the co"pany.s stoc+ in fact doing !ell?
Another trick stock -uestion that you should not answer too -uickly. "irst,
ask what the .eta of the company is. /0emember, the .eta represents the
volatility of the stock with respect to the market.1 If the .eta is , and the
market /i.e. the Dow 2ones Industrial Average1 has gone up 3) percent, the
company actually has not done too well compared to the broader market.
1%. Which do you thin+ has higher gro!th potential' a stoc+ that is
currently trading at /2 or a stoc+ that is trading at /0&?
4his -uestion tests your fundamental understanding of a stocks value. 4he
short answer to the -uestion is, 5It depends.6 (hile at first glance it may
appear that the stock with the lower price has more room for growth, price
does not tell the entire picture. Suppose the 78 stock has , billion shares
outstanding. 4hat means it has 78 billion market cap, hardly a small cap
stock. 9n the flip side, if the 7:* stock has 8*,*** shares gives it a market
cap of 7,,8**,***, and hence it is e%tremely small and is probably seen as
having higher growth potential. 1enerally' high gro!th potential has little
to do !ith a stoc+2s price' and has "ore to do !ith it2s operations and
revenue prospects.
Forward rates
4hese are agreed-upon interest rates for a bond to be issued in the future. "or
e%ample, the one year forward rate for a five-year ;.S. 4reasury note represents the interest
forward rate on a five-year 4-note that will be issued
one year from now /and that will mature si% years from now1. 4his
5forward6 rate changes daily <ust like the rates of already-issued bonds. It is
essentially based on the markets e%pectation of what the interest rate a year
from now will be, and can be calculated using the rates of current bonds.
some amount of inflation /usually around , to 8 percent1 is a sign of a healthy economy. If the
economy is healthy and the stock market is growing, consumer spending increases. 4his means
that people are buying more goods, and by conse-uence, more goods are in demand. =o inflation
means that you do not have a robust economy > that there is no competitive demand for goods.
In general, a positive economic event /such as a decrease in unemployment, greater consumer
confidence, higher personal income, etc.1 drives up inflation over the long term /because there are
more people working, there is more money to be spent1, which drives up interest rates, which
causes a decrease in bond prices.
When should a co"pany issue de*t instead of issuing e3uity?
"irst, a company needs a steady cash flow before it can consider issuing debt
/otherwise, it can -uickly fall behind interest payments and eventually see
its assets sei?ed1. 9nce a company can issue debt, it should almost always
prefer issuing debt to issuing e-uity.
@enerally, if the e%pected return on e-uity is higher than the e%pected return
on debt, a company will issue debt. "or e%ample, say a company believes
that pro<ects completed with the 7, million raised through either an e-uity
or debt offering will increase its market value from 7A million to 7,*
million. It also knows that the same amount could be raised by issuing a 7,
million bond that re-uires 73**,*** in interest payments over its life. If the
company issues e-uity, it will have to sell 8* percent of the company, or 7,
millionB7) million /7) million is the new value of the company after the
capital infusion1. 4his would then grow to 8* percent of 7,* million, or 78
million. 4hus, issuing the e-uity will cost the company 7, million /78
million - 7, million1. 4he debt, on the other hand, will only cost 73**,***.
4he company will therefore choose to issue debt in this case, as the debt is
cheaper than the e-uity.
Also, interest payments on bonds are ta% deductible. A company may also
wish to issue debt if it has ta%able income and can benefit from ta% shields.
"inally, issuing debt sends a -uieter message to the market regarding a
companys cash situation.
0. $f you *elieve interest rates !ill fall' !hich should you *uy4 a 1&-year
coupon *ond or a 1&-year 5ero coupon *ond?
4he ,*-year ?ero coupon bond. A ?ero coupon bond is more sensitive to
changes in interest rates than an e-uivalent coupon bond, so its price will
increase more if interest rates fall.
6. Which is ris+ier4 a #&-year coupon *ond or a #&-year 5ero coupon
A3*-year ?ero coupon bond. &eres whyC A coupon bond pays interest semiannually, then pays the
principal when the bond matures /after 3* years, in this case1. A?ero coupon bond pays no interest,
but pays one lump sum upon
maturity /after 3* years, in this case1. 4he coupon bond is less risky because
you receive some of your money back before over time, whereas with a ?ero
coupon bond you must wait 3* years to receive any money back. /Another
answerC 4he ?ero coupon bond is more risky because its price is more
sensitive to changes in interest rates.1
12. Why can inflation hurt creditors?
If you are a creditor lending out money at a fi%ed rate, inflation cuts into the percentage that you
are actually making. If you lend out money at D percent a year, and inflation is ) percent, you are
only really clearing 8 percent.
1#. o! !ould the follo!ing scenario affect the interest rates4 the
7resident is i"peached and convicted.
(hile it cant be said for certain, chances are that these kind of events will
lead to fears that the economy will go into recession, so the "ed would want
to balance those fears by lowering interest rates to e%pand the economy.
10. o! !ould you value a perpetual 5ero coupon *ond?
4he value will be ?ero. A ?ero coupon doesnt pay any coupons, and if that
continues on perpetually, when do you get paid' =ever > so it aint worth
16. 8et.s say a report released today sho!ed that inflation last "onth !as very lo!.
o!ever' *ond prices closed lo!er. Why "ight this happen?
.ond prices are based on e%pectations of future inflation. In this case, you
can assume that traders e%pect future inflation to be higher /regardless of the
report on last months inflation figures1 and therefore they bid bond prices
down today. /A report which showed that inflation last month was benign
would benefit bond prices only to the e%tent that traders believed it was an
indication of low future inflation as well.1
19. $f the stoc+ "ar+et falls' !hat !ould you e:pect to happen to *ond
prices' and interest rates?
ou would e%pect that bond prices would increase and interest rates would
1;. $f une"ploy"ent is lo!' !hat happens to inflation' interest rates'
and *ond prices?
Inflation goes up, interest rates also increase, and bond prices decrease.
2&. What is a *ond2s <)ield to Maturity=?
AbondEs yield to maturity is the yield that would be reali?ed through coupon
and principal payments if the bond were to be held to the maturity date. If
the yield is greater than the current yield /the couponBprice1, it is said to be
selling at a discount. If the yield is less than the current yield, it is said to
be selling at a premium.
Apot e:change rate4 4he price of one currency relative to another, i.e., the
number of one currency you can buy using another currency. /4he e%change
rate people commonly talk about is actually the spot e%change rate.1
Bor!ard e:change rate4 4he prices of currencies at which they can be
bought and sold for future delivery
Example: Lets say that today the one-month forward rate for British pound
is $1.562! the three-month rate is $1.5625! and the one-year rate is
$1.561. "hese represent the pri#es at whi#h the mar$et %&uyers and sellers'
would a(ree %today' to ex#han(e #urren#ies one month! three months! or a
year from now.
In this e%ample, the dollar is said to be trading at a one-month forward
discount, because you can get fewer pounds for the dollar in the future than
you can today. Alternately, the dollar is trading at a forward premium for a
three-month or one-year period, because you can get more pounds for the
dollar in the future than you can today.
So !hat deter"ines the rate at !hich dollars and pounds' or dollars and *aht'
or *aht and rou*les are e:changed? 4he perfect market e%change rate
between two currencies is determined primarily by two factorsC the interest rates in the t!o
countries and the rates of inflation in the t!o countries.
&owever, in the real world, governments of many countries regulate the
e%change rate to control growth and investment of foreign capital in the
economy. Fconomists believe that such artificial controls are the main
reason currencies fall so drastically sometimes.
$f the interest rate of a foreign country relative to the ho"e country goes up, the home
currency weakens. In other words, it takes more of the home currency to buy the same amount of
foreign currency. /=oteC (e are talking here about the real interest rate, or the interest rate after
inflation. After all, if interests rates and inflation were to go up by the same amount, the effect on
the countrys currency would generally be a wash, of no net effect.1
Explanation4 (hen interest rates in a country rise, investments held in that
countrys currency /for e%ample, bank deposits, bonds, +Ds, etc.1 will earn
a higher rate of return. 4herefore, when a countrys interest rates rise, money
and investments will tend to flow to that country, driving up the value of its
Influence of Inflation on Foreign Exchange
If the inflation in the foreign country goes up relative to the home currency,
the foreign currency devalues or weakens relative to the home currency. In
other words, it takes less of the home currency to buy the same amount of
foreign currency.
Example: Let us say that at the &e(innin( of the year! sil)er #osts $1!5**+l&
in the ,.-. and .1!***+l& in the ,./. 0t the same time it ta$es $1.5 to &uy
.1. Let us now assume that inflation in the ,./. is at 1* per#ent while that
in the ,.-. is at * per#ent. 0t the end of the year! the sil)er still #osts
$1!5**+l& in the ,.-.! &ut it #osts pounds .1!1** in ,./. &e#ause of inflation.
Be#ause of the ,./.s hi(her inflation rate! the British pound will wea$en
relati)e to the dollar %so that! for example! it may ta$e $1.16 to &uy .1'.
0d)an#ed Explanation: Gets say again that at the beginning of the year,
silver costs 7,,)**Blb in the ;.S. and H,,***Blb in the ;.I. At the same time,
it takes 7,.) to buy H,. Get us now assume that inflation in the ;.I. is at ,*
percent while inflation in the ;.S. is at * percent.
At the end of the year, the silver still costs 7,,)**Blb in the ;.S., but it costs
H,,,**Blb in the ;.I. because of inflation. If the e%change rate were to
remain the same, people would start buying silver in the ;.S., selling it in
the ;.I., and converting their money back to dollars, thus making a tidy
profit. In other words, if you had 7,,)**, you would buy a pound of silver
in ;.S., sell it in the ;.I. for H,,,** at the end of the year, convert the
.ritish pounds into dollars at 7,.)BH,, thus receiving 7,,:)*. "or each pound
of silver with which you did this, you would make a neat profit of 7,)*.
Capital Market Equilibrium
4he principle of capital market e-uilibrium /+JF1 states that there should
be e-uilibrium in the currency markets all over the world so that there is no
arbitrage opportunity in shifting between two currencies.
The three factors
4hese three factors > interest rates, inflation, and the principle of capital
market e-uilibrium > govern the valuation of various currencies. .ecause
the ;.S. dollar is generally considered the worlds most stable currency, it is
the widely accepted basis for foreign e%change valuation. 9ther currencies
that are considered stable are the 2apanese yen and the Furo.
Exchange Rate Effects on Earnings
+ompanies that do business abroad are e%posed to currency risk. "or e%ample, if a ;.S. company
that manufactures goods in the ;.S. sells them in Fngland, its -uarterly earnings will fluctuate
based on fluctuating dollar pound e%change rates.
If the dollar weakens /i.e., one dollar can buy fewer pounds1, the companys
earnings will increase because when the pounds earned by selling the product are sent back to the
;.S., they will be able to buy more dollars. If the dollar strengthens, then the earnings will go
Effect of Exchange Rates on Interest Rates and Inflation
A weak dollar means that the prices of imported goods will rise when
measured in ;.S. dollars /i.e., it will take more dollars to buy the same
good1. (hen the prices of imported goods rise, this contributes to higher
inflation, which also raises interest rates. +onversely, a strong dollar means
that the prices of imported goods will fall, which will lower inflation /which
will lower interest rates1. 4he following table summari?es the relationship
between interest rates, inflation, and e%change rates.
A note on devaluation
;nder a fi%ed-e%change-rate system in which e%change rates are changed only by official
government action, a weakening of the currency is called Devaluation. A strengthening of the
currency under fi%ed e%change rates is called revaluation, rather than appreciation.
#. $f the >.A. dollar !ea+ens' should interest rates generally rise' fall or
stay the sa"e?
0ise. A weak dollar means that the prices of imported goods will rise when
measured in ;.S. dollars /i.e., it will take more dollars to buy the same
good1. 0ising prices of imported goods contributes to higher inflation, which
raises interest rates.
(. $f >.A. inflation rates fall' !hat !ill happen to the relative strength of
the dollar?
It will strengthen.
%. $f the interest rate in Bra5il increases relative to the interest rate in
the >.A.' !hat !ill happen to the e:change rate *et!een the Bra5ilian
real and the >.A. dollar?
4he real will strengthen relative to the dollar.
0. $f inflation rates in the >.A. fall relative to the inflation rate in ?ussia'
!hat !ill happen to the e:change rate *et!een the dollar and the rou*le?
4he dollar will strengthen relative to the rouble
6. What is the difference *et!een currency devaluation and currency
Devaluation occurs in a fi%ed-e%change-rate system and is usually fi%ed as
a function of @overnment policy, while depreciation occurs when a country
allows its currency to move according to the international currency
e%change market.
CE?$DE,$DEA F -7,$-@A
(ell, there is an entire market > called the options market > that helps these
transactions go through. "or every option holder there must be an option
seller. 4his seller is often referred to as the writer of the option. So selling a
put option is called writing a put. Anyone who owns the underlying asset,
such as an individual or a mutual fund > can write options.
Options Pricing
4here are at least si% factors that affect the value of an optionC the stock
price, e%ercise price, the volatility of the stock price, the time to e%piration,
the interest rate and the dividend rate of the stock.
7rice of underlying security4 If an option is purchased at a fi%ed e%ercise
price, and the price of the underlying stock increases, the value of a call
option increases. +learly, if you have the option to buy I.J stock at 7,**,
the value of your option will increase with any increase in stock priceC
from 7K) to 7,**, from 7,** to 7,*), from 7,*) to 7,*:, etc. /4he value
of a put option in this scenario decreases.1
L E:ercise G<stri+eHI price4 +all options can be bought at various e%ercise
prices. "or e%ample, you can buy an option to buy stock in I.J at 7,**,
or you can buy an option to buy stock in I.J at 7,,*. 4he higher the
e%ercise price, the lower the value of the call option, as the stock price has
to go up higher for you to be in the money. /&ere, the value of the put
option increases, as the stock price does not need to fall as low.1
L Dolatility of underlying security4 4he option value increases if the
volatility of the underlying stock increases. 4he reason this potential upside increases the options
value is that the downside loss that you can incur is fi%ed. ou have the option to e%ercise and not
the obligation to buy at 7,**.
,i"e to e:piration4. 4he more time the holder has to e%ercise the option,
the more valuable the option.
$nterest rates4 If interest rates are higher, the e%ercise price has a lower
present value. 4his also increases the value of the call option.
L Cividends4 A higher dividend rate policy of the company means that out
of the total e%pected return on the stock, some is being delivered in the
form of dividends. 4his means that the e%pected capital gain of the stock
will be lower, and the potential increase in stock price will be lower.
&ence, larger dividend pay outs lower the call value.
"utures differ from other forwards in the fact that they are li-uid, standardi?ed, traded on an
e%change, and their prices are settled at the end of each trading day.
Bor!ard' Butures' -ption' A!ap
A swap is an e%change of future cash flows. 4he most popular forms include
foreign e%change swaps and interest rate swaps.
#. Aay $ hold a put option on Microsoft stoc+ !ith an e:ercise price of
/0&' the e:piration date is today' and Microsoft is trading at /%&. E*out
ho! "uch is "y put !orth' and !hy?
our put is worth about 7,*, because today, you can sell a share of stock for
7:*, and buy it for 7)*. /If the e%piration date were in the future, the option
6. Why do interest rates "atter !hen figuring the price of options?
.ecause of the ever-important concept of net present value, all else being
e-ual, higher interest rates lower the value of call options.
ME?1E?A F ECJ>$A$,$-@A4
Types of buyers
4here are two main categories of buyers of companiesC strategic *uyers and
financial *uyers. Strategic buyers are corporations who want to ac-uire
another company for strategic business reasons. "inancial buyers are buyers
who want to ac-uire another company purely as a financial investment.
(ho will pay more for a companyC strategic buyers or financial buyers'
=ine times out of ten, a strategic buyer will pay more than a financial buyer.
Stock Swaps vs. Cash ffers
.ankers and finance officials at companies have a couple of financing
options when they consider how to structure a mergerC a stock swap or a cash
deal. Stock swaps occur more often when there is a strong stock market, because companies with a
high market capitali?ation can ac-uire companies with that more valuable stock.
!ender ffers
4ender offers are associated with hostile takeovers. In a tender offer, the
hostile ac-uirer renders a tender offer for the publics stock at a price higer
than the current market in an attempt to gather a controlling interest in
/ma<ority ownership of1 a company.