Completed-Intrduction To Finance - Notes

Introduction to Business Finance
Lecture Notes
™
Topic Including:
Chapter No. 1 – Introduction to Business Finance

Chapter No. 2 – Analysis Financial statements
Chapter No. 3 – Time Value of Money
Chapter No. 4 – Financial Market and Institute
Chapter No. 5 – Interest Rate
Chapter No. 6 – Risk and Rate of Return
Chapter No. 7 – Cost of Capital
Chapter No. 8 – Bond Valuation
Chapter No. 9 – Stock valuation
Chapter No. 10 – The Basic of Capital Budgeting
Prof. M.Faseeh Khan
Introduction to Bus. Financial-Notes 1 of 81 Sir M.Faseeh khan

Chapter No. 1 – Introduction to Business
Finance
What is Finance?
•Some important questions that are answered using finance
•What long-term investments should the firm take on?
•Where will we get the long-term financing to pay for the investment?
•How will we manage the everyday financial activities of the firm?
• Finance is about the bottom line of business activities.
• Every business is a process of acquiring and disposing assets:
• Real assets - tangible and intangible.
• Financial assets.
• Two objectives of business:
• Grow wealth (create value).
• Use wealth (assets) to best meet economic needs.
• Financially, a business decision reduces to:
• Valuation of assets.
• Management of assets.
• Valuation is the central issue of finance.
Cash Flows and Financial Decisions of Households

• Real Economic
• Activities
• Household
• Financial
• Assets/Liabilities
• bonds
• stocks
• mortgages
Financial Manager
•Financial managers try to answer some or all of these questions
•The top financial manager within a firm is usually the Chief Financial Officer (CFO)
• Treasurer – oversees cash management, credit management, capital
expenditures and financial planning
• Controller – oversees taxes, cost accounting, financial accounting and data
processing
Financial Management Decisions

• Capital budgeting
• What long-term investments or projects should the business take on?
• Capital structure
• How should we pay for our assets?

• Should we use debt or equity?
• Working capital management
• How do we manage the day-to-day finances of the firm?
Forms of Business Organization

• Three major forms in the United States
• Sole proprietorship
• Partnership
• General
• Limited
• Corporation
• S-Corp
• Limited liability company
Sole Proprietorship
• Advantages
• Easiest to start
• Least regulated
• Single owner keeps all the profits
• Taxed once as personal income
• Disadvantages
• Limited to life of owner
• Equity capital limited to owner’s personal wealth
• Unlimited liability
• Difficult to sell ownership interest
Partnership
• Advantages
• Two or more owners
• More capital available
• Relatively easy to start
• Income taxed once as personal income
• Disadvantages
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves when one partner dies or wishes to sell
• Difficult to transfer ownership
Corporation
• Advantages
• Limited liability
• Unlimited life
• Separation of ownership and management
• Transfer of ownership is easy

• Easier to raise capital
• Disadvantages
• Separation of ownership and management
• Double taxation (income taxed at the corporate rate and then dividends
taxed at the personal rate)
Goal of Financial Management

• What should be the goal of a corporation?
• Maximize profit?
• Minimize costs?
• Maximize market share?
• Maximize the current value of the company’s stock?
• Does this mean we should do anything and everything to maximize owner
wealth?

Chapter No. 2 – Analysis Financial
statements
Chapter Outline
1. The Balance Sheet
2. The Income Statement
3. Taxes
4. Cash Flow
5. Standardized Financial Statements
6. Ratio Analysis
7. The DuPont Identity
8. Using Financial Statement Information
Balance Sheet
• The balance sheet is a snapshot of the firm’s assets and liabilities at a given point
in time
• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• Balance Sheet Identity
• Assets = Liabilities + Stockholders’ Equity
The Balance Sheet - Figure

Net Working Capital and Liquidity
• Net Working Capital
• Current Assets – Current Liabilities
• Positive when the cash that will be received over the next 12 months
exceeds the cash that will be paid out
• Usually positive in a healthy firm
• Liquidity
• Ability to convert to cash quickly without a significant loss in value
• Liquid firms are less likely to experience financial distress
• But liquid assets earn a lower return
• Trade-off to find balance between liquid and illiquid assets
Market Vs. Book Value

• The balance sheet provides the book value of the assets, liabilities and equity.
• Market value is the price at which the assets, liabilities or equity can actually be
bought or sold.
• Market value and book value are often very different. Why?
• Which is more important to the decision-making process?
Income Statement
• The income statement is more like a video of the firm’s operations for a specified
period of time.
• You generally report revenues first and then deduct any expenses for the period
• Matching principle – GAAP – ex: to show revenue when it accrues and match the
expenses required to generate the revenue
Sources and Uses

• Sources
• Cash inflow – occurs when we “sell” something
• Decrease in asset account (Sample B/S)
• Accounts receivable, inventory, and net fixed assets
• Increase in liability or equity account
• Accounts payable, other current liabilities, and common stock
• Uses
• Cash outflow – occurs when we “buy” something
• Increase in asset account
• Cash and other current assets
• Decrease in liability or equity account
• Notes payable and long-term debt
Statement of Cash Flows

• Statement that summarizes the sources and uses of cash
• Changes divided into three major categories

• Operating Activity – includes net income and changes in most current
accounts
• Investment Activity – includes changes in fixed assets
• Financing Activity – includes changes in notes payable, long-term debt
and equity accounts as well as dividends
Standardized Financial Statements

• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare financial information,
particularly as the company grows
• They are also useful for comparing companies of different sizes, particularly
within the same industry
Ratio Analysis
• Ratios also allow for better comparison through time or between companies
• As we look at each ratio, ask yourself what the ratio is trying to measure and why
is that information is important
• Ratios are used both internally and externally
Categories of Financial Ratios

• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
(1) Computing Liquidity Ratios

• Current Ratio = CA / CL
• 2256 / 1995 = 1.13 times
• Quick Ratio = (CA – Inventory) / CL
• (2256 – 1995) / 1995 = .1308 times
• Cash Ratio = Cash / CL
• 696 / 1995 = .35 times
• NWC to Total Assets = NWC / TA
• (2256 – 1995) / 5394 = .05
• Interval Measure = CA / average daily operating costs
• 2256 / ((2006 + 1740)/365) = 219.8 days
(2) Computing Long-term Solvency Ratios

• Total Debt Ratio = (TA – TE) / TA

• (5394 – 2556) / 5394 = 52.61%
• Debt/Equity = TD / TE
• (5394 – 2556) / 2556 = 1.11 times
• Equity Multiplier = TA / TE = 1 + D/E
• 1 + 1.11 = 2.11
• Long-term debt ratio = LTD / (LTD + TE)
• 843 / (843 + 2556) = 24.80%
(3) Computing Coverage Ratios

• Times Interest Earned = EBIT / Interest
• 1138 / 7 = 162.57 times
• Cash Coverage = (EBIT + Depreciation) / Interest
• (1138 + 116) / 7 = 179.14 times
(4) Computing Inventory Ratios

• Inventory Turnover = Cost of Goods Sold / Inventory
• 2006 / 301 = 6.66 times
• Days’ Sales in Inventory = 365 / Inventory Turnover
• 365 / 6.66 = 55 days
(5) Computing Receivables Ratios

• Receivables Turnover = Sales / Accounts Receivable
• 5000 / 956 = 5.23 times
• Days’ Sales in Receivables = 365 / Receivables Turnover
• 365 / 5.23 = 70 days
(6) Computing Total Asset Turnover

• Total Asset Turnover = Sales / Total Assets
• 5000 / 5394 = .93
• It is not unusual for TAT < 1, especially if a firm has a large amount of
fixed assets
• NWC Turnover = Sales / NWC
• 5000 / (2256 – 1995) = 19.16 times
• Fixed Asset Turnover = Sales / NFA
• 5000 / 3138 = 1.59 times

Chapter No. 3 – Time Value of Money
TIME VALUE OF MONEY
OUTLINE
Time lines are used to help visualize what is happening in time value of money
problems. Cash flows are placed directly below the tick marks, and interest rates
are shown directly above the time line; unknown cash flows are indicated by a
symbol for the particular item that is missing. Thus, to find the future value of $100
after 5 years at 5 percent interest, the following time line can be set up:
Time: 0 1 2 3 4 5
5%
| | | | | |
Cash flows: -100 FV5 = ?
Finding the future value (FV), or compounding, is the process of going from today's
values (or present values) to future amounts (or future values). It can be calculated
as
FVn = PV(1 + i)n = PV(FVIFi,n),
where PV = present value, or beginning amount; i = interest rate per year; and n =
number of periods involved in the analysis. FVIFi,n, the Future Value Interest
Factor, is a short-hand way of writing the equation. This equation can be solved in
one of three ways: numerically with a regular calculator, with a financial calculator,
or with a spreadsheet program. For calculations, assume the following data that
were presented in the time line above: present value (PV) = $100, interest rate (i) =
5%, and number of years (n) = 5.

 To solve numerically, use a regular calculator to find 1 + i = 1.05 raised to the
fifth power, which equals 1.2763. Multiply this figure by PV = $100 to get the
final answer of FV5 = $127.63 .
 With a financial calculator, the future value can be found by using the time value
of money input keys, where N = number of periods, I = interest rate per period,
PV = present value, PMT = payment, and FV = future value. By entering N = 5, I
= 5, PV = -100, and PMT = 0, and then pressing the FV key, the answer 127.63 is
displayed.
 Some financial calculators require that all cash flows be designated as either
inflows or outflows, thus an outflow must be entered as a negative number
(for example,
PV = -100 instead of PV = 100).
 Some calculators require you to press a “Compute” key before pressing the
FV key.

 Spreadsheet programs are ideally suited for solving time value of money
problems. The spreadsheet itself becomes a time line.
A B C D E F G
1 Interest rate .05
2 Time 0 1 2 3 4 5
3 Cash flow -100
4 Future value 105.00 110.25 115.76 121.55 127.63
 Row 4 contains the spreadsheet formula for future value.
 The Excel formula in Cell G4 is written as =-$B$3*(1+$B$1)^G2. This
gives us flexibility to change the interest rate in Cell B1 to see how the future
value changes with changes in interest rates.
 An alternative Excel formula in Cell G4 could have been entered. This is the
FV function, and it is =FV(5%,5,0,-100,1). The first argument of this
formula is the interest rate, the second the number of periods, the third the
annual payments, the fourth is the present value, and the fifth indicates that
payments are all made at the end rather than the beginning of each year.
 Note that small rounding differences will often occur among the various solution
methods.
 In general, you should use the easiest approach.
 A graph of the compounding process shows how any sum grows over time at
various interest rates. The greater the interest rate, the faster the growth rate.
Finding present values is called discounting, and it is simply the reverse of

compounding. In general, the present value of a cash flow due n years in the future
is the amount which, if it were on hand today, would grow to equal the future
amount. By solving for PV in the future value equation, the present value, or
discounting, equation can be developed and written in several forms:
n
 1 
PV = FVn n = FVn   = FVn ( PVIF i, n ).
(1 + i ) 1+i
 PVIFi,n, the Present Value Interest Factor, is a short-hand way of writing the
equation.
 To solve for the present value of $127.63 discounted back 5 years at a 5%
opportunity cost rate, one can utilize any of the four solution methods:
 Numerical solution: Divide $127.63 by 1.05 five times to get PV = $100.
 Financial calculator solution: Enter N = 5, I = 5, PMT = 0, and FV = 127.63,
and then press the PV key to get PV = -100.
 Spreadsheet solution:

A B C D E F G
1 Interest rate .05
2 Time 0 1 2 3 4 5
3 Cash flow 0 0 0 0 127.63
4 Present value 100
Any of three formulas could be entered using Excel in Cell B4:
(1) =G3/(1+$B$1)^G2, (2) =NPV($B$1,C3:G3), or (3) =PV(B1,G2,0,G3).
The second formula finds the present value of each number in the range of
cells from C3 to G3, discounted at 5 percent. The third formula find the
present value of G3, when discounted for G2 periods at a rate of B1.
 A graph of the discounting process shows how the present value of any sum to be
received in the future diminishes as the years to receipt increases. At relatively
high interest rates, funds due in the future are worth very little today, and even at
a relatively low discount rate, the present value of a sum due in the very distant
future is quite small.
There are four variables in the time value of money compounding and discounting
equations: PV, FV, i, and n. If three of the four variables are known, you can find
the value of the fourth.
 If we are given PV, FV, and n, we can determine i by substituting the known
values into either the present value or future value equations, and then solve for i.
Thus, if you can buy a security at a price of $78.35 which will pay you $100 after
5 years, what is the interest rate earned on the investment?
 Numerical solution: Solve for i in the following equation using the
exponential feature of a regular calculator: $100 = $78.35(1 + i)5.
 Financial calculator solution: Enter N = 5, PV = -78.35, PMT = 0, and FV =
100, then press the I key, and I = 5 is displayed.
A B C D E F G
1 Time 0 1 2 3 4 5
2 Cash flow -78.35 0 0 0 0 100
3 Interest rate 5%
4
 The Excel formula in Cell B3 is entered as =IRR(B2:G2). The formula

calculates the internal rate of return, and its argument is the range of the cash
flows. Alternatively, you could enter =Rate(G1,0,B2,G2), which finds the
rate given G1 periods, a present value of B2, and a future value of G2.
 Likewise, if we are given PV, FV, and i, we can determine n by substituting the
known values into either the present value or future value equations, and then
solve for n. Thus, if you can buy a security with a 5 percent interest rate at a price
of $78.35 today, how long will it take for your investment to return $100?

 Numerical solution: Solve for n in the following equation using the natural
logarithm feature of a regular calculator: $100 = $78.35(1 + .05)n.
 Financial calculator solution: Enter I = 5, PV = -78.35, PMT = 0, and FV =
100, then press the N key, and N = 5 is displayed.
 Spreadsheet solution: Enter the formula =NPER(.05,0,-78.35,100), which
finds the number of periods, given a rate of 5%, a present value of –78.35,
and a future value of 100.
An annuity is a series of equal payments made at fixed intervals for a specified

number of periods. If the payments occur at the end of each period, as they
typically do, the annuity is an ordinary (or deferred) annuity. If the payments occur
at the beginning of each period, it is called an annuity due.
 The future value of an annuity is the total amount one would have at the end of
the annuity period if each payment were invested at a given interest rate and held
to the end of the annuity period.
 Defining FVAn as the compound sum of an ordinary annuity of n years, and
PMT as the periodic payment, we can write
n  (1  i) n  1 
FVA n  PMT  (1 + i ) n -t
= PMT    PMT( FVIFA i, n ).
 i 
t =1  
 FVIFAi,n is the future value interest factor for an ordinary annuity. This is a
short-hand notation for the formula shown above.
 For example, the future value of a 3-year, 5 percent ordinary annuity of $100
per year would be $100(3.1525) = $315.25.
 The same calculation can be made using the financial function keys of a
calculator. Enter N = 3, I = 5, PV = 0, and PMT = -100. Then press the FV
key, and 315.25 is displayed.
 Most spreadsheets have a built-in function to find the future value of an
annuity. In Excel the formula would be written as =FV(.05,3,-100).
 For an annuity due, each payment is compounded for one additional period,
so the future value of the entire annuity is equal to the future value of an
ordinary annuity compounded for one additional period. Thus:
FVAn (Annuity due) = PMT(FVIFAi,n)(1 + i).
 For example, the future value of a 3-year, 5 percent annuity due of $100 per
year is $100(3.1525)(1.05) = $331.01.
 Most financial calculators have a switch, or key, marked “DUE” or “BEG”
that permits you to switch from end-of-period payments (an ordinary annuity)
to beginning-of-period payments (an annuity due). Switch your calculator to
“BEG” mode, and calculate as you would for an ordinary annuity. Do not
forget to switch your calculator back to “END” mode when you are finished.
 For an annuity due, the spreadsheet formula is written as =FV(.05,3,-
100,0,1). The fourth term in the formula, 0, means that no extra payment is

made at t = 0, and the last term, 1, tells the computer that this is an annuity
due.
 The present value of an annuity is the single (lump sum) payment today that
would be equivalent to the annuity payments spread over the annuity period. It is
the amount today that would permit withdrawals of an equal amount (PMT) at the
end (or beginning for an annuity due) of each period for n periods.
 Defining PVAn as the present value of an ordinary annuity of n years and
PMT as the periodic payment, we can write
 1 
t  1  
n
 1   (1  i) 
n
PVA n  PMT     PMT    PMT(PVIFA i,n ).
t =1  1 + i  
i

 
 PVIFAi,n is the present value interest factor for an ordinary annuity. This is a
short-hand notation for the formula shown above.
 For example, an annuity of $100 per year for 3 years at 5 percent would have
a present value of $100(2.7232) = $272.32.
 Using a financial calculator, enter N = 3, I = 5, PMT = -100, and FV = 0, and
then press the PV key, for an answer of $272.32.
A B C D E
1 Interest rate .05
2 Time 0 1 2 3
3 Cash flow 100 100 100
4 Present value $272.32
 Two formulas can be used to solve this problem. Excel’s NPV formula can
be entered in Cell B4: =NPV($B$1,C3:E3). The second formula that can be
used is Excel’s PV annuity function: =PV(.05,3,-100).
 The present value for an annuity due is
PVAn (Annuity due) = PMT(PVIFAi,n)(1 + i).
 For example, the present value of a 3-year, 5 percent annuity due of $100 is
$100(2.7232)(1.05) = $285.94.
 Using a financial calculator, switch to the “BEG” mode, and then enter N = 3,
I = 5, PMT = -100 , and FV = 0, and then press PV to get the answer,
$285.94. Again, do not forget to switch your calculator back to “END” mode
when you are finished.
 For an annuity due, the spreadsheet formula is written as =PV(.05,3,-
100,0,1). The fourth term in the formula, 0, means that you are not making
any additional payments at t = 3, and the last term, 1, tells the computer that
this is an annuity due.

An annuity that goes on indefinitely is called a perpetuity. The payments of a
perpetuity constitute an infinite series.
 The present value of a perpetuity is:

PV (Perpetuity) = Payment/Interest rate = PMT/i.
 For example, if the interest rate were 12 percent, a perpetuity of $1,000 a year
would have a present value of $1,000/0.12 = $8,333.33.
Many financial decisions require the analysis of uneven, or no constant, cash flows
rather than a stream of fixed payments such as an annuity.
 The present value of an uneven stream of income is the sum of the PVs of the
individual cash flow components. Similarly, the future value of an uneven stream
of income is the sum of the FVs of the individual cash flow components.
 With a financial calculator, enter each cash flow (beginning with the t = 0
cash flow) into the cash flow register, CFj, enter the appropriate interest rate,
and then press the NPV key to obtain the PV of the cash flow stream.
 Spreadsheets are especially useful for solving problems with uneven cash
flows.
A B C D E F G H I
1 Interest rate .06
2 Time 0 1 2 3 4 5 6 7
3 Cash flow 100 200 200 200 200 0 1,000
4 Present value 1,413.19
 The Excel spreadsheet formula in Cell B4 is written as =NPV(B1,C3:I3).

 Some calculators have a net future value (NFV) key which allows you to
obtain the FV of an uneven cash flow stream.
 If one knows the relevant cash flows, the effective interest rate can be calculated
efficiently with either a financial calculator or a spreadsheet program. Using a
financial calculator, enter each cash flow (beginning with the t = 0 cash flow) into
the cash flow register, CFj, and then press the IRR key to obtain the interest rate
of an uneven cash flow stream.
Semiannual, quarterly, and other compounding periods more frequent than an

annual basis are often used in financial transactions. Compounding on a no annual
basis requires an adjustment to both the compounding and discounting procedures
discussed previously.
 The effective annual rate (EAR or EFF%) is the rate that would have produced
the final compounded value under annual compounding. The effective annual
percentage rate is given by the following formula:

Effective annual rate (EAR) = EFF% = (1 + iNom/m)m  1.0,
 where iNom is the nominal, or quoted, interest rate and m is the number of
compounding periods per year. The EAR is useful in comparing securities with
different compounding periods.
 For example, to find the effective annual rate if the nominal rate is 6 percent and
semiannual compounding is used, we have:
EAR = (1 + 0.06/2)2 – 1.0 = 6.09%.
 For annual compounding use the formula to find the future value of a single
payment (lump sum):
FVn = PV(1 + i)n.

 When compounding occurs more frequently than once a year, use this formula:
FVn = PV(1 + iNom/m)mn.

 Here m is the number of times per year compounding occurs, and n is the number
of years.
 The amount to which $1,000 will grow after 5 years if quarterly compounding is
applied to a nominal 8 percent interest rate is found as follows:
FVn = $1,000(1 + 0.08/4)(4)(5) = $1,000(1.02)20 = $1,485.95.

 Financial calculator solution: Enter N = 20, I = 2, PV = -1000, and PMT = 0,
and then press the FV key to find FV = $1,485.95.
 Spreadsheet solution: The spreadsheet developed to find the future value of a
lump sum under quarterly compounding would look like the one for annual
compounding, with two changes: The interest rate would be quartered, and
the timeline would show four times as many periods.
 The present value of a 5-year future investment equal to $1,485.95, with an 8

percent nominal interest rate, compounded quarterly, is found as follows:
$1,485.95  PV1  0.08 / 4

( 4 )( 5)
$1,485.95
PV  20 = $1,000.
(1.02 )
 Financial calculator solution: Enter N = 20, I = 2, PMT = 0, and FV =
1485.95, and then press the PV key to find PV = -$1,000.00.
 Spreadsheet solution: The spreadsheet developed to find the present value of

a lump sum under quarterly compounding would look like the one for annual
compounding, with two changes: The interest rate would be quartered, and
the time line would show four times as many periods.

The nominal rate is the rate that is quoted by borrowers and lenders. Nominal rates
can only be compared with one another if the instruments being compared use the
same number of compounding periods per year. Note also that the nominal rate is
never shown on a time line, or used as an input in a financial calculator, unless
compounding occurs only once a year. In general, no annual compounding can be
handled one of two ways.
 State everything on a periodic rather than on an annual basis. Thus, n = 6 periods
rather than n = 3 years and i = 3% instead of i = 6% with semiannual
compounding.
 Find the effective annual rate (EAR) with the equation below and then use the
EAR as the rate over the given number of years.
m
 
EAR = 1 + i N o m   1.0.
 m 
Fractional time periods are used when payments occur within periods, instead of at
either the beginning or the end of periods. Solving these problems requires using
the fraction of the time period for n, number of periods, and then solving either
numerically, with a spreadsheet program, or with a financial calculator. (Some
older calculators will produce incorrect answers because of their internal “solution”
programs.)
An important application of compound interest involves amortized loans, which are

paid off in equal installments over time.
 The amount of each payment, PMT, is found as follows: PV of the annuity =

PMT(PVIFAi,n), so PMT = PV of the annuity/PVIFAi,n.
 With a financial calculator, enter N (number of years), I (interest rate), PV

(amount borrowed), and FV = 0, and then press the PMT key to find the periodic
payment.
 The spreadsheet is ideal for developing amortization tables. The set up is similar
to the table in the text, but you would want to include “input” cells for the interest
rate, principal value, and the length of the loan.
 Each payment consists partly of interest and partly of the repayment of principal.
This breakdown is often developed in a loan amortization schedule.
 The interest component is largest in the first period, and it declines over the
life of the loan.
 The repayment of principal is smallest in the first period, and it increases
thereafter.

Formulas
N
u Time
m Value of
Compounded (m) Times per Continuous
b Money Annual Compounding
Year Compounding
e Formula
r For:
Future
Value of a nm
 i 
1 Lump F V = P V ( 1+ i ) n
FV = PV 1 +  FV = PV(e )in
Sum. (  m
FVIFi,n )
Present
Value of a - nm
 i 
2 Lump PV = FV ( 1 + i ) -n
PV = FV 1 +  PV = FV( e )-in
Sum. (  m
PVIFi,n )
Future
Value of  ( 1 + i )n - 1   1  (i / m) nm  1
3 an FVA = PMT   FVA  PMT  
Annuity. (  i   i/m 
FVIFAi,n )
Present
Value of 1 - ( 1 + i )- n  1 -  1 + (i / m) - nm 
4 an PVA = PMT   PVA = PMT  
Annuity. (  i   i/m 
PVIFAi,n )
Present PMT PMT
5 Value of a PVperpetuity  PVperpetuity 
Perpetuity. i [(1  i )1/ m  1]
Effective
Annual m
 i 
6 Rate EAR = APR EAR =  1 +  - 1 EAR = e i - 1
given the  m
APR.
The length
of time
1
ln ( FV/PV) n= * ln ( FV/PV)
required ln (FV/PV) n= i
7 n=
m * ln  1  
i
for a PV to ln (1 + i )
grow to a m
FV.
The APR
 FV 
1/ n  FV 1/( nm)  1
8 required i=  -1 i = m *   - 1 i= * ln (FV/PV)
for a PV to  PV   PV   n
grow to a

FV.
The length
of time
required
 i  FVA m 
for a  (FVA)( i )  ln   + 
series of ln  + 1  m  PMT i 
9
PMT’s to  PMT  n=
n=   i 
grow to a ln (1 + i ) m * ln 1 + 
future   m 
amount
(FVA).
The length
of time
required  (PVA )(i / m) 
ln 1  
 (PVA )(i ) 
n 
for a ln 1  PMT
series of PMT  ,
10 PMT’s to n  ,   i 
m * ln1  
ln (1  i )
exhaust a   m 
specific
for PVA(i) < PMT
present
for PVA(i/m) < PMT
amount
(PVA).
Legend
i = the nominal or Annual Percentage Rate n = the number of periods
m = the number of compounding periods EAR = the Effective Annual Rate
per year
ln = the natural logarithm, the logarithm to e = the base of the natural logarithm ≈
the base e 2.71828
PMT = the periodic payment or cash flow Perpetuity = an infinite annuity

Chapter No. 4 – Financial Market and
Institute
Financial Markets
 Channel through which financial assets are exchanged. Process also known
as funds intermediation.
 Surplus Units – suppliers of funds, because they spend less than they
receive. Households are the only net supplier of funds.
 Deficit Units – users of funds, because they spend more than they receive.
Households, corporations, and governments can all be deficit units.
Financial Markets
 Money Markets – markets that trade debt instruments with maturities of up to

one year.
 Treasury bills, commercial paper, federal funds, negotiable CDs,

repurchase agreements, and banker’s acceptances.
 Capital Markets – markets that trade equity and debt instruments with
maturities of more than one year.
 Stocks, bonds, and mortgages.
 Primary Markets – markets in which corporations raise funds through new

issues of securities, such as stocks and bonds.
 May be first-time issues by firm’s initially going public, the sale of

additional new shares of an already publicly traded firm, or first time debt
issuances.
 Secondary Markets – markets in which existing securities are traded.
 Organized Exchanges – physical meeting place and communication facilities

are provided for members to conduct their transactions.
 Over-the-Counter (OTC) markets – no central location. Financial claims can

be traded by phoning an OTC dealer or by using a computer system.

 Efficiency – Simply the idea that the market accurately prices the securities
that are traded in them. Markets can be weak, semi-strong, or strong form
efficient.
 Regulation – Most important regulator is the Securities and Exchange

Commission (SEC).
 Globalization – Increased integration. It is becoming easier to acquire

information about foreign companies and invest accordingly.
Financial Institutions
 Institutions – serve as intermediaries because markets are not perfect.
 Depository Institutions – receive deposits and make loans.
 Commercial Banks – most dominant depository institution.
 Savings Institutions – take in deposits and provide mortgage loans.
 Credit Unions – take in deposits and provide retail loans.
 No depository Financial Institutions – do not accept deposits from consumers.
 Finance Companies – Spans a variety of fringe companies.
 Consumer finance companies
 Business finance companies
 Sales finance companies
 No depository Financial Institutions (cont.)
 Mutual Funds – primary investment tool of many households.
 Securities Firms – multiproduct firms that usually specialize in several

market related activities.
Examples include brokerage houses, underwriters, investment banks, and

market makers.
 No depository Financial Institutions (cont.)
 Hedge Firms – sells shares to upscale investors and are allowed to invest
in risky assets. Largely unregulated.

 Insurance Companies – receive money from premiums and invest in
financial securities.
 Pension Funds – Governments and companies allow employees to invest

money in securities.
 Competition – U.S. banks face increasing foreign competition.
 Consolidation – Banks continue to consolidate as regulations have relaxed.
 Global Expansion – U.S. banks, insurance companies, and securities firms

have expanded into foreign countries in recent years.
Key Trends Affecting Banks
 Service Proliferation – rapidly expanding services.
 Rising Competition – financial service firms entering other markets.
 Government Deregulation – fewer restrictions.
 Technological Change – ATMs, Point of Sale terminals, online payments, etc.
 Consolidation and Geographic Expansion – roll-up of the industry continues.
 Convergence – the movement of financial institutions across product lines.
 Globalization – largest banks compete with each other internationally.

Chapter No. 5 – Interest Rate
The interest-rate market is the market in which individuals and businesses lend
cash to other individuals and businesses in return receive compensation in the
form of interest.
The interest-rate market is not a market with a single physical location.
When a lender makes a loan to a borrower, an interest-rate asset is created for
the lender and an interest-rate liability is created for the borrower.
Characteristics of Money Market Instruments:

 Term The term of a fixed-income instrument is the length of time
that the borrower borrows the money.
 Principal The principal is the amount that the borrower agrees to
repay to the lender on the maturity date.
 Interest Rate This is the amount that the borrower agrees to pay
the lender for the use of the money, usually expressed as an
annual percentage of the principle. Interest rates may be paid in
regular installments over the term of the instrument, or in a lump
sum at the maturity date.
 Marketability If ownership of the interest-rate asset or liability can
be readily transferred to a third party, the instruments is said to be
marketable. Most interest-rate securities are marketable
instruments.
 Security Fixed-income instruments can be either secured, or
collateralized, by specific assets, or unsecured. If an instrument is
secured, the lender has the right to take ownership of the specified
asset if the borrower does not fulfill his or her obligation to repay
the principal. If an instrument is unsecured, the lender has no
specific claim to any of the borrower’s assets if the borrower does
not repay the principal.
 Call or Put features Some instruments have a position that allows
the borrower to repay the principle (a call feature) or the lender to
demand repayment of the principle (a put feature) before the
maturity date.
Deposits and Loans
Deposits from Businesses
1. Demand deposits, more commonly known as checking accounts, can be
withdrawn by the depositor at any time, without giving any notice to the
bank. Most banks pay little or no interest on demand deposits.

2. Notice deposits, which consist primarily of savings accounts, require the
depositor to give the bank advance notice before withdrawing the funds,
although this requirement is rarely, if ever, enforced. Notice deposits are
floating-rate deposits. The rates offered by most banks are usually low,
and they change infrequently.
3. Fixed-term deposits have fixed term and must be repaid, with interest, to
the depositor on the maturity date. Fixed-term deposits are also known as
term deposits or time deposits. Some fixed-term deposits, however, have
a provision that allows the depositor to withdraw the deposit before the
maturity date. There may or may not be penalty for doing so.
Loans to Businesses
Banks lend money to businesses in many different forms. Loans to
Medium-sized and large corporations are usually structured as credit facilities,
also called credit lines. A credit facility is a flexible, customized arrangement in
which the corporation has a variety of ways to borrow money from the bank.
Repurchase Agreements
A repurchase agreement, or repo, is a loan in which a borrower sells a
security to a lender at one price with an agreement to buy the security back on a
future date at a higher price.
An overnight repo is a repo with a term of one day.
Investment dealers make an extensive use of repurchase agreements to finance
their inventories of equity and interest-rate securities. They pay interest
according to the standard formula for computing the interest on a short-term loan:
Interest Paid = Principal * Interest Rate * (DTM/ADC)
where DTM = the number of days until maturity,
ADC = the denominator of the relevant day-count convention
International Markets
The international market for deposits and loans is known as the
Eurocurrency market. This is the market for term deposits and loans in a
currency other than the local currency of the bank branch that is accepting the
deposit or extending the loan.
The London Interbank Offered Rate (LIBOR)
One each business day in London, banks in the Eurocurrency interbank market
constantly lend and borrow Eurocurrency deposits to and from each other. The
most popular currencies represented include the US dollar, the Japanese yen,
the Swiss franc, the Canadian dollar, the Australian dollar, and the euro.
Ay 11:00 a.m. London time each day, the British Banker’s Association (BBA)
surveys the rate offered by at least eight banks chosen for the ‘reputation, scale
of activity in London market, and perceived expertise in the currency concerned,
and giving due consideration to credit standing’.

Money Market Securities
 Interest-rate risk. The risk that interest rates will rise (fall) and the price of
the security will accordingly fall (rise).
 Credit risk. The risk that the issuer of the security will default on its
obligations to repay interest, principal or both.
 Liquidity risk. The risk that an investor wishing to sell a security is not able
to do so quickly without sacrificing price.
Treasury Bills
Treasury bills (also known as T-bills) are a short-term securities issued by the
governments, normally national governments, often using auction mechanisms,
as part of their liquidity management operations.
T-bills do not explicitly pay interest. Instead, they are sold to investors for less
than their face value; when they mature, they are repaid at their face value. The
following equation is used to calculate the (bond equivalent) yield of a T-bill from
its price:
Y=(FV-P)/P * ADC/DTM
Where: Y = the yield
FV = the face value of the T-bill
P = the price of the T-bill
DTM = the number of days until maturity
ADC = the denominator of the relevant day count conversion
Commercial Paper
Corporations in need of short-term financing usually borrow money from
one or more banks. For large corporations with good credit ratings, an alternative
to bank lending is the commercial paper market. It does not pay explicit interest:
it is used at a discount to its face value and it matures at face value.
Bankers’ Acceptances
A banker’s acceptance (BA) is short-term debt that is issued by a
corporation and guaranteed by a bank. BAs may be used to facilitate the
purchase and sale of goods, either domestically or internationally, or to borrow
money for any purchase.
Certificates of Deposit
A certificate of deposit is a tine deposit with a bank which can be traded.
They generally have maturity of less than three months.
Bond Market
In most countries government expenditure exceeds the level of
government income received through taxation. This shortfall is met by

government borrowing, and bonds are issued to finance the government’s debt.
The core of any domestic capital market is usually the government bond market,
which also forms the benchmark for all other borrowings. Government agencies
also issue bonds, as so local governments or municipalities. Often (but not
always) these bonds are virtually as secure as government bonds.
The world bond market has increased in size more than 15 times in the
last thirty years. As at the end of 2002 outstanding volume stood at over $21
trillion.
The Players
A wide range of participants are involved in the bond markets. We can
group them broadly into borrowers and investors, plus the institutions and
individuals who are part of the business of bond trading. Borrowers accept the
bond market as part of their financing requirements; hence, borrowers can
include sovereign governments, local authorities, public sector organizations and
corporations.
Intermediaries and Banks

In its simplest form a financial intermediary is a broker or agent. Today we
would classify the broker as someone who acts on behalf of the borrower or
lender, buying or selling a bond as instructed.
A retail bank deals mainly with the personal financial sector and small
businesses, and in addition to loans and deposits also provides cash
transmission services.
An investment bank will deal with governments, corporate and institutional
investors. Investment bank performs an agency role for their customers and are
the primary vehicle through which a corporate will borrow funds in the bond
markets.
Institutional Investors
 Short-term institutional investors. These include banks and building societies,
money market fund managers, central banks and the treasury desks of some
types of corporate.
 Long-term institutional investors. Typically these types of investors include
pension funds and life insurance companies. Their investment horizon is long-
term, reflecting the nature of their liabilities.
 Mixed horizon institutional investors. This is possibly the largest category of
investors and will include general insurance companies and most corporate
bodies.
Market professionals
These players include the banks and specialist financial intermediaries
mentioned above, firms that one would not automatically classify as ‘investors’
although they will also have an investment objective. Their time horizon will
range from one day to the very long term. They include:
 Proprietary trading desks of investment banks;

 Bond market makers in securities houses and banks providing a service to
their customers;
 Inter-dealer brokers that provide an anonymous broking facility.
Proprietary traders will actively position themselves in the market in order
to gain trading profit, for example in response to their view on where they think
interest rate levels are headed. These participants will trade direct with other
market professionals and investors, or via brokers.
Market makers or ‘traders’ (also called ‘dealers’ in the United States) are
wholesalers in the bond markets; they make two-way prices in selected bonds.
Bonds by Issuers
Government Bonds
The four major government bond issuers in the world are the euro-area
countries, Japan, the United States and, to a lesser extend, the United Kingdom.
US Agency Bonds
These are issued by different organization, seven of which dominate the US
market in terms of outstanding debt:
 the Federal National Mortgage Association (Fannie Mae),
 the Federal Home Loan Bank System (FHLBS),
 the Federal Home Loan Mortgage Corporation (Freddie Mac),
 the Farm Credit System (FCS),
 the Student Loan Marketing Association (Sallie Mae),
 the Resolution Funding Corporation (RefCorp) and
 the Tennessee Valley Authority (TVA).
Agencies have at least two common features:

 They were created to fulfill a public purpose.
 The debt is not necessarily guaranteed by the government.
Municipal Bonds
Municipal securities constitute the municipal market, that is, the market where
state and local governments – counties, special districts, cities and towns – raise
funds in order to finance projects for the public good such as schools, highways,
hospitals, bridges and airports.
Corporate Bonds
Corporate bonds are issued by entities belonging to the private sector. They
represent what market participants call the credit market. In the corporate
markets, bond issues usually have a stated term to maturity, although the term is
often not fixed because of the addition of call or put features.
Eurobonds (International Bonds)
In every market there is a primary distinction between domestic bonds and
other bonds. Domestic bonds are issued by borrowers domiciled in the country of
issue, and in the currency of the country of issue. Generally they trade only in
their original market. A Eurobond is issued across national boundaries and can
be in any currency, which is why they are also sometimes called international

bonds. An example of a foreign bond is a Bulldog, which is a sterling bond issued
for trading in the UK market by a foreign borrower.
The Markets
A distinction is made between financial instruments of up to one year’s
maturity and instruments of over one year’s maturity. Short-term instruments
make up the money market while all other instruments are deemed to be part of
the capital market. There is also a distinction made between the primary market
and the secondary market. A new issue of bonds made by an investment bank
on behalf of its client is made in the primary market. Such an issue can be public
offer, in which anyone can apply to buy the bonds, or a private offer, where the
customers of the investment bank are offered the stock. The secondary market is
the market in which existing bonds are subsequently traded.
The Government Bond Market
Government bonds are traded on the following four markets:
 The primary market
 The secondary market
 The when-issued market: securities are traded on a forward basis,
before they are issued by the government.
 The repo market: securities are issued as collateral for loans.
The Corporate Bond Market
The market by country and sector
Underwriting a new issue
The Eurobond Market
The key feature of a Eurobond market is the way it is issued, internationally
across borders and by an international underwriting syndicate.
Reasons why borrowers access Eurobond markets include:
 A desire to diversify sources of long-term funding
 For both corporates and emerging country governments, the prestige
associated with an issue of bonds in the international market.
 The flexibility of a Eurobond issue compared to a domestic bond issue or
bank loan, illustrated by the different types of Eurobond instruments
available.
Potential downsides of a Eurobond issue include:

 For all but the largest and most creditworthy of borrowers, the rigid nature
of the issue procedure becomes significant during times of interest-rate
and exchange-rate volatility, reducing the funds available for the
borrowers.
 Issuing debt in currencies other than those in which a company holds
matching assets, or in which there are no prospects of earnings, exposes
the issuer to foreign exchange risk.
Market Conversions
A particular market will apply one of five different methods to calculate
accrued interest:

 Actual/365 Accrued = Coupon days/365
 Actual/ 360 Accrued = Coupon days/360
 Actual/actual Accrued = Coupon days/ actual number of days in the
interest period
 30/360 see below
 30E/360 see below
The Foreign Exchange

The foreign exchange (or forex) market encompasses all the places in
which one nation’s currency is exchanged for another at a specific exchange
rate. An exchange rate is the price of one currency in terms of another.
The Interbank Market
The interbank foreign exchange market has been described as a
‘decentralized, continuous, open bid, double-auction’ market.
 Decentralized. The interbank market is an OTC market without a single
location. It operates globally, through telephone and computer systems
that link banks and other currency traders. Most trading activity, however,
occurs in three major financial centers: London, New York and Tokyo.
Smaller but important interbank centers exist in Frankfurt, Paris,
Singapore and Toronto.
 Continuous. Price quotes in the interbank foreign exchange market vary
continuously. Banks call each other and ask for the currency market prices
for a particular currency trade. They are quoted a bid/ offer price that is
stated as the price of one currency in terms of another. The bid/ offer price
can change from moment to moment, reflecting changes in market
sentiment as well as demand and supply conditions.
 Open bid. Those who request a bid/ offer price do not have to specify the
amount they with to exchange, or even whether they intend to buy or sell
the currency.
 Double auction. Banks that receive calls for quotations also call other
banks and ask for their market, that is, their buy (bid) and sell (ask) rates.
In 2001, the BIS’s Triennial Foreign Exchange Survey showed that the global
average daily turnover in the interbank foreign exchange market was US$1210
billion. This is actually a decrease from the BIS’s previous survey in 1998, when
daily turnover was nearly US$1500 billion. The BIS cites four factors for the
overall decline in activity:
 The introduction of the euro.
 Consolidation in the international banking system.
 Consolidation in the corporate sector
 A large share of electronic brokering in the spot market.
Exchange-Rate Quotations
Direct Dealing
Direct dealing is the common practice by which a trader at one bank
telephones a trader at another bank to get a quote on a certain currency.
Foreign Exchange Brokers

Given the large number of banks participating in the global market, or
even within North America, Europe or Asia, one can imagine the intricate network
of contacts and technology required to maintain relationships with as many other
banks as possible.
Electronic Brokering Systems
Until recently, ‘physical’ brokering – the process just described – was a
key source of quotes and counterparties. However, due to the rapid evolution of
technology and computing power, the physical brokering business is rapidly
being supplanted by electronic brokering systems. Electronic brokering system is
similar to physical brokering system, except that orders are placed into a
computer system rather than with a person.
The role of the US Dollar
The US dollar has been the world’s primary vehicle currency for almost a
century. This means that it is the accepted benchmark currency against which
most other currencies are valued, because most global trade transactions take
place in US dollars.
Some currencies, however, are quoted directly form the US perspective,
including the British pound sterling (GBP), the euro (EUR) the Australian dollar
(AUD) and the New Zealand dollar (NZD).
Market and Quoting Conversions
Traders have special ways of quoting bid and offer prices for foreign
currencies. For example, a trader at bank A may call a trader at bank B and ask
for B’s market on the Canadian dollar (CAD) versus USD. B shows a market
price of 1.5599-1.5604. Normally the trader at B would not waste his and the
caller’s time by saying ‘one fifty-five ninety-nine’ and ‘one fifty-six-oh-four’, but
would rather quote only the last two decimal places, or points, as in ‘ninety-nine’
or ‘oh-hour’. Traders are always aware of what this means and will always know
what the initial numbers are.
Cross Trades and Cross Rates
Most foreign currencies are not traded or quoted directly against one
another. For example, if a corporation wants to sell Mexican pesos (MXN) in
exchange for Hong Kong dollar (HKD), the transaction would take place as a
cross trade that involves selling MXN for USD and then selling USD for HKD.
The quote that is supplied for this trade would be derived from the two
currencies’ quotes versus the US dollar. This quote is known as a cross rate.
Determinants of Foreign Exchange Rates

The Fundamental Approach
Foreign exchange rates have strong, long-term relationships with a
country’s identifiable economic fundamentals. These include: gross domestic
product (GDP), rate of inflation, productivity, interest rates, unemployment levels,
balance of payments, and current account balance.
The Short-Term Approach
The forex market is fast-moving and volatile. On any given day, a currency
may move a few points or several hundred points. Traders try to take advantage
of these changes, large or small, to make a profit. Traders consult charts and use

technical analysis to understand currencies the same way that equity analyst and
traders try to understand the position and future of a particular company or
industry.
Spot and Forward Markets
A currency can be bought or sold in either spot or the forward market.
The Spot Market
Suppose that on Monday a trader at BMO buys US$10 million spot from a
trader at CIBC at a CAD exchange rate of 1.5604. To settle this transaction,
CIBC will notify its correspondent bank in New York to debit its US dollar account
by US$10 million and send the money to BMO’s correspondent bank in New
York for further credit to BMO. The transfer of US dollars through the
correspondent banks is done through the Clearing House Interbank Payments
System (CHIPS), a central clearing house for USD transactions conducted by its
member banks. The CHIPS transfer will settle the next business day, on Tuesday
(assuming both Monday and Tuesday are US business days).
At the same time, BMO will send CIBC $15,604,000 through the Large Value
Transfer System (LVTS) operated by the Canadian Payment Association (CPA).
BMO will use the Society for Worldwide Interbank Financial Telecommunications
(SWIFT) system to transmit the instructions. At the end of the day, the LVTS
balance for each CPA member is settled by a debit or credit to its account with
the Bank of Canada.
The Forward Market
The main thing that distinguishes the forward market from the spot market
is the timing of delivery. Spot market transactions settle one or two business
days after the trade date, but the settlement of forward market transactions can
occur one week after the trade date to as much as 10 years after the trade date.
Forward Discounts and Premiums
Forward Premium or Forward discount = (Fn-S)/S * (360/n)
Example: Currency Swap Rates and Forward Premiums
Interest Rate Parity
Example: Covered Interest Arbitrage
Example: Fair Value Forward Rates
Structure of a Foreign Exchange Operation

The Stock Market
Stocks (also known as shares or equities) represent an interest in the
ownership of companies or corporations. These securities may exist as paper
certificates (‘bearer form’) or notional entries in the computers of the share
register (‘boo entry form’). These stocks are bought and sold (traded) among
different market participants, including investors, hedge funds and investment
banks.
As the business grows and the need for capital expands, the existing
shareholders frequently ‘float’ the company on a stock market by issuing new
shares to new investors. This process is often known as ‘listing’ or doing an initial
primary offering (IPO). Alternatively, as corporations grow, they may need more

capital. One way of raising extra funds for a company that is already listed is to
make a ‘secondary’ or ‘rights offering’.
A stock market is therefore, in general, a regulated marketplace for the
buying and selling of the ownership of corporations for the purpose of spreading
risk and raising capital. The corporations benefit by having a large liquid market
in which to raise capital, and investors benefit by having the ability to spread and
control their investment risk via the liquidity that a large and deep market offers.
The details of stock that are listed on the various stock markets are
generally available via daily official lists from the market controller which are
often reproduced in whole or part in newspapers such as the Financial Times or
Wall Street Journal.
The Characteristics of Common Stock
Table: Simplified balance sheet of a company

Assets Liabilities
Fixed Assets Creditors/Bond Holders
Debtors Shareholders’ Funds
Table: Pay-out hierarchy on liquidation

First in the queue Inland Revenue/Tax Authorities
Secured Creditors (Mortgagor)
Trade Creditors
Senior Bond Holders
Junior Bond Holders
Last in the queue Equity Holders
Share Premium and Capital Accounts and Limited Liability

Equity Shareholder’s Rights and Dividends
The ordinary shareholder usually has voting rights associated with the holding
in the corporation’s stock at special company meetings such as the annual
general meeting (AGM). Therefore, a shareholder with 30% of the issued equity
would carry a 30% weight in any vote or resolution.
Other types of Equity Shares – Preference Shares
In addition to ordinary shares, a company may issue other classes of equity
such as preference shares. These shares are usually senior to the ordinary
equity, but junior to bonds, as usually carry a fixed dividend such as 5% per
annum based on their face value or a fixed amount cash such as US$5.
Equity Price Data
Details of trading activity of stocks in the market are distributed widely via
electronic and print media. This may be ‘real-time’ (almost as it happens_ or
delayed or summary statistics.
Table: Equity data Pharmaceuticals & Biotech
Share Price Change 1y 1y Low Yield P/E Volume
High Ratio

Glaxo 1130 +5 1395 980 3.6% 14.7 18,941,000
25p xd
Ord.
Market Capitalization (or ‘Market Cap’)

The market capitalization value of a listed company is the total amount of
issued share capital multiplied by the current share price.
Stock Market Indices
Stock market indices such as the S&P 500 and the FTSE 100 are used to
measure broad equity market performance and to benchmark investment
portfolios. Most indices are weighted by market cap, although simple price-
weighting indices do exist (e.g. Nikkei 225, Dow Jones).
The Main Participants – Firms, Investment Banks and Investors
Market Mechanics
The market requires secure communication between qualified participants. In
earlier times the right people met in a designated secure room or place at an
agreed time and traded directly with each other.
The Primary Market – IPOs and Private Placements

Initial public offerings (IPOs) is the name given to a formerly privately owned
company selling equity securities to third-party investors for the first time,
sometimes known as floating on the market or listing. Seasoned new issue
(SNIs) is the name given to companies issuing securities after they have
floated.
Basic Primary Market Process

Initial Public Offerings
The lead manager is responsible for marketing the new issue once the
SEC has accepted the issue registration documents and preliminary
prospectus. This marketing may take the form of a ‘road show’ to investors,
having two main aims:
 Informing investors of the floating company and its activities,
emphasizing its attraction as an investment; and
 Sounding out the investors as to likely price levels at which they will
purchase the securities at launch.
Talking to investors and getting them to commit to purchase securities at
launch is called book building, and this process allows fine tuning of the
offer price.
Private Placements
Private placements of common stock are much cheaper than IPOs since
the entire issue of securities is sold to a small group of investors under
rule SEC 144A ( in the USA), which permits a simpler (and therefore
cheaper) registration and listing process.

The Secondary Market – the Exchange versus OTC Market
The Exchange
Usually each developed country has at least one national stock
exchange. In the USA there are two major ones – The American Stock
Exchange (AMEX) and the NYSE – and several regional exchanges
dealing in smaller local companies. Only members of the exchange are
allowed to trade on it, and the membership is called a seat.
The NUSE has approximately 3000 members and trades in about
3300 common and preference stocks, which represent the vast majority of
large and medium-sized corporations in the USA.
The basic trading mechanism on an exchange is illustrated for the
NYSE as an example (other exchanges may vary somewhat):
 An investor places an order with a broker (who owns a seat on the
exchange);
 The order is passed to the firm’s commission broker on the floor of the
exchange.
 He approaches the specialist, who is responsible for market making (making
two-way prices and managing the order flow) in that particular stock (on the
NYSE there is only one specialist per stock);
 The order is placed and dealt; and
 Confirmation of the ‘fill’ flows back to the investor via the broker chain.
There are essentially two types of order for buying or selling stock on exchange:
 Market order – deal the stock at the current market price and size
 Limit order – deal the whole order at a pre-fixed price
The Over-the-Counter Market

Transactions or exchanges all go via the central market maker(s) or
specialists. In the OTC market, deals are done directly between broker / dealers
who make two-way prices to each other in the stocks that they trade.
Trading Costs
Commission
The commission paid to brokers is normally negotiable and will depend on
the size and volume of trades to be placed via the broker and the level of service
expected.
Bid-Offer Spread
A major cost difference between on-exchange and OTC deal execution is
that on the former many trades will be crossed between brokers inside the
indicated market maker bid-offer spread. This is called price improvement.
Market Impact
When a trade is executed it represents new information in the market and
the market price reacts. Buying stock should drive up the market price, all else
being equal.
Buying on Margin
Essentially, buying stock on margin consists of taking a loan from the
broker (a broker call loan) to buy more stock than his own funds will allow. The

investor leverages his position in a stock through a combination of his won and
borrowed funds.
Leverage
Leverage is the use of borrowed funds to allow an investor to take a larger
risk position than he would ordinarily be able to do with his own funds.
Percentage Margin and Maintenance Margin
Once the loan has been agreed, subject to the maximum leverage not
being exceeded, the money is invested in the stock.
Short Sales and Stock Borrowing Costs
Short-selling is the process of selling a security that the investor does not
won with the intention of buying it back more cheaply later to make a profit. The
short sale is the method by which an investor can speculate on the fall in share
prices rather than their rise. In order to sell short it is necessary to borrow stock
for delivery in the initial sale trade. Then, when the position is to be closed our,
the shorted shares are bought in the market and returned to the counterparty
who lent the stock. This is called covering the short. Clearly, the lender of the
stock demands a fee for this service, and this is known as the stock-borrowing
cost or repo cost.
Short Sale
In some markets, notably the USA, there are restrictions on when a short
sale can occur. The so-called up-tick rule prevents a short sale unless the last
price move in the stock was positive.
Stock Borrowing
Typically, stocks are lent by brokers/dealers from securities that are
pledged or held in custody on behalf of their clients. Large investors who hold
their own stocks (e.g. insurance companies) may lent directly in the market.
Typical stock borrow/loan fees in large European stocks are 30 basis points
(0.3%) per annum.
Chapter No. 6 – Risk and Rate of

Return
What is investment risk?
 Investment Alternatives
(Given in the problem)
 Why is the T-bill return independent
of the economy?
 Do T-bills promise a completely
risk-free return?
 Do the returns of HT and Coll. move with or counter to the economy?

 HT: Moves with the economy, and has a positive correlation. This is
typical.
 Coll: Is countercyclical of the economy, and has a negative
correlation. This is unusual.
 Calculate the expected rate of return on each alternative:
 What’s the standard deviation
of returns for each alternative?
 i) measures total, or stand-alone, risk.
 i , the lower the probability that actual returns will be
close to the expected return.
 Expected Returns vs. Risk
 Coefficient of Variation (CV)
 Portfolio Risk and Return
 Portfolio Return, kp
 Alternative Method
 p = 3.3% is much lower than that of either stock (20% and 13.4%).
 p = 3.3% is lower than average of HT and Coll = 16.7%.

 Reason: negative correlation.
 General statements about risk
 Most stocks are positively correlated. rk,m

 Combining stocks generally lowers risk.
 Returns Distributions for Two Perfectly Negatively Correlated Stocks
(r = -1.0) and for Portfolio WM
 Returns Distributions for Two Perfectly Positively Correlated Stocks
(r = +1.0) and for Portfolio MM’
 What would happen to the
riskiness of an average 1-stock
portfolio as more randomly
selected stocks were added?
 p would decrease because the added stocks would not be perfectly
correlated but kp would remain relatively constant.
 As more stocks are added, each new stock has a smaller risk-
reducing impact.
 p falls very slowly after about 10 stocks are included, and after 40
p is about
M .
 Stand-alone Market Firm-specific
 By forming portfolios, we can eliminate about half the riskiness of
individual stocks (35% vs. 20%).
 NO!
 Stand-alone risk or CV is not important
to a well-diversified investor.
 Rational, risk- p , which is
based on market risk.

 There can only be one price, hence market return, for a given
security. Therefore, no compensation can be earned for the
additional risk of a one-stock portfolio.
 Beta measures a stock’s market risk. It shows a stock’s volatility
relative to the market.
Beta shows how risky a stock is if the stock is held in a well-
diversified portfolio.
 How are betas calculated?
 Run a regression of past returns on Stock i versus returns on the
market. Returns = D/P + g.
 The slope of the regression line is defined as the beta coefficient.
 If beta = 1.0, average stock.
 If beta > 1.0, stock riskier than average.
 If beta < 1.0, stock less risky than average.
 Most stocks have betas in the range of 0.5 to 1.5.
 List of Beta Coefficients
 Can a beta be negative?
 Use the SML to calculate the
required returns.
 Assume kRF = 8%.
 Note that kM = kM is 15%. (Equil.)
 RPM = kM – kRF = 15% – 8% = 7%.
 Required Rates of Return
 Expected vs. Required Returns
 Calculate beta for a portfolio with 50% HT and 50% Collections
 The required return on the HT/Coll. portfolio is:
 If investors raise inflation expectations by 3%, what would happen to
the SML?
 If inflation did not change but risk aversion increased enough to
cause the market risk premium to increase by 3 percentage points,
what would happen to the SML?
 Has the CAPM been verified through empirical tests?
 Not completely. Those statistical tests have problems that make
verification almost impossible.
 Investors seem to be concerned with both market risk and total risk.
 Therefore, the SML may not produce a correct estimate of ki:
o ki = kRF + (kM – kRF)bi + ?
 Also, CAPM/SML concepts are based on expectations, yet betas are

calculated using historical data. A company’s historical data may
not reflect investors’ expectations about future riskiness.
Chapter No. 7 – Cost of Capital

(Detail Information see in chapter
No.10)
Chapter No. 8 – Bond Valuation

• The Basic Structure of Bonds Bond Valuation and Interest Rates what is
a Bond?
• In its broadest sense, a bond is any debt instrument that promises a

fixed income stream to the holder
• Fixed income securities are often classified according to maturity, as

follows:
– Less than one year – Bills or “Paper”

– 1 year < Maturity < 7 years – Notes
– < 7 years – Bonds
Basic Structure of Bonds
• A typical bond has the following characteristics:
– A fixed face or par value, paid to the holder of the bond, at

maturity
– A fixed coupon, which specifies the interest payable over the life
of the bond
• Coupons are usually paid either annually or semi-annually
– A fixed maturity date
Note:
– The coupon rate, the maturity date, par value are all set (fixed) at
the time the bond was originally sold to the market
– The coupon rate will reflect the required rates of interest at the
time of bond issue.
– After issue, interest rates, and required rates of return will

change. Because everything is fixed except the required rate of
return and the bond price, as rates change, so too will bond
prices!
• Bonds may be either:
– Bearer bonds
– Registered bonds
• Bond indenture - the contract between the issuer of the bond and the
investors who hold it
• The market price of a bond is equal to the present value of the

payments promised by the bond

(See the basic pattern of cash flows from a traditional bond on the next
slide)

Cash Flow Pattern for a Traditional Coupon-Paying Bond
Cash Flow Pattern of a Bond
Bond Features and Provisions
Bond Valuation and Interest Rates
Bond Indenture
• The bond indenture is the contract between the issuer and the holder.
It specifies:
– Details regarding payment terms
– Collateral
– Positive & negative covenants
– Par or face value (usually increments of $1,000)
– Bond pricing – usually shown as the price per $100 of par value,
which is equal to the percentage of the bond’s face value
More Bond Terminology
• Term-to-maturity – the time remaining to the bond’s maturity date
• Coupon rate – the annual percentage interest paid on the bond’s face
value. To calculate the dollar value of the annual coupon, multiply the
coupon rate times the face value.
– If the coupon is paid twice a year, divide the annual coupon by

two
– Example: A $1000 bond with an 8% coupon rate will have an $80

coupon if paid annually or a $40 coupon if paid semi-annually.
Security & Protective Provisions
• Mortgage bonds – secured by real assets
• Debentures – either unsecured or secured with a floating charge over

the firm’s assets

• Collateral trust bonds – secured by a pledge of financial assets, such
as common stock, other bonds or treasury bills
• Equipment trust certificates – secured by a pledge of equipment, such

as railway rolling stock
• Covenants
– Positive covenants – things the firm agrees to do

• Supply periodic financial statements
• Maintain certain ratios
– Negative covenants – things the firm agrees not to do

• Restrictions on the amount of debt the firm can take on
• Prevents the firm from acquiring or disposing of assets
More Bond Features More Bond Features
• Call feature – allows the issuer to redeem or pay off the bond prior to
maturity, usually at a premium
• Retractable bonds – allows the holder to sell the bonds back to the
issuer before maturity
• Extendible bonds – allows the holder to extend the maturity of the

bond
• Sinking funds – funds set aside by the issuer to ensure the firm is able
to redeem the bond at maturity
• Convertible bonds – can be converted into common stock at a pre-

determined conversion price
Bond Valuation
• The value of a bond is a function of:
– The bond’s par (face) value
– Term to maturity

– Coupon rate
– Investor’s required rate of return (discount rate is also known as

the bond’s yield to maturity)
Bond Valuation: Example
• What is the market price of a ten year, $1,000 bond with a 5% coupon,
if the bond’s yield-to-maturity is 6%?
Bond Valuation
Semi-Annual Coupon Payments
Bond Valuation: Semi-Annual Coupons
• So far, we have assumed that all bonds have annual pay coupons.
While this is true for many Eurobonds, it is not true for most domestic
bond issues, which have coupons that are paid semi-annually
• To adjust for semi-annual coupons, we must make three changes:
– Size of the coupon payment (divide the annual coupon payment
by 2 to get the cash flow paid each 6 months )
– Number of periods (multiply number of years to maturity by 2 to
get number of semi-annual periods)
– Yield-to-maturity (divide by 2 to get the semi-annual yield)
– Once you solve for the semi-annual yield, you will want to
convert it back to an annualized rate of return (YTM).
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a 5 year, $10,000 Government

of Canada bond with a 4% coupon, paid twice a year, given a YTM of
6%.
Factors Affecting Bond Prices
• There are three factors that affect the price volatility of a bond
– Yield to maturity

– Time to maturity
– Size of coupon
• We will look at each of these in turn.
Inverse Relationship Between Bond Prices and Yields to Maturity
• When interest rates (required rate of return on the bond) increase,

bond prices fall.

Bond Price-Yield Curve
Bond Convexity
• The convexity of the price/YTM graph reveals two important insights:
– The price rise due to a fall in YTM is greater than the price
decline due to a rise in YTM, given an identical change in the
YTM
– For a given change in YTM, bond prices will change more when
interest rates are low than when they are high
Coupon Rate Relationship to Yield-to- Maturity
• The relationship between the coupon rate and the bond’s yield-to-
maturity (YTM) determines if the bond will sell at a premium, at a
discount or at par

Inverse Relationship Between Yields and Prices
• Yield to maturity (investor’s required return)
– Bond prices go down when the YTM goes up
– Bond prices go up when the YTM goes down
• Look at the graph on the next slide. It shows how the price of a 25
year, 10% coupon bond changes as the bond’s YTM varies from 1% to
30%
• Note that the graph is not linear – instead it is said to be convex to the
origin

Price & Yield: 25 Year Bond, 10% Coupon
Other Factors Affecting Bond Prices

Term to Maturity and Size of Coupon
• Term to maturity - long bonds have greater price volatility than short
bonds
• Size of coupon – low coupon bonds have greater price volatility than
high coupon bonds

Time to Maturity
• Time to maturity
– Long bonds have greater price volatility than short bonds

• The longer the bond, the longer the period for which the
cash flows are fixed
• More distant cash flows are affected more in the
discounting process (remember the exponential nature of
compounding…and that discounting is the inverse of
compounding)
• The most distant cash flow from a bond investment is the
most important (it is the face value of the bond) and this
cash flow is affected the greatest in the discounting
process.

Size of the Coupon Rate
• Size of coupon
– Low coupon bonds have greater price volatility than high coupon
bonds
• High coupons act like a stabilizing device, since a greater
proportion of the bond’s total cash flows occur closer to
today & are therefore less affected by a change in YTM
• The greatest price volatility is found with stripped bonds
(no coupon payments)
Interest Rate Risk & Duration
• The sensitivity of bond prices to changes in interest rates is a measure

of the bond’s interest rate risk
• A bond’s interest rate risk is affected by:
– Yield to maturity
– Term to maturity
– Size of coupon
• These three factors are all captured in one number called Duration
Duration
• Duration is a measure of interest rate risk
• The higher the duration, the more sensitive the bond is to changes in
interest rates
• A bond’s duration will be higher if its:
– YTM is lower
– Term to maturity is longer
– Coupon is lower
Bond Quotations
Bond Prices
Discount and Premium Priced Bonds
• Bonds trading at prices > par - premium priced
• Bonds trading at prices < par – discount priced
Bond Quotations
Cash versus Quoted Prices
• The quoted price is the price reported by the media
• The cash price is the price paid by an investor
– The cash price includes both the quoted price plus any interest
that has accrued since the last coupon payment date

Cash Versus Quoted Price: Example
• Assume that you want to purchase a $1,000 bond with a 5% coupon,

paid semi-annually. Today is July 15th. The last coupon was paid June
30th. If the quoted price is $902, how much is the cash price?
Cash Versus Quoted Price: Solution
• The cash price is equal to:

– Quoted price of $902
– Plus 15 days of interest
Bond Yields
Bond Yields
The Yield to Maturity = Investor’s Required Rate of Return
• Yield-to-maturity (YTM) – the discount rate used to evaluate bonds
– The yield earned by a bond investor who:

• Purchases the bond at the current market price
• Holds the bond to maturity
• Reinvests all of the coupons at the YTM for the remaining
term to maturity (the reinvestment rate assumption)
– Is the bond’s Internal Rate of Return (IRR)
Bond Yield to Maturity
• The yield to maturity is that discount rate that causes the sum of the
present value of promised cash flows to equal the current bond price.
Solving for YTM
• To solve for YTM, solve for YTM in the following formula:

• There is a Problem:
– You can’t solve for YTM algebraically; therefore, must either use
a financial calculator, Excel, trial & error or approximation
formula.

Solving for YTM
• Example: What is the YTM on a 10 year, 5% coupon bond (annual pay

coupons) that is selling for $980?
Solving for YTM: Semi-annual Coupons
• When solving for YTM with a semi-annual pay coupon, the yield
obtained must be multiplied by two to obtain the annual YTM
• Example: What is the YTM for a 20 year, $1,000 bond with a 6%

coupon, paid semi-annually, given a current market price of $1,030?
Solving for YTM: Semi-annual Coupons
Using the Approximation Formula to Solve for Yield to Maturity
The Approximation Formula
• This formula gives you a quick estimate of the yield to maturity
– It is an estimate because it is based on a linear approximation

(again you will remember the exponential nature of compound
interest)
• Should you be concerned with the ‘error’ inherent in the approximated

YTM?
– NO
– Remember a YTM is an ex ante calculation – as a forecast, it is

based on assumptions which may or may not hold in this case,
therefore as a forecast or estimate, the approximation approach
should be fine.

The Approximation Formula
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity
Example
• Find the yield-to-maturity of a 5 year 6% coupon bond that is currently

priced at $850. (Always assume the coupon interest is paid semi-
annually.)
• Therefore there is coupon interest of $30 paid semi-annually
• There are 10 semi-annual periods left until maturity
Example – with Solution
Find the yield-to-maturity of a 5 year 6% coupon bond that is currently

priced at $850. (Always assume the coupon interest is paid semi-
annually.)
The Logic of the Equation

Approximation Formula for YTM
• The numerator simply represents the average semi-annual returns on

the investment…it is made up of two components:
– The first component is the average capital gain (if it is a discount
bond) or capital loss (if it is a premium priced bond) per semi-
annual period.
– The second component is the semi-annual coupon interest
received.
• The denominator represents the average price of the bond.
• Therefore the formula is basically, average semi-annual return on
average investment.
• Of course, we annualize the semi-annual return so that we can
compare this return to other returns on other investments for
comparison purposes.

Yield To Call
Yield to Call
• If a bond has a call feature, the issuer can call the bond prior to its
stated maturity
• To calculate the yield to call, simply replace the maturity date with the
first call date
Yield to Call
• The yield to call is that discount rate that causes the present value of
all promised cash flows including the call price (CP) to equal the
current bond price.
Solving for YTC: Semi-annual Coupons
Current Yield
Current Yield
• The current yield is the yield on the bond’s current market price
provided by the annual coupon
– It is not a true measure of the return to the bondholder because it
does not consider potential capital gain or capital losses based
on the relationship between the purchase price of the bond and
it’s par value.
Current Yield
Example
• The current yield is the yield on the bond’s current market price
provided by the annual coupon
• Example: If a bond has a 5.5% annual pay coupon and the current
market price of the bond is $1,050, the current yield is:

Short-Term Interest Rates
Interest Rate Determinants
• Interest is the “price” of money
– Interest rate changes are often measured in Basis points – 1/100

of 1%
• Interest rates go:
– Up – when the demand for loanable funds rises
– Down – when the demand for loanable funds falls
Risk-free Interest Rate
• Usually use the yield on short federal government Treasury bills as a

proxy for the risk-free rate (RF)
• The risk-free rate is comprised of two components:
– Real rate – compensation for deferring consumption
– Expected inflation – compensation for the expected loss in

purchasing power
Inflation and Yields over Time
Fisher Equation
• If we call the risk-free rate the nominal rate, then the relationship
between the real rate, the nominal rate and expected inflation is
usually referred to as the Fisher Equation (after Irving Fisher)
Fisher Equation
• When inflation is low, can safely use the approximation formula:

• When inflation is high, use the exact form of the Fisher Equation:
Fisher Equation
Example
• If the real rate is 3% and the nominal rate is 5.5%, what is the
approximate expected future inflation rate?

Global Influences on Interest Rates
• Canadian domestic interest rates are heavily influenced by global

interest rates
• Interest rate parity (IRP) theory states that FX forward rates will be
established that equalize the yield an investor can earn, whether
investing domestically or in a foreign jurisdiction
– A country with high inflation and high interest rates will have a
depreciating currency
Term Structure of Interest Rates

(Long-term Interest Rates)
• Is that set of rates (YTM) for a given risk-class of debt securities (for
example, Government of Canada Bonds) at a given point in time.
• When plotted on a graph, the line is called a Yield Curve
• The Yield Curve is the graph created by putting term to maturity on the
X axis, YTM on the Y axis and then plotting the yield at each maturity.
• The four typical shapes of yield curves:
•Upward sloping (the most common and persistent shape
historically when short-term interest rates and inflation are low)
•Downward sloping (occurs at peaks in the short-term interest rate
cycle, when inflation is expected to decrease in the future)
•Flat (occurs when rates are transitioning)
•Humped (occurs when rates are transitioning or perhaps market
participants are attracted in large numbers to particular maturity
segment of the market)
•Historical Yield Curves

1990, 1994, 1998, 2004
Theories of the Term Structure
• Three theories are used to explain the shape of the term structure

– Liquidity preference theory
• Investors must be paid a “liquidity premium” to hold less
liquid, long-term debt
– Expectations theory
• The long rate is the average of expected future short
interest rates
– Market segmentation theory

• Distinct markets exist for securities of different maturities

Risk Premiums
• More risky bonds (ie. BBB rated Corporate Bonds) will have their own
yield curve and it will plot at higher YTM at every term to maturity
because of the default risk that BBBs carry
• The difference between the YTM on a 10-year BBB corporate bond and
a 10-year Government of Canada bond is called a yield spread and
represents a default-risk premium investors demand for investing in
more risky securities.
• Spreads will increase when pessimism increases in the economy
• Spreads will narrow during times of economic expansion (confidence)
Yield Curves for Different Risk Classes

Risk Premiums (Yield Spreads)
Risk Premiums
• The YTM on a corporate bond is comprised of:

• The maturity yield differential is explained by the term structure
• Spread is the additional yield due to default risk Debt Ratings
• All publicly traded bonds are assigned a “risk rating” by a rating

agency, such as Dominion Bond Rating Service (DBRS), Standard &
Poors (S&P), Moodys, Fitch, etc.
• Bonds are categorized as:
– Investment grade – top four rating categories (AAA, AA, A &

BBB)

– Junk or high yield – everything below investment grade (BB, B,
CCC, CC, D, Suspended)
Why do Bonds Have Different Yields?
• Default risk – the higher the default risk, the higher the required YTM
• Liquidity – the less liquid the bond, the higher the required YTM
• Call features – increase required YTM
• Extendible feature – reduce required YTM
• Retractable feature – reduce required YTM
Other Types of Bonds/Debt Instruments
Treasury Bills
• Short-term obligations of government with an initial term to maturity of

one year or less
• Issued at a discount & mature at face value
• The difference between the issue price and the face value is treated as
interest income
• To calculate the price of a T bill, use the following formula:
Treasury Bills: Example
• What is the price of a $1,000,000 Canadian T bill with 80 days to

maturity and a BEY of 4.5%?
Solving for Yield on a T Bill
• To solve for the yield on a T bill, rearrange the previous formula and
solve for BEY.
• Example: What is the yield on a $100,000 T bill with 180 days to
maturity and a market price of $98,200?
Zero Coupon Bonds
• A zero coupon bond is a bond issued at a discount that matures at par

or face value

• A zero coupon bond has no reinvestment rate risk, since there are no
coupons to be reinvested
• To calculate the price of a zero coupon bond, solve for the PV of the
face amount
Zero Coupon Bonds
• Example: What is the market price of a $50,000 zero coupon bond with
25 years to maturity that is currently yielding 6%?
Floating Rate & Real Return Bonds
• Floating rate bonds have a coupon that floats with some reference
rate, such as the yield on T bills
– Because the coupon floats, the market price will typically be

close to the bond’s face value
• Real return bonds are issued by the Government of Canada to protect

investors against unexpected inflation
– Each period, the face value of the bond is grossed up by the

inflation rate. The coupon is then paid on the grossed up face
value.
• A Canada Savings Bond (CSB) is a special type of bond issued by the
Government of Canada
• It is issued in two forms:
– Regular interest – interest is paid annually
– Compound interest – interest compounds over the life of the
bond
• CSBs are redeemable at any chartered bank in Canada at their face
value plus accrued interest (after the first three months after issue)
• There is no secondary market for CSBs (they are ‘non-negotiable’
meaning that they cannot be traded in a market between investors.
Summary and Conclusions
In this chapter you have learned:
– About the nature of bonds as an investment
– How to value a bond using discounted cash flow concepts

– About the determinants of interest rates and theories used to
explain the term structure of interest rates
Concept Review Question 1

Bonds and Mortgages
In what ways are bonds different from mortgages?
Duration
• An alternative measure of bond price sensitivity is the bond’s
duration.
• Duration measures the life of the bond on a present value basis.
• Duration can also be thought of as the average time to receipt of the
bond’s cash flows.
• The longer the bond’s duration, the greater is its sensitivity to interest
rate changes.
Duration Rules-of-Thumb
• Duration of zero-coupon bond (strip bond) = the term left until
maturity.
• Duration of a consol bond (ie. a perpetual bond) = 1 + (1/k)
where: k = required yield to maturity

• Duration of an FRN (floating rate note) = 1/2 year
Other Duration Rules-of-Thumb
Duration and Maturity

 Duration increases with maturity of a fixed-income asset, but
at a decreasing rate.
Duration and Yield

 Duration decreases as yield increases.
Duration and Coupon Interest

 The higher the coupon or promised interest payment on the
security, the lower its duration.

Economic Meaning of Duration
• duration is a direct measure of the interest rate sensitivity or elasticity
of an asset or liability. (ie. what impact will a change in YTM have on
the price of the particular fixed-income security?)
• interest rate sensitivity is equal to:
dP = - D [ dk/(1+k)]
Where: P= Price of bond
C= Coupon (annual)
k= YTM
N= Number of periods
F= Face value of bond
Interest Rate Elasticity
• the percent change in the bond’s price caused by a given change in

interest rates (change in YTM)

Price Elasticity of Stripped Bonds
Price Sensitivity of a Stripped Bond
Take our previous example where a $20,000 30-year stripped bond has a
required rate of return of 12%:
P0 = $20,000(PVIFn=30, k = 12%)
= $20,000 (.0334)
= $668.00
Assume now that interest rates fall by 16.7% from 12% to 10%. What is the
percentage change in price of the bond?
P0 = $20,000(PVIFn=30, k = 10%)
= $20,000 (.0573)
= $1,146.00
Percentage change in price = ($1,146 - $668) / $668
=71.6%
Duration and Coupon Rates

• A bond’s duration is affected by the size of the coupon rate offered by
the bond.
– The duration of a zero coupon bond is equal to the bond’s term to
maturity. Therefore, the longest durations are found in stripped
bonds or zero coupon bonds. These are bonds with the greatest
interest rate elasticity.
– The higher the coupon rate, the shorter the bond’s duration.
Hence the greater the coupon rate, the shorter the duration, and
the lower the interest rate elasticity of the bond price.

Duration
The numerator of the duration formula represents the present value of

future payments, weighted by the time interval until the payments occur.
The longer the intervals until payments are made, the larger will be the
numerator, and the larger will be the duration. The denominator represents
the discounted future cash flows resulting from the bond, which is the
bonds present value.
Duration Example
A Formula-based Duration Calculation for a Three Year, 7% Coupon Bond
• As an example, the duration of a bond with $1,000 par value and a 7
percent coupon rate, three years remaining to maturity, and a 9
percent yield to maturity is:
Duration Example
A Formula-based Duration Calculation for a Zero Coupon Bond
• As an example, the duration of a zero-coupon bond with $1,000 par
value and three years remaining to maturity, and a 9 percent yield to
maturity is:
Duration of a Portfolio
• Bond portfolio mangers commonly attempt to immunize their portfolio,
or insulate their portfolio from the effects of interest rate movements.
• This is a common challenge when the investment portfolio is
‘dedicated’ to funding a future liability.
• Duration of a Portfolio Insurance Company Example

A life insurance company knows that they need $100 million 30 years from
now cover actuarially-determined claims against a group of life insurance
policies just no sold to a group of 30 year olds.
The insurance company has invested the premiums into 30-year

government bonds. Therefore there is no default risk to worry about. The
company expects that if the realized rate of return on this bond portfolio
equals the yield-to-maturity of the bond portfolio, there won’t be a problem
growing that portfolio to $100 million. The problem is, that the coupon
interest payments must be reinvested and there is a chance that rates will
fall over the life of the portfolio.
If this happens the portfolio’s terminal value will be less than the liability
the insurance company needs to finance. This shortfall in investment
returns will have to be borne at the expense of the Insurance company’s
shareholders.
Duration of a Portfolio ...

Interest Rate Risk
• The life insurance company example illustrates a key risk in fixed-
income portfolio management - interest rate risk.
• The portfolio manager, before-the-fact calculates the bond portfolio’s
yield-to-maturity. This is an ex ante calculation.
• As such, a naïve assumption assumption is made that the coupon
interest received each year is reinvested at the yield-to-maturity for the
remaining years until the bond matures.
• Over time, however, interest rates will vary and reinvestment
opportunities will vary from that which was forecast.
Duration of a Portfolio
Immunization
• The insurance company will want to IMMUNIZE their portfolio from this
reinvestment risk.
• The simplest way to do this is to convert the entire bond portfolio to
zero-coupon/stripped bonds. Then the ex ante yield-to-maturity will
equal ex post (realized) rate of return. (ie. the ex ante YTM is locked in
since there are no intermediate cash flows the require reinvestment).

Chapter No. 9 – Stock valuation
Stock Valuation
• Firms obtain their long-term sources of equity financing by issuing

common and preferred stock.
• The payments of the firm to the holders of these securities are in the
form of dividends.
• The common stockholders are the owners of the firm and have the
right to vote on important matters to the firm, such as the election of the
Board of Directors.
• Preferred stock, on the other hand, is a hybrid form of financing,

sharing some features with debt and some with common equity.
Stock Valuation
• The value of these securities, as with other assets, is based upon the
discounted value of their expected future cash flows. The value of a share
of stock is often calculated as the present value of the stream of dividends
the stock is expected to provide in the future.
• We will illustrate the valuation of a constant growth stock, i.e., a

stock whose dividends are growing at a rate.
• Preferred stock is a perpetuity and is a little easier to value than

common stock.
Equations
• Constant Growth Stock Price:

P0 = [D0(1+g)]/(r – g) = D1/(r-g)
• You can also solve for the expected return:
• r = (D1/P0) + g
• Preferred Stock:

• P p = Dp / r
Equations
where:
• P0 = the stock price at time 0
• D0 = the current dividend
• D1 = the next dividend (i.e., at time 1)
• g = the growth rate of the dividends
• r = the required return on the stock
• Note that g < r.
• Pp = the preferred stock price
• Dp = the preferred dividend
• Constant Growth Stocks
• A constant growth stock is a stock whose dividends are expected to

grow at a constant rate in the foreseeable future.
• This condition fits some established firms, which tend to grow over
the long run at the same rate as the economy.
• There are numerous, more complicated models which we will not

discuss in this learning module.
An Example
• Find the stock price given that the current dividend is $2 per share,
dividends are expected to grow at a rate of 5% in the forseeable
future, and the required return is 10%
• Step 1 – Draw Timeline

An Example
• Step 2 – Write equation
• P0 = D0(1+g)/(r – g) = D1/(r – g)
• Step 3 – Fill in equation
• P0 = $2 (1 + 5%)/(10% - 5%)
• Step 4 – Solve equation
• P0 = $2.10/5% = $2.10/0.05 = $42
• This means that the value of the stock at time zero is $42 dollars
given a required rate of return of 10%, a growth rate of 5% and a
dividend at time zero of $2.
Preferred Stock
• Preferred stock is defined as equity with priority over common stock

with respect to the payment of dividends and the distribution of
assets in a liquidation.
• Preferred stock has the following features:
• Par Value - The par value represents the claim of the preferred
stockholder against the value of the firm.
• Preferred Dividend / Preferred Dividend Rate - The preferred dividend

rate is expressed as a percentage of the par value of the preferred
stock. The annual preferred dividend is determined by multiplying
the preferred dividend rate times the par value of the preferred stock.
• Since preferred dividends are generally fixed, preferred stock can be

valued as a constant growth stock with a dividend growth rate equal
to zero.

An Example
• Find the price of a share of preferred stock given that the par value is
$100 per share, the preferred dividend rate is 10%, and the required
return is 12%.
• A timeline is not really needed, because the dividends of preferred

stock are fixed. However, you can always draw one if it helps.
• Step 2 – Write equation
• Pp = Dp/r
Note: The formula is the same as a constant growth stock with g = 0,

so
P0 = D1/(r – g) = Pp = Dp/r when g = 0.
An Example
• Step 3 – Fill In Equation
• Pp = $10/12%

Chapter No. 10 – The Basic of Capital
Budgeting
Capital Budgeting
• The making of long-term planning decisions for investments.
• Capital Budgeting Decisions
• Should we purchase new labor-saving equipment to perform

operations presently performed manually
• Should we replace existing equipment with more efficient, newer

equipment?
• Should we enter a new market with a new product or purchase an

existing business already in that market
• The Process of Capital Budgeting
• Process of Capital Budgeting

o Identification Stage
o Search Stage
o Information-Acquisition Stage
o Selection Stage
o Financing Stage
o Implementation and Control Stage
• Project Selection . . .
o Selection in capital budgeting comes in two phases:
o Screening, and
o Preference Screening . . .
• A specific criterion is used to eliminate unprofitable and/or high-risk

investment proposals.

• Preference Selection
• The surviving projects are subjected to a ranking criterion.
• Outcome: The most favorable projects are selected for any given
amount of capital to be invested.
• We interrupt this regularly scheduled program to bring you a special

bulletin on the characteristics of business investments.
• Characteristics of Business Investments
• Business Investments
o Most business investments involve depreciable assets; and
o The returns on business investments extend over long periods
of time.
• Depreciable Assets
To Illustrate . . .
• A firm purchases land (a non-depreciable asset) for $5,000; and
• Rents it out at $750.00 per year for ten years.
What is the Return?
• Since the asset will still be intact at the end of the 10-year period,
each year’s $750 inflow is a return on the original $5,000 investment.
The rate of return is therefore:
• Return on Assets Must
• Provide a return on the original investment.
• To Illustrate . . .
• A firm purchases land (a non-depreciable asset) for $5,000; and
• Rents it out at $750.00 per year for ten years.

• What is the Return?
• Why?
• Because part of the yearly $750 inflow from the equipment must go
to recoup the original $5,000 investment itself, since the equipment
will be worthless at the end of its 10-year life.
• Long Periods of Time
• Long Periods of Time
• In approaching capital budgeting decisions, it is necessary to employ

techniques that recognize the time value of money.
DCF Models . . .
• Focus on . . .
• Cash inflows; and
• Cash outflows
• Rather than on net income
• DCF Models . . .
o There are two main variations of the discounted cash flow
model . . .
o Net Present Value (NPV); and
o Internal Rate of Return (IRR)
• Net Present Value
• Typical Cash Outflows

o The initial investment
o Additional amount of working capital
o Repairs and maintenance
o Additional operating costs
• Typical Cash Inflows

• Incremental revenues
• Reduction in costs
• Salvage value
• Release of working capital
• PDQ company requires a minimum return of 18% on all

investments.
• The company can purchase a new machine at a cost of $40,350.

The new machine would generate cash inflows of $15,000 per
year and have a four-year life with no salvage value.
• What is the net present value of this project?
• Each $15,000 Inflow . . .
• Provides for a recovery of a portion of the original $40,350

investment; and
• Also provides a return of 18% on this investment.
• Practice Exercise 1
• Calculate Net Present Value (NPV)
• An investment that costs $10,000 will return $4,000 per year for four
years.
• Determine the net present value of the investment if the required rate
of return is 12 percent. Ignore income taxes.
• Should the investment be undertaken?

• Calculate Net Present Value (NPV)
• Magnolia Florist is considering replacing an old refrigeration unit

with a larger unit to store flowers.
• Because the new refrigeration unit has a larger capacity, Magnolia

estimates that they can sell an additional $6,000 of flowers a year
(the cost of the flowers is $3,500).
• In addition, the new unit is energy efficient and should save $950 in
electricity each year.
• It will cost an extra $150 per month for maintenance.
• The new refrigeration unit costs $20,000 and has an expected life of
10 years.
• The old unit is fully depreciated and can be sold for an amount equal
to disposal cost.
• At the end of 10 years, the new unit has an expected residual value
of $5,000
• Determine the NPV of the investment if the RRR is 14% (ignore

taxes).
• Should the investment be made.
• Determine the net cash flow for the life of the equipment.
• Limiting Assumptions . . .

• All cash flows occur at the end of the period.
• All cash flows generated by an investment are immediately

reinvested in another project which yields a return at least as large
as the discount rate used in the first project.
• Discount Rate . . .
o The rate generally viewed as being the most appropriate is a
firm’s cost of capital.
o This rate is also known as . . .
o Hurdle Rate
o Cutoff Rate
o Required Rate of Return
• Internal Rate of Return
• Net Present Value Method
• Internal Rate of Return

o When the annual cash flows are even, the IRR formula is
simply . . .
o df = I / CF, or
o Investment/Annual Cash Flow
• Cost of Capital as a Screening Tool
• Using the IRR Method

o The cost of capital takes the form of a hurdle rate that a project
must clear for acceptance.
o If the IRR on a project is not great enough to clear the cost of
capital hurdle, then the project is rejected.
• Using the NPV Method
• The cost of capital becomes the actual discount rate used to compute
the NPV of a proposed project.
• Projects yielding negative NPVs are rejected unless no quantitative

factors, such as social responsibility, employee morale, etc.,
intervene.

• Compare
Net Present Value and
Internal Rate of Return
• Compare IRR & NPV . . .

o The NPV method is simpler to use.
o Using the NPV method makes it easier to adjust for risk.
o The NPV method provides more usable information than does
the IRR method.
• Simplified Approaches to Capital Budgeting
• The Payback Period . . .

o This method involves a span of time known as the payback
period.
o The payback period is the length of time it takes for an
investment project to recoup its own initial cost out of the
cash receipts that it generates.

o The basic premise of this method is that the more quickly the
cost of an investment can be recovered, the more desirable is
the investment.
• The payback period is expressed in years. The basic formula is . . .
• Calculate the Payback period
• The Lower Valley Wheat Cooperative is considering the construction

of a new silo.
• It will cost $41,000 to construct the silo.
• Determine the payback period if the expected cash inflows are $5,000
per year.

• Simplified Approaches to Capital Budgeting
• The Simple Rate of Return

o The Simple Rate of Return is equal to
o Incremental income from the project divided by
o the initial investment in the project.
TEXT BOOKS:
Financial Management: Theory and Practice. 13th Edition. By: Eugene
F. Brigham & Michael C. Ehrhardt.
RECOMMENDED:
1. Fundamentals of Financial Management, Ramesh K. S. Rao.

2. Fundamentals of Corporate Finance, Ross, Westerfield and Jordan.
3. Fundamentals of Corporate Finance, Brealey Myers Marcus.
4. CFA Level-1 Curriculum: Corporate Finance and Portfolio Theory.
Glossary of terms
A
Accounts Payable (Payables): Money owed to suppliers.
Accounts Receivable (Receivables): Money owed by customers.
Annuity Investment: that generates a stream of equal cash flows.
Arbitrage (risk arbitrage): Simultaneous purchase of a security and sale of another to
generate a risk-free profit.
Arbitrage: A transaction that generates a risk-free profit.
Asset Allocation: The process of determining the optimal division of an investor's
portfolio among different assets. Most frequently this refers to allocations between
debt, equity, and cash.
Asset Liability Management: A risk management technique for protecting an
institution's capital.
Assets: Anything that the firm owns.
Average Tax Rate: The rate calculated by dividing the total tax liability by the entity's
taxable income. Also referred to as “Effective Tax Rate” (ETR)
B

Balance Sheet: A basic accounting statement that represents the financial position of
a firm on a given date.
Bankers' Acceptance: A draft drawn on a specific bank by a seller of goods to obtain
payment of goods that have been sold to a customer. The customer maintains an
account with that specific bank.
Base currency: The currency in which the Forex risk is quantified.
Basis Point: .01 percent. Used to measure changes in yields of bonds. Always used in
“floating rate of interest” as opposed to “fixed rate of interest”.
Beta: A relative (to a benchmark) measure of risk. Measures of an asset's non-
diversifiable -- market-- risk. See also systematic risk.
Bid: The lowest price anyone wants to sell the security for at a given time. (See: Ask,
and Bid-Ask Spread)
Bid-Ask Spread: The difference between the bid and the ask for a security at a given
time.
Bill Debt: that has less than 1-year maturity at time of issue.
Bond Long-Term IOU: Whereby the holder (lender or buyer) is promised to receive
fixed payments over a pre-specified time period. Corporate bonds are one of the
available instruments that companies can resort to for their financing needs.
Bond Par Value: The face value that is to be returned to a bondholder at maturity.
Book Value: The depreciated value of a company's assets (original cost less
accumulated depreciation) less the outstanding liabilities. This can be book value of
equity shares, book value of fixed assets, book value of investments made by a
business entity etc.
Broker: A person who facilitates transactions (buy and sell) in the secondary market.
Brokerage Commission: The amount of money your brokerage house would charge
for a given transaction (buy/sell). This is how these firms make their living.
Buyback: When a firm repurchases its own stock from the public.
C
Call Provision: A provision that entitles the corporation to repurchase its bonds or
preferred stock from their holders at stated prices over specified periods.
Callable Bond: A bond that may be terminated prior to maturity by its issuer.
Cap: A derivative instrument that is linked to interest rates.
Capital Asset: All property used in conducting a business other than assets held
primarily for sale in the ordinary course of business or depreciable, and real property
used in conducting a business.
Capital Asset Pricing Model (CAPM): An equation relating an asset's relative riskiness
(beta) to its required return.
Capital Budgeting: The decision-making process with respect to investment in fixed-
assets. It involves measuring the additional cash flows associated with investment
proposals and evaluating the viability of those proposed investment.
Capital Gains or Loss: The profit or loss made when an asset is sold for more than
the purchase price is a capital gain. If the sale price is less than the purchase price,
this is a capital loss.
Capital Markets: Markets for long-term financial securities.
Capital Rationing: Shortage of funds that forces a company to choose between
projects.

Capital Structure Mix of different securities issued by a company.
Capitalization: A company's amount of capital. Usually measured as the sum of a
company's market value of equity and debt.
Cash Budget: A detailed plan of future cash flows. This budget is composed of four
elements: cash receipts, cash disbursements, net change in cash for the period, and
new financing needed.
CD (Certificate of Deposit): Receipts for funds deposited in bank or S&L for a fixed
period. The funds earn a fixed interest rate.
Change: This shows the change in price of a security from the previous day's closing
price.
Cheap: An asset is said to be cheap when it is worth (intrinsic value) more than its
market value.
Closing Price (alternatively close) : The price at which the last trade took place on a
given day in a particular security.
Collateral Assets: That is used as security for a loan.
Commercial Paper: Unsecured debt (IOU), issued by large corporations, with
maturities (at time of issue) less than a year. They can be traded on OTC.
Commission: The broker's fee for purchasing or selling assets.
Common Shares: These are securities that represent equity ownership in a company.
Common shares typically allow an investor to vote on such matters as the election of
board of directors. They also give the holder a share in a company's profits via
dividend payments or the capital appreciation of the security. Also referred to as
“equity shares” or “equity”.
Compounding: A process whereby the value of an investment appreciates
exponentially over time as interest is earned on interest. This is possible, as interest is
not physically paid out to the investor during the holding period.
Consumer Price Index (CPI): The CPI measures the prices of consumer goods and
services and is a measure of the pace of Indian inflation.
Conversion Ratio: The number of shares of common stock for which a convertible
security can be exchanged. Convertible debentures, convertible bonds or convertible
preference shares.
Convertible Bond: Bond that can be converted to equity at a pre-specified conversion
ratio.
Corporation: A legal entity that functions separate and apart from its owners.
Correlated exposure: Exposure to a risk factor, taking into account the impact of
correlated risk factors.
Correlation: A notion from probability.
Cost Budgets: Budgets prepared for every major expense category of the firm, such
as administrative cost, financing cost, production cost, selling cost, and research and
development.
Cost of Capital: The rate that must be earned by the company to satisfy all the firm's
providers of capital. It is based on the opportunity cost of funds.
Coupon Interest Rate: The Interest to be annually paid by the issuer of a bond as a
percent of per value, which is specified in the contractual agreement.
Covariance: A measure of co-movement between two variables.

Credit Enhancement: Any methodology that reduces the credit risk in a commercial or
financial transaction. Commercial transaction – selling goods or services for money.
Financial transaction – giving loans.
Credit Exposure: Exposure to possible default in a commercial transaction or a
financial transaction.
Credit Risk: The risk that the other party in a business deal or transaction may fail to
perform on its obligations.
Credit Scoring: A procedure for assigning scores to companies or individuals on the
basis of the risk of default.
Credit Spread: A spread in prices or interest rates resulting from credit risk.
Cum dividend: With dividend – when you purchase a share it is just before declaration
of dividend by the shares issuing company. Hence the price will be slightly higher as
the seller requires compensation for loss of dividend.
Cum Rights: With rights – when you purchase a share it is just before declaration of
Rights Issue. As a holder of equity shares, you have the option of purchasing the
Rights Issue shares or sell off the rights. Hence the price will be higher than post-
Rights Issue.
Current Asset: Asset that is expected to be turned into cash within a year.
Current Liability: Liability that is expected to be paid in less than a year.
D
Date of Record: The date on which a shareholder must officially own shares in order
to be entitled to a dividend.
DCF: Discounted Cash Flows
Debentures: Secured medium-term debt and debenture certificates are issued to the
holders by the debt raising company.
Default Risk: Uncertainty of a firm's ability to meet its debt obligations on time and in
full.
Depreciation: (1) Reduction in the book or market value of an asset.
(2) Portion of an investment that can be deducted from taxable income.
Discount Bond: A bond that sells at value below par value.
Discounting: The inverse of compounding. This process is used to determine the
present value of a cash flow.
Diversifiable Risk: The components of an asset's risk that can be eliminated when the
asset is combined in a well-diversified portfolio.
Diversification: A technique for managing risk where risk is divided among multiple,
uncorrelated exposures.
Dividend: Distribution of wealth by firm to shareholders based on number of shares
owned.
Dividend Yield Dividends per share divided by the price of the security.
E
Earnings Per Share (EPS): Company's earnings divided by the number of shares
outstanding.
EBIT: A company's Earnings Before Interest and Taxes.
Exchange Rate Mechanism (ERM): Or the currency grid - is a system that limits
currency fluctuations to a range of 15 percent in either direction.
Exchange Traded: Traded on an exchange, as opposed to being traded over the

counter.
Ex-Dividend Date: The date that determines ownership of stock for the purpose of
paying dividends. Owners purchasing shares on or after the ex-dividend date do not
receive the dividends. Only owners before this date would be registered to receive the
declared dividend. The date is set at four business days prior to the record date. Also
see dividend.
Expected return: The average possible return for an investment
Exposure: Sensitivity to a source of risk.
External Financing: Financing projects through new issues of securities; debt and/or
equity.
Extra Dividend: Dividend that is not expected to be repeated.
F
Face Value: Value of security shown on certificate. Also called par value, which is
typically Re.1/- to Rs.100/- in the case of equity shares and Rs.100/- to Rs.1000/- in
the case of bond or a debenture.
Financial Assets: Securities that have a claim on assets of a borrower. Term used to
denote the assets of a lender.
Financial Engineering: The design of financial portfolios to achieve specified goals.
Financial Intermediaries: Financial institutions, banks, NBFCs that assist the transfer
of savings from economic agents with excess savings to those that need capital for
investments.
Financial Investment: Investment in financial assets.
Financial Risk: Additional risk borne by shareholders because of a firm's use of debt.
Financial Risk Management: The process whereby an organization optimizes the

manner in which it takes risks.
Firm Specific Risk Uncertainty in returns due to factors specific to the company. See
diversifiable risk.
Fixed Costs (overhead): A cost that is fixed for a given period of time. It is not
dependent on the amount of goods and services produced during the period. Fixed
costs are to a large extent dependent upon fixed assets.
Floatation Cost: The underwriter's revenue associated with assisting a firm in issuing
and marketing new securities.
Forward: An agreement to execute a transaction at some time in the future.
Forward Rate Agreement: A type of forward contract that is linked to interest rates.

FRA: Forward Rate Agreement
Free Cash Flow Value: The value of a firm based on the cash flow available for
distributing to any of the providers of long-term capital to the firm. The free cash flows
equal operating cash flow less any incremental investments made to support a firm's
future growth.
Future: An agreement to execute a transaction at some time in the future.
Futures Contract: This is an agreement that allows an investor to buy or sell a

commodity, like gold or wheat, or a financial instrument, like a currency, at some time
in future. A future is part of a class of securities called derivatives, so named because
such securities derive their value from the worth of an underlying asset. These
contracts trade on organized futures exchanges.
Futures Exchange: Traded contracts specifying a future date of delivery or receipt of a
specific product or asset. The assets include agricultural products like, pork bellies
and oranges; metal; and financial instruments and indices. They are used by firms to
hedge against potentially unfavorable price changes, and by speculators who hope to
benefit from betting on the direction or magnitude of change.
Futures Market: Where futures contracts are traded.
G
Growth: Stocks of companies that have an opportunity to invest in projects that earn
more that the required rate of return.
H
Hedge: To take offsetting risks.
Hedging: The purchase or sale of a derivative security (such as options or futures) in
order to reduce or eliminate risk associated with undesirable price changes of another
security.
High-Yield Bond: A bond that pays a high yield due to significant credit risk.
Horizontal Integration: When firms in the same industry merge. Also referred to as
horizontal merger.
Horizontal Merger: Merger between two companies that produce similar products.
Also referred to as horizontal integration.
Hostile Takeover: A merger or acquisition in which management resists the group
initiating the transaction.
Hurdle Rate: The minimum required return on a project.
Hypothecation: The posting of collateral security in the case of a loan
I
Income Stocks: Companies with high dividend yield or no NPV > 0 opportunities.
Indenture: The legal agreement between the firm issuing the bond and the
bondholders, providing the specific terms of the loan agreement.
Index: A yardstick to measure change from a base year.

Index Funds: Mutual funds whose objective is to replicate the performance of an
index. The most popular equity index is the BSE Sensex.
Inflation: A general increase in prices of goods and services.
Intermediaries: See Financial Intermediaries.
Internal Financing: Financing projects through retained earnings.
Investment Banks: Are firms that assist companies in initial sale of securities in
primary market.
Investment-Grade Bonds: Bonds rated Baa or above.
IPO (Initial Public Offering): Securities are offered for the first time to the public.
J
Junk bond: A bond that pays a high yield due to significant credit risk.
K
Key factor: A risk factor that is used in estimating value at risk.
L
Legal Risk: Risk relating to legal uncertainties
Letter of Credit: Letter from a bank stating that it has established credit in the
company's favor.
Leverage: Operating and financial. Operating – taking advantage of operating fixed
costs remaining constant for some time and financial – use of debt financing to
enhance EPS.
(LIBOR) London Inter-Bank Offered Rate: The lending rate among international banks
in London. Typical example of Floating Rate of Interest
Limited Liability: Limitation of a shareholder's losses to the amount invested.
Liquidation Value: The amount that could be realized if an asset were sold
independently of the going concern.
Liquidity: Refers to an investor's ability to convert an asset into cash. The faster the
conversion the more liquid the asset. Illiquidity is a risk in that an investor might not be
able to convert the asset to cash when most needed. Moreover, having to wait for the
sale of an asset can pose an additional risk if the price of the asset decreases while
waiting to liquidate.
Listing: When a company's stock trades on an official exchange.
Long Investors who go "long" own stock or another financial security. It is a term that
means the opposite of "short." See short selling.
Long position: A position which entails ownership or effective ownership of an asset.
Long-term gain: A gain on the sale of a capital asset where the holding period was six
months or more and the profit was subject to the long-term capital gains tax.
M
Margin Cash or securities set aside by an investor as evidence for ability to honor a
financial commitment.
Marked-to-Market: An arrangement whereby the profits or losses on a futures contract
are settled up each day.

Market Portfolio: A theoretical portfolio that comprises all risky assets available to
investors.
Market risk: Risk from changes in market prices.
Market value: The value at which an asset trades, or would trade in the market.
Marketable Securities: Security investments that the firm can quickly convert into cash
balances.
Maturity Date: The date on which the last payment on a bond is due.
Maturity Matching: The practice of financing long-term projects with long-term assets,
while financing short-term projects with short-term financing.
Medium-term Note Debt: With a typical maturity of 1 to 10 years at the time of issue
that is offered by a company..
Merger Acquisition: In which all assets and liabilities of a company are absorbed by
the buyer to form a combined business entity.
MM: Short-hand notation for "millions."
Modern Portfolio Theory: A body of theory relating to how investors optimize portfolio
selections.
Mortgage Backed Security: A security interest in a pool of mortgages.
N
NAV (Net Asset Value): The market value of a fund share, synonymous with a bid
price. In the case of no-load funds, the NAV, market price, and offering price are all
the same figure, which the public pays to buy shares; load fund market or offer prices
are quoted after adding the sales charge to the net asset value. NAV is calculated by
most funds after the close of the exchanges each day by taking the closing market
value of all securities owned plus all other assets such as cash, subtracting all
liabilities, then dividing the result (total net assets) by the total number of shares
outstanding. The number of shares outstanding can vary each day depending on the
number of purchases and redemptions
.Net Present Value (NPV): A project's net contribution to shareholders wealth, which
is determined by the present value of a project's cash flows less initial investment.
Net Working Capital (NWC): Current assets minus current liabilities.
Nominal Interest: Rate Interest as expressed in money terms. See real interest rate
Normal Distribution: A type of probability distribution.
O
Odd Lot: Refers to buying stocks in a quantity that is not a multiple of 100.
Off-Balance-Sheet Financing: Financing that is not shows as a liability in a company's
balance sheet.
Open Order: An order to buy or sell a security that remains in effect until it is either
canceled by the customer or executed.
Open-End Fund A mutual fund that stands ready to redeem stocks and issue new
stock. Also see closed-end funds.
Operating Leverage: Capitalizing on fixed operating costs in a business enterprise
Operational Risk: Risk from mistakes or failures in operations.
Opportunity Cost of Capital: The expected return that is foregone by investing in a
project rather than a financial security with comparable risk.

Overbought: Typically a reference to a security or the general market after it exhibits a
sharp rise in prices.
Oversold: Opposite of overbought.
Over-valued: An asset whose market value is greater than its intrinsic (formula or
theoretical) value.
P
P/E Ratio: Price to earnings ratio. The price of a share of stock divided by earnings
per share of stock for a twelve-month period.
Payment Date: Date on which dividends are paid to registered owners.
Payout Ratio: Percent of earnings that is paid out as dividends.

PIBOR: Paris Inter-bank Offered Rate.
Policy Surrender: The early termination of an insurance product by the policyholder.
Portfolio: A combination of assets.
Portfolio Theory: A body of theory relating to how investors optimize portfolio
selections.
Preferred Stock: Stock that takes priority over common stock in regard to dividend
and liquidation. The dividend is usually fixed at time of issue.
Premium :(1) This generally refers to extra money an investor is willing to pay to buy
something. (2) For a bond, a premium is the amount for which the security sells above
its par value.
Prepayment: The payment of a debt prior to its being due.
Primary Instrument: A financial instrument whose value is not derived from that of
another instrument, but instead is determined by the market.
Primary Market is where firms sell new financial assets typically with the assistance of
an investment banker.
Prime Rate: The interest rate that banks charge their "best" clients, , i.e., those with
the lowest possibility of default.
Principal: (1) Shareholders; (2) Amount of debt that must be paid at maturity.
Private Placement: A direct sale, by the issuing firm, of newly issued securities to a
small group of investors.
Probability Distribution: A graph that shows the different possible outcomes of a single
variable and the probability of getting the outcome.
Probability Distribution: A notion from probability.
Promissory Note (PN): Promise to pay.
Prospectus: Summary of the registration statement providing information to investors
on an issue of securities.
Put Option :Option to sell an asset at a specified excise price on or before a specified
exercise date. Also see call option.
Q
Quote: The highest bid to buy and the lowest offer to sell a security at a given time.
(See: Ask, and Bid)

Rally: An increase in the price of a stock or the level of the market.
Rate Of Return: A measure of investment performance.
Rating: Agency Companies that rate the likelihood of a firm to default on its debt
obligations.
Real Assets: Tangible assets include: plant and equipment; intangible include:
technical expertise, trademarks & patents.
Real Interest Rate Interest: Rate that is adjusted for inflation.
Record Date: Date set by the company when dividends are declared. Owners who
are registered on this date receive dividends. Also see ex-dividend date.
Regression Analysis: A statistical technique for fitting best line through data.
Regular Dividend: Dividend that is expected to be maintained at regular time intervals.

Reorganization: Financial restructuring of a firm under bankruptcy. Both the firm's
assets and its financial structure are modified.
Repo (Repurchase Agreement) : Purchase of Treasury securities from a securities
dealer with an agreement that the dealer will repurchase them at a specified price.
Repurchase Agreement: An agreement to sell and repurchase an asset.
Required Return: Minimum return required by investors to compensate them for
assuming risk.
Residual Dividend: An approach to dividends that suggests a firm pay dividends if and
only if acceptable investment opportunities for those funds are currently unavailable.
Retained Earnings: Earnings not paid out as dividends.
Return on Equity: The return on the equity shareholders’ funds = Paid up capital and
reserves and surplus. Formula = {PAT (-) Preference share dividend}/Paid up capital
+ reserves and surplus.
Reverse Repo: An agreement to purchase and resell an asset.
Risk: Exposure to uncertainty.
Risk Factor: A random variable whose uncertainty represents a source of risk.
Risk Limit: A procedural tool for managing risk.
Risk Premium: Additional return, over the risk-free rate, to compensate investors for
accepting (holding) risk.
Risk-Free-Rate: A theoretical interest rate at which an investment may earn interest
without incurring any risk.
Risk Metrics: A free service offered by JP Morgan.
Round Lot :The purchase or sale of a quantity of stocks that is in multiples of 100,
such as 200, 1,000, etc.
S
Salvage value: Scrap value of a plant or equipment.
Scenario: A possible set of future events.
Secondary Market: Where trading (exchange of ownership) of financial assets takes
place.
Securities Lending: The lending of securities in exchange for a fee.
Securitization: The creation of security interests in an asset. (mostly financial asset)
Senior Debt: Debt that in the event of liquidation, must be repaid before subordinated
debt receives any payment. Also see Junior Debt.

Sensitivity: Exposure to a risk factor.
Share: A unit of measuring ownership in a company (i.e., if a firm has 1,000 shares
outstanding and if you own 100 of them, then you have a 10% claim on the firm's net
income (NI) and assets).
Short Sale: Sale of an asset that the investor does not own or any sale that is
completed by the delivery of a security borrowed by the seller. Short selling is a
legitimate trading strategy. Short sellers assume the risk that they will be able to buy
the stock at a more favorable price than the price at which they sold short.
Short Term Gain (Loss): The gain (loss) realized from the sale of securities or other
capital assets held six months or less.
Simulation: Analysis based on determining the consequences of possible scenarios.

Specific Risk: Risk which is unique to a particular asset or liability.
Spin-Off: A newly created company that used to be part of a parent company. Parent
company shareholders receive a pro rata ownership in the new company.
Spot: For immediate delivery.
Standard Deviation: A notion from probability.
Stock Split: An accounting transaction that increases the number of shares held by
existing shareholders in proportion to the number of shares currently held.
Structured Note: A type of security.
Subordinated Debt (Junior debt) : Debt whose holders, in the event of liquidation, get
paid only after senior debt is paid off in full. (Also see senior debt)
Syndicate: A group of investment bankers who together underwrite and market a new
issue of securities or a large block of an outstanding issue.
Systematic Risk: Risk which is common to an entire class of assets or liabilities.
T
T-Bill (Treasury Bill): Debt issued by the RBI with maturity less than a year.
Term Structure of Interest Rates: See yield curve
.Tombstone: Advertisement listing the issuing firm, type of security, its issuing price,
number of securities to be issued, and names of underwriters of a new issue.
Transaction Costs: The costs of transacting trades.
Tunnel A type of derivatives hedge.
U
Uncorrelated Exposure: Exposure to a risk factor, assuming that all other risk factors
will remain constant.
Under pricing: Issue of securities below their market value.
Under-valued: An asset that is selling at a price below its intrinsic (theoretical or
formula) value.
Underwriter (Investment Banker) Firm that buys an issue from a company and resells
it to investors; a primary market activity.
Un diversifiable Risk: See Market Risk.
V
Value at Risk: A measure of market risk.

Variance: A measure of a variable's volatility relative to its average.
Venture Capital: Capital supplied to particularly high-risk projects, such as start-ups or
to companies denied conventional financing.
Vertical Integration: Merger between a supplier and its customers. An example would
be when an oil-refining firm acquires a firm that owns oil fields.
W
Warrant: A financial asset, issued by the firm, which gives its holder the right to
purchase a fixed number of shares of common stock at a predetermined price. Also
referred to as “equity warrants”
Working Capital. Current assets minus current liabilities.
XYZ
Yield: A measure of a bond's potential return.
Yield Curve: A description of yields for multiple horizons.
Yield Curve: The return on debt securities with different maturities, for a level of
default risk.
Yield to Maturity (YTM): The market interest rate on a bond. It is the yield an investor
would receive in the bond is held to maturity.
Yield to Maturity (YTM): The rate of return the investor will earn if the bond is held to
maturity.

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Introduction to Business Finance

Chapter No. 1 – Introduction to Business Finance

Prof. M.Faseeh Khan

Introduction to Bus. Financial-Notes 1 of 81 Sir M.Faseeh khan

Cash Flows and Financial Decisions of Households

Financial Management Decisions

Introduction to Bus. Financial-Notes 2 of 81 Sir M.Faseeh khan

Forms of Business Organization

Introduction to Bus. Financial-Notes 3 of 81 Sir M.Faseeh khan

Goal of Financial Management

Introduction to Bus. Financial-Notes 4 of 81 Sir M.Faseeh khan

The Balance Sheet - Figure

Introduction to Bus. Financial-Notes 5 of 81 Sir M.Faseeh khan

Market Vs. Book Value

Sources and Uses

Statement of Cash Flows

Introduction to Bus. Financial-Notes 6 of 81 Sir M.Faseeh khan

Standardized Financial Statements

Categories of Financial Ratios

(1) Computing Liquidity Ratios

(2) Computing Long-term Solvency Ratios

Introduction to Bus. Financial-Notes 7 of 81 Sir M.Faseeh khan

(3) Computing Coverage Ratios

(4) Computing Inventory Ratios

(5) Computing Receivables Ratios

(6) Computing Total Asset Turnover

Introduction to Bus. Financial-Notes 8 of 81 Sir M.Faseeh khan

Introduction to Bus. Financial-Notes 9 of 81 Sir M.Faseeh khan

 In general, you should use the easiest approach.

Finding present values is called discounting, and it is simply the reverse of

Introduction to Bus. Financial-Notes 10 of 81 Sir M.Faseeh khan

 The Excel formula in Cell B3 is entered as =IRR(B2:G2). The formula

Introduction to Bus. Financial-Notes 11 of 81 Sir M.Faseeh khan

An annuity is a series of equal payments made at fixed intervals for a specified

Introduction to Bus. Financial-Notes 12 of 81 Sir M.Faseeh khan

Introduction to Bus. Financial-Notes 13 of 81 Sir M.Faseeh khan

 The present value of a perpetuity is:

 The Excel spreadsheet formula in Cell B4 is written as =NPV(B1,C3:I3).

Semiannual, quarterly, and other compounding periods more frequent than an

Introduction to Bus. Financial-Notes 14 of 81 Sir M.Faseeh khan

EAR = (1 + 0.06/2)2 – 1.0 = 6.09%.

FVn = PV(1 + i)n.

FVn = PV(1 + iNom/m)mn.

FVn = $1,000(1 + 0.08/4)(4)(5) = $1,000(1.02)20 = $1,485.95.

 The present value of a 5-year future investment equal to $1,485.95, with an 8

$1,485.95  PV1  0.08 / 4

 Spreadsheet solution: The spreadsheet developed to find the present value of

Introduction to Bus. Financial-Notes 15 of 81 Sir M.Faseeh khan

An important application of compound interest involves amortized loans, which are

 The amount of each payment, PMT, is found as follows: PV of the annuity =

 With a financial calculator, enter N (number of years), I (interest rate), PV

Introduction to Bus. Financial-Notes 16 of 81 Sir M.Faseeh khan

Introduction to Bus. Financial-Notes 17 of 81 Sir M.Faseeh khan

Introduction to Bus. Financial-Notes 18 of 81 Sir M.Faseeh khan

 Money Markets – markets that trade debt instruments with maturities of up to

 Treasury bills, commercial paper, federal funds, negotiable CDs,

 Stocks, bonds, and mortgages.

 Primary Markets – markets in which corporations raise funds through new

 May be first-time issues by firm’s initially going public, the sale of

 Secondary Markets – markets in which existing securities are traded.

 Organized Exchanges – physical meeting place and communication facilities

 Over-the-Counter (OTC) markets – no central location. Financial claims can

Introduction to Bus. Financial-Notes 19 of 81 Sir M.Faseeh khan