VIVA QUESTIONS FOR SECOND YEAR

Chairman: Prof. Shabbir Ahmad

BBA Director: Samia Sultana Tani

Books:

F Name Book + Writer Teacher

201 F.A.R Financial Accounting: IFRS Weygendt Kieso
202 Micro Microeconomics by Dominick Salvatore
203 Business Taxation Taxation II: CA Manual
204 Principles of Marketing Principles of Marketing by P. Kolter
205 Legal Environment of Business MC KUCHHAL
206 Financial Management Essentials of Managerial Finance Brigham
207 Applied Statistics Stats. Tech. in Biz & Econ. LIND
208 Macro Samuelson, Mankiew, Dornsbuch, Mishkin
209 Law and Practice of Banking Multiple books combined (P.N Varnshey)
210 Insurance and Risk Management RMI = Herrington & R&I = AH Chowdhury

APPLIED STATISTICS

 PROBABILITY  Classical Probability of an event = (Number of

 Statistical inference deals with conclusions about
a population based on a sample taken from that
population.
 PROBABILITY is a value between zero and one,
inclusive, describing the relative possibility
(chance or likelihood) an event will occur.
 Thus, the probability of 1 represents something
that is certain to happen, and the probability of 0
represents something that cannot happen.
 EXPERIMENT is a process that leads to the
occurrence of one and only one of several possible
observations.
 For example, the tossing of a coin is an
experiment. You may observe the toss of the coin,
but you are unsure whether it will come up
“heads” or “tails.”
 EVENT is a collection of one or more outcomes of
an experiment.
 Two approaches to assigning probabilities to an
event: (1) objective and (2) subjective.
 Objective probability is subdivided into (1)
classical probability and (2) empirical probability.
 Classical probability is based on the assumption
that the outcomes of an experiment are equally
likely.
favorable outcomes )/(Total number of possible
outcomes)
 Consider an experiment of rolling a six-sided die.
What is the probability of the event “an even
number of spots appear face up”? There are three
“favorable” outcomes (a two, a four, and a six) in
the collection of six equally likely possible
outcomes. Therefore, P = (3÷6) = 0.5 or 50%
 MUTUALLY EXCLUSIVE is the occurrence of one
event means that none of the other events can
occur at the same time.
 If an experiment has a set of events that includes
every possible outcome, such as the events “an
even number” and “an odd number” in the die-
tossing experiment, then the set of events is
collectively exhaustive.
 EMPIRICAL PROBABILITY is the probability of an
event happening is the fraction of the time similar
events happened in the past.
 Empirical probability = (Number of times the
event occurs )/(Total number of observations)
 LAW OF LARGE NUMBERS over a large number of
trials, the empirical probability of an event will
approach its true probability.
 SUBJECTIVE CONCEPT OF PROBABILITY is the
likelihood (probability) of a particular event
 happening that is assigned by an individual based
on whatever information is available.
 For example, Estimating the likelihood you will be
married before the age of 25.
 P(A or B) = P(A) + P(B)
 P(A or B or C) = P(A) + P(B) + P(C)
 P(A or B) = P(A) + P(B) – P(A∩B)
 English logician J. Venn (1834–1923) developed a
diagram to portray graphically the outcome of an
experiment.
 INDEPENDENCE is the occurrence of one event has
no effect on the probability of the occurrence of
another event.
 P(A ∩ B) = P(A) . P(B)
 P(A ∩ B ∩ C) = P(A).P(B).P(C)
 P(A∩B) = P(A).P(B|A)
 P(B|A) = P(A∩B) / P(A).
 P(A∩B∩C) = P(A).P(B|A).P(C|A∩B)
 With or without replacement!
 A table used to classify sample observations
according to two or more identifiable
characteristics is called a Contingency Table
 The tree diagram is a graph that is helpful in
organizing calculations that involve several
stages. Each segment in the tree is one stage of
the problem.
 To facilitate counting there are three formulas:
the multiplication formula, permutation &
combination.
 If there are m ways of doing a thing and n ways
of doing another thing, there are m×n ways of
doing both.
 PERMUTATION FORMULA, nPr = 𝑛! 
(𝑛−𝑟)!
 COMBINATION FORMULA, nCr = 𝑛!
𝑟!(𝑛−𝑟)!
 Combination = kom = order not important.
 DISCRETE.PROB
 PROBABILITY DISTRIBUTION A listing of all the
outcomes of an experiment and the probability
associated with each outcome.
 Below are the major characteristics of a
probability distribution: (1) The probability of a
particular outcome is between 0 and 1 inclusive
(2) The outcomes are mutually exclusive events
(3) The list is exhaustive. So, the sum of the
probabilities of the various events is equal to 1.
 RANDOM VARIABLE A quantity resulting from an
experiment that, by chance, can assume different
values.
 A random variable may be either discrete or
continuous.
 A discrete random variable can assume only a
certain number of separated values.
 If there are 100 employees, then the count of the
number absent on Monday can only be 0, 1, 2, 3,
. . . , 100. A discrete random variable is usually
the result of counting something.
 If the random variable is continuous, then the
distribution is a continuous probability
distribution.
 So, what is the difference between a probability
distribution and a random variable? A random
variable reports the particular outcome of an
experiment. A probability distribution reports all
the possible outcomes as well as the
corresponding probability.
 Usually a discrete distribution is the result of
counting something, such as: • The number of
heads appearing when a coin is tossed 3 times. •
The number of students earning an A+ in this
class. • The number of production employees
absent from the second shift today. • The number
of 30-second commercials on BTV from 8 to 11
P.M. tonight.
 Continuous distributions are usually the result of
some type of measurement, such as: • The length
of each song on the latest Linkin Park CD. • The
weight of each student in this class. • The
temperature outside as you are reading this book.
•
 We identify the mean of a probability distribution
by the lowercase Greek letter mu (μ) and the
standard deviation by the lowercase Greek letter
sigma (σ).
 The mean of a discrete probability distribution is
computed by the formula: Σx.P(x)
 The formula for the variance of a probability
distribution is: 𝟔𝟐 = ∑(𝒙 − 𝝁)𝟐. 𝑷(𝒙)
 The standard deviation, σ, is found by taking the
positive square root of 𝝈𝟐.
 The characteristic of the binomial probability
experiment:
 o Two possible outcomes on a particular
trial of an experiment.
o There is a fixed number of trials.
o The probability of success and failure stay
the same for each trial.
o The trials are independent
 The binomial probability distribution is a widely
occurring discrete probability distribution.
 A binomial probability is computed by the
formula: P(x) = nCx 𝛑 𝒙(1-π )𝒏−𝒙
 If n remains the same but 𝝅 increases from .05
to .95, the shape of the distribution changes. The
distribution for a 𝜋 of .05 is positively skewed.
 As 𝜋 approaches .50, the distribution becomes
symmetrical. As 𝜋 goes beyond .50 and moves
toward .95, the probability distribution becomes
negatively skewed.
 If 𝜋, the probability of success, remains the same
but n becomes larger, the shape of the binomial
distribution becomes more symmetrical.
 The Poisson probability distribution describes the
number of times some event occurs during a
specified interval. The interval may be time,
distance, area, or volume.
 This distribution is also a limiting form of the
binomial distribution when the probability of a
success is very small and n is large.
 It is often referred to as the “law of improbable
events,” meaning that the probability, 𝜋, of a
particular event’s happening is quite small.
 Probability is proportional to the length of the
interval.
 A Poisson probability distribution has these
characteristics:
1. The random variable is the number of times
some event occurs during a defined interval.
2. The probability of the event is proportional to
the size of the interval.
3. The intervals do not overlap and are
independent.
 The Poisson distribution can be described
𝑥𝑒−𝜇
mathematically by the formula, P (x) = 𝜇
𝑥!
 In Poisson distribution, mean (µ) = variance (𝝈𝟐)
= n.𝝅
 CONT.DIST
 A continuous probability distribution results from
measuring something, such as the distance,
weight etc.
 A continuous random variable has an infinite
number of values within a particular range.
 The uniform probability distribution is perhaps
the simplest distribution for a continuous random
variable. This distribution is rectangular in shape
and is defined by minimum and maximum values.
 The mean of a uniform distribution is located in
the middle of the interval between the minimum
and maximum values. It is computed as: µ =
(a+b)/2
 Standard deviation of the uniform distribution, σ
𝟐
(𝒃−𝒂)
=√
𝟏𝟐
 The equation for the uniform probability
distribution, P(x) = 𝟏 ; if a ≤ x ≤ b and 0
𝒃−𝒂
elsewhere
 Area = 1 𝑥 (𝑏 − 𝑎) = 1.0
(𝑏−𝑎)
 The normal probability distribution
characteristics: bell-shaped, symmetrical,
asymptotic, family
 Family = different sd + same mean, same sd +
different mean, different sd & mean
 The number of normal distributions is unlimited,
each having a different mean (µ), sd (σ), or both.
 z value is the signed distance between a selected
value (X), and the mean, µ, divided by the
standard deviation, σ. Standard normal value, z =
𝑋− µ
𝜎
 SEE SHEETS FOR FINDING AREA UNDER THE
CURVE.***
 Empirical rule= 68%, 95%, 99% within 1, 2, 3 SD
from mean.
 SAMPLING
 The population is the entire group of individuals
or objects under consideration, and the sample is
a part or subset of that population.
 The purpose of inferential statistics is to find
something about a population based on a sample.
 Here are some of the reasons for sampling: time
consumption, prohibitive, physical
impossibility, destructive nature, adequate.
 SIMPLE RANDOM SAMPLE is a sample selected so
that each item or person in the population has the
same chance of being included.
 Drawing name or number from a box randomly is
an example of simple random sampling.
 SYSTEMATIC RANDOM SAMPLE is when a random
starting point is selected, and then every kth
member of the population is selected.
 For example, a number from a random number
table between 1 and k, or 20, would be selected.
Say the random number was 18, so, starting with
the 18th invoice, every 20th invoice (18, 38, 58,
etc.) would be selected as the sample.
 When the physical order is related to the
population characteristic, then systematic
random sampling should not be used. For
example, if the invoices in the example were filed
in order of increasing sales, systematic random
sampling would not guarantee a random sample.
Other sampling methods should be used.
 When a population can be clearly divided into
groups based on some characteristic, we may use
stratified random sampling. It guarantees each
group is represented in the sample. The groups
are also called strata.
 STRATIFIED RANDOM SAMPLE is when population is
divided into subgroups, called strata, and a
sample is randomly selected from each stratum.
 SEE EXAMPLE FROM SHEETS.
 Cluster sampling is employed to reduce the cost
of sampling a population scattered over a large
geographic area.
 CLUSTER SAMPLE is when a population is divided
into clusters using naturally occurring geographic
or other boundaries.
 Then, clusters are randomly selected and a
sample is collected by randomly selecting from
each cluster.
 SAMPLING ERROR The difference between a
sample statistic and its corresponding population
parameter.
 If you were to determine the sum of these
sampling errors over a large number of samples,
the result would be very close to zero because the
sample mean is an unbiased estimator of the
population mean.
 SAMPLING DISTRIBUTION OF THE SAMPLE MEAN A
probability distribution of all possible sample
means of a given sample size.
 There are, NCn = 𝑁! possible samples.
𝑛!(𝑁−𝑛)!
 Important relationships between the population
distribution and the sampling distribution of the
sample mean:
o The mean of the sample means is exactly
equal to the population mean.
o The dispersion of the sampling distribution
of sample means is narrower than the
population distribution.
o The sampling distribution of sample means
tends to become bell-shaped and to
approximate the normal probability
distribution.
 CENTRAL LIMIT THEOREM If all samples of a
particular size are selected from any population,
the sampling distribution of the sample mean is
approximately a normal distribution. This
approximation improves with larger samples.
 The central limit theorem itself does not say
anything about the dispersion of the sampling
distribution of the sample mean or about the
comparison of the mean of the sampling
distribution of the sample mean to the mean of
the population.
 Finding the Z value when the population SD is
known, z = 𝑥− 𝜇
𝜎 / √𝑛
 POINT ESTIMATE The statistic, computed from
sample information that estimates the population
parameter.
 The sample mean, 𝑋, is not the only point
estimate of a population parameter.
 CONFIDENCE INTERVAL A range of values
constructed from sample data so that the
population parameter is likely to occur within that
range at a specified probability. The specified
probability is called the level of confidence.
 We will consider two situations. We use sample
data to estimate:
o µ with 𝑋 and the population standard
deviation (σ) is known.
o µ with 𝑋 and the population standard
deviation (σ) is unknown.
 These confidence interval statements provide
examples of levels of confidence and are called a
95 percent confidence interval and a 99 percent
confidence interval.
 In general, a confidence interval for the
population mean when the population follows the
normal distribution and the standard deviation is
known is computed by the following.
 Confidence Interval For Population Mean With σ
𝜎
Known = 𝑋± 𝑧. (margin of error
√𝑛
 How do we interpret these results? We could
expect about 95 percent of these confidence
intervals to contain the population mean. About 5
percent of the intervals would not contain the
population mean annual income, which is µ.
 Note that not all intervals include the population
mean. Both the endpoints of the fifth sample are
less than the population mean. We attribute this
to sampling error, and it is the risk we assume
when we select the level of confidence.
 The t distribution is a continuous probability
distribution, with many similar characteristics to
the z distribution. William Gosset, an English
brewmaster, was the first to study the t
distribution.
t=
𝑿− 𝝁
𝒔/√𝒏
 Characteristics of the t distribution:
o It is a continuous distribution.
o It is bell-shaped and symmetrical.
o There is not one t distribution, but rather
a family of t distributions.
o The t distribution is more spread out and
flatter at the center than the standard
normal distribution.
 As the sample size increases, however, the t
distribution approaches the standard normal
distribution, because the errors in using s to
estimate σ decrease with larger samples.
 Confidence Interval for The Population Mean, σ
𝑠
Unknown = 𝑋± 𝑡.
√𝑛
 SAMPLE SIZE FOR ESTIMATING THE POPULATION
MEAN, 𝑧𝜎 2
𝑛=( )
𝐸
 ONE SAMPLE HYPOTHESIS TESTING
 HYPOTHESIS A statement about a population
parameter subject to verification
 HYPOTHESIS TESTING A procedure based on
sample evidence and probability theory to
determine whether the hypothesis is a reasonable
statement.
 There is a five-step procedure that systematizes
hypothesis testing; when we get to step 5, we are
ready to reject or not reject the hypothesis.
 To put it another way, failing to reject the null
hypothesis does not prove that H0 is true, it
means we have failed to disprove H0.
 NULL HYPOTHESIS A statement about the value of
a population parameter developed for the
purpose of testing numerical evidence.
 ALTERNATE HYPOTHESIS A statement that is
accepted if the sample data provide sufficient
evidence that the null hypothesis is false.
 LEVEL OF SIGNIFICANCE (α) The probability of
rejecting the null hypothesis when it is true.
 Traditionally, the .05 level is selected for
consumer research projects, .01 for quality
assurance, and .10 for political polling.
 TYPE I ERROR Rejecting the null hypothesis, H0,
when it is true.
 The probability of committing another type of
error, called a Type II error, is designated by (β).
 TEST STATISTIC A value, derived from sample
information, used to determine whether to reject
H0.
 In hypothesis testing for the mean (μ) when σ is
−𝝁
known, the test statistic z = 𝑿
𝝈/√𝒏
 CRITICAL VALUE The dividing point between the
region where the null hypothesis is rejected and
the region where it is not rejected.
 Summary of the steps in hypothesis testing:
o Establish the null hypothesis (H0) and the
alternate hypothesis (H1).
o Select the level of significance, that is, α.
o Select an appropriate test statistic.
o Formulate a decision rule based on steps
1, 2, and 3 above.
o Make a decision regarding the null
hypothesis based on the sample
information. Interpret the results of the
test
  How the hypothesis testing procedure just
described compare with that of confidence
intervals? In general, H0 is rejected if the
confidence interval does not include the
hypothesized value. If the confidence interval
includes the hypothesized value, then H0 is not
rejected. So, the “do not reject region” for a test
of hypothesis is equivalent to the proposed
population value occurring in the confidence
interval. The primary difference between a
confidence interval and the “do not reject”
region for a hypothesis test is whether the
interval is centered around the sample statistic,
such as 𝑋, as in the confidence interval, or around
0, as in the test of hypothesis.
 Given the null hypothesis is true,
P < α → Reject Null
P > α → Fail to Reject
 Determining the p-value not only results in a
decision regarding H0, but it gives us additional
insight into the strength of the decision.
 A very small p-value, such as 0.0001, indicates
that there is little likelihood the H0 is true. On
the other hand, a p-value of 0.2033 means that
H0 is not rejected, and there is little likelihood
that it is false.
 If population standard deviation σ is not known (1)
we use the sample standard deviation s. (2) we
use the t-distribution
 Testing a mean with σ unknown, t = 𝑿 
−𝝁
𝒔/√𝒏
 The major characteristics of the t distribution
are:
1. It is a continuous distribution.
2. It is bell-shaped and symmetrical.
3. There is a family of t distributions. ∆df → a
new distribution is created.
4. ↑df = t_distribution → standard normal
distribution.
5. It is flatter, or more spread out, than the
standard normal distribution
 The level of significance, identified by the symbol
α, is the probability of rejecting null hypothesis
when it is true which is called a Type I error.
 The probability of a Type II error is identified by
the Greek letter beta (β). That is, we accept a
false null hypothesis.
 Type II error = z =
𝑋𝑐− 𝜇1
𝜎 / √𝑛
 TWO SAMPLE HYPOTHESIS TESTING
 If the two distributions of sample means follow
the normal distribution, then we can reason that
the distribution of their differences will also
follow the normal distribution. This is the first
hurdle.
 If the populations have the same mean, then we
would expect the difference between the two
sample means to be zero.
 If there is a difference between the population
means, then we expect to find a difference
between the sample means.
 Statistically, the distribution of the differences
has a variance (standard deviation squared) equal
to the sum of the two individual variances.
𝑋𝑠−𝑋𝑓
 z= 2
𝜎2 𝜎
√ 𝑠+ 𝑓
𝑛𝑠 𝑛𝑓
 Variance of the distribution of differences in
𝜎12 𝜎22
means = + 𝑛2
𝑛1
 ANOVA
 The probability distribution used here is the F
distribution. It was named to honor Sir Ronald
Fisher, one of the founders of modern-day
statistics.
 F is used to (1) test if two samples are from
populations having equal variances (2) compare
several population means simultaneously.
(ANOVA)
 The characteristics of the F distribution:
o There is a family of F distributions.
o The F distribution cannot be negative.
o It is a continuous distribution.
o It is positively skewed.
o It is asymptotic.
 Comparing population variances, the null
hypothesis and the alternate hypothesis are:

 To conduct the test, we select a random sample
of observations from one population, and a
random sample of n2 observations from the second
population.
 F = S12 / S22
 The terms 𝑠2 and 𝑠2 are the respective sample
1 2
variances. If the null hypothesis is true, the test
statistic follows the F distribution with n1 - 1 and
n2 - 1 degrees of freedom.
 In order to reduce the size of the table of critical
values, the larger sample variance is placed in the
numerator; hence, the tabled F ratio is always
larger than 1.00.
 To use ANOVA, we assume the following:
1. The populations follow the normal
distribution.
2. The populations have equal standard
deviations ()
3. The populations are independent.
 Why do we need to study ANOVA? Why can’t we
just use the test of differences in population
means like before?
 Because we conduct six separate (independent)
tests, the probability that we do not make an
incorrect decision due to sampling error in any of
the six independent tests is P(All correct) =
(0.95)𝟔 = 0.735
 To find the probability of at least one error due
to sampling, 1 – 0.735 = 0.265
 To summarize, if we conduct six independent
tests using the t distribution, the likelihood of
rejecting a true null hypothesis because of
sampling error is increased from .05 to an
unsatisfactory level of .265!!!
 It is obvious that we need a better method than
conducting six t tests. ANOVA will allow us to
compare the treatment means simultaneously and
avoid the buildup of Type I error.
 ANOVA was first developed for applications in
agriculture, and many of the terms related to that
context remain.
 The term treatment is used to identify the
different populations being examined viz.
treatment refers to how a plot of ground was
treated with a particular type of fertilizer.
 The underlying strategy is to estimate the
population variance (standard deviation squared)
two ways and then find the ratio of these two
estimates.
o Ratio = 1: two estimates & the population
means are the same.
o Ratio ≠ 1: the population means are not
the same.
 TOTAL VARIATION The sum of the squared
differences between each observation and the
overall mean.
 Next, break this total variation into two
components: (1) which is due to the treatments
(2) which is random.
 TREATMENT VARIATION The sum of the squared
differences between each treatment mean and
the grand or overall mean.
 RANDOM VARIATION The sum of the squared
differences between each observation and its
treatment mean.
 F=
𝑇𝑉 ÷(𝑘−1)
𝑅𝑉 ÷ (𝑛−𝑘)
 MULTIPLE REGRESSION
 When there are two independent variables, the
regression equation is: 𝒀̂ = 𝒂 + 𝒃𝟏 𝑿𝟏 + 𝒃𝟐 𝑿𝟐
 It is important to keep in mind that a regression
equation is not generally used outside the range
of the sample values.
 General multiple regression equation = 𝒀 ̂ = 𝒂 +
𝒃𝟏𝑿𝟏 + 𝒃𝟐𝑿𝟐 + 𝒃𝟑𝑿𝟑
 To review, the total variation of the dependent
variable, Y, is divided into two components: (1)
regression, or the variation of Y explained by all
the independent variables and (2) the error or
residual, or unexplained variation of Y.
 Regression degrees of freedom = k.
 Error degrees of freedom = n  1 k = n  (k+1)
 Total degrees of freedom = n  1
 SSR = ∑(𝑌̂− 𝑌)2 = Regression Sum of Squares
 SSE = ∑(𝑌 − 𝑌̂)2 = Residual or Error Sum of Squares
 SST = ∑(𝑌 − 𝑌)2 = Total Sum of Squares
 MULTIPLE STANDARD ERROR OF ESTIMATE,
√ ∑(𝒀−𝒀̂)𝟐 𝑺𝑺𝑬
SY.123…k = 𝒏−(𝒌+𝟏) = √𝒏−(𝒌+𝟏) = √𝑴𝑺𝑬
 How do we interpret the standard error of
estimate of 51.05? It is the typical “error” when
we use this equation to predict the cost.
 First, the units are the same as the dependent
variable, so the standard error is in dollars,
$51.05.
 Second, we expect the residuals to be
approximately normally distributed, so about 68
percent of the residuals will be within ±$51.05
and about 95 percent within ±2(51.05) = ±$102.10
 The coefficient of determination is defined as the
percent of variation in the dependent variable
explained, or accounted for, by the independent
variable.
 The characteristics of the coefficient of multiple
determination are:
 It is symbolized by a capital R squared. In other
words, it is written as because it behaves like the
square of a correlation coefficient.
 It can range from 0 to 1. A value near 0 indicates
little association between the set of independent
variables and the dependent variable. A value
near 1 means a strong association.
 It cannot assume negative values. Any number
that is squared or raised to the second power
cannot be negative.
 It is easy to interpret. Because R2 is a value
between 0 and 1, it is easy to interpret, compare,
and understand.
 R2 = SSR/SST = 1-(SSE/SST)
 The number of independent variables in a
multiple regression equation makes the
coefficient of determination larger. Each new
independent variable causes the predictions to be
more accurate. Hence, R2 increases only because
of the total number of independent variables and
not because the added independent variable is a
good predictor of the dependent variable.
𝑆𝑆𝐸/𝑛−(𝑘+1)
 R 2adj = 1- 𝑆𝑆𝑇/(𝑛−1)
 The error and total sum of squares are divided by
their degrees of freedom.
 We now test whether the regression coefficients
in the population are all zero. The hypothesis are:
 If the null hypothesis is true, it implies the
regression coefficients are all zero and, logically,
are of no use in estimating the dependent
variable.
 To test the null hypothesis that the multiple
regression coefficients are all zero, we employ
the F distribution and use the .05 level of
significance.
SSR/k 𝑀𝑆𝑅
 F = 𝑆𝑆𝐸/𝑛−(𝑘+1) = 𝑀𝑆𝐸
 The decision rule can be based on either of two
methods: (1) comparing the test statistic to a
critical value or (2) comparing the p-value to the
significance level.
 We find the critical value of F that requires three
pieces of information:
(1) the numerator degrees of freedom,
(2) the denominator degrees of freedom, and
(3) the significance level
 Why is it important to know if any of the equal
0? If a β could equal 0, it implies that this
particular independent variable is of no value in
explaining any variation in the dependent value.
If there are coefficients for which cannot be
rejected, we may want to eliminate them from
the regression equation.
 t = (bi - 0)/Sb = Coefficients/SE
 The assumptions for multiple regression are
similar, such are:
o There is a linear relationship.
o The variation in the residuals is the same
̂
for both large and small values of Y
o The residuals follow the normal
probability distribution.
o The independent variables should not be
correlated.
o The residuals are independent.
 Linear relationship determined using: Scatter
diagram or Residual plot
 Scatter graphs help us to visualize the
relationships and provide some initial information
about the direction (positive or negative),
linearity, and strength of the relationship.
 In a residual plot, if the points are scattered and
there is no obvious pattern, so there is no reason
to doubt the linearity assumption. This plot
supports the assumption of linearity.
 HOMOSCEDASTICITY The variation around the
regression equation is the same for all of the
values of the independent variables.
 This requirement indicates that the variation
about the predicted values is constant, regardless
of whether the predicted values are large or
small.
 To be sure that the inferences we make in the
global and individual hypotheses tests are valid,
we evaluate the distribution of residuals. The
residuals should follow a normal probability
distribution.
 Basically, the normal probability plot supports the
assumption of normally distributed residuals if the
plotted points are fairly close to a straight line
drawn from the lower left to the upper right of
the graph.
 Multicollinearity exists when independent
variables are correlated. Correlated independent
variables make it difficult to make inferences
about the individual regression coefficients and
their individual effects on the dependent
variable.
 First, we should point out that multicollinearity
does not affect a multiple regression
equation’s ability to predict the dependent
variable.
 However, when we are interested in evaluating
the relationship between each independent
variable and the dependent variable,
multicollinearity may show unexpected results.
 For example, if we use two highly multicollinear
variables, high school GPA and high school class
rank, to predict the GPA of incoming college
freshmen (dependent variable), we would expect
that both independent variables would be
positively related to the dependent variable.
However, because the independent variables are
highly correlated, one of the independent
variables may have an unexpected and
inexplicable negative sign.
 A second reason for avoiding correlated
independent variables is they may lead to
erroneous results in the hypothesis tests for the
individual independent variables.
 This is due to the instability of the standard error
of estimate. Several clues that indicate problems
with multicollinearity include the following: (1)
An independent variable known to be an
important predictor ends up having a regression
coefficient that is not significant. (2) A regression
coefficient that should have a positive sign, may
be negative, or vice versa.
 When an independent variable is added or
removed, there is a drastic change in the values
of the remaining regression coefficients.
 A general rule is if the correlation between two
independent variables is between -0.70 and
0.70, there likely is not a problem using both of
the independent variables.
 VIF = 1/(1-R2)
 A VIF greater than 10 is considered unsatisfactory,
indicating that the independent variable should
be removed from the analysis.
 Autocorrelation frequently occurs when the data
are collected over a period of time.
 Note the run of residuals above the mean of the
residuals, followed by a run below the mean. A
scatter plot such as this would indicate possible
autocorrelation.
 In a dummy variables in which one of the two
possible conditions is coded 0 and the other 1
 Is it possible to use a qualitative variable with
more than two possible outcomes? Yes, but the
coding scheme becomes more complex and will
require a series of dummy variables.
 TIME SERIES
 A time series is a collection of data recorded over
a period of time—weekly, monthly, quarterly, or
yearly.
 An analysis of history—a time series— is used by
management to make current decisions and plans
based on long-term forecasting.
 There are four components to a time series: the
trend, the cyclical variation, the seasonal
variation, and the irregular variation. [TSCI]
 SECULAR TREND The smooth long-term direction
of a time series.
 CYCLICAL VARIATION The rise and fall of a time
series over periods longer than one year.
 SEASONAL VARIATION Patterns of change in a time
series within a year. These patterns tend to
repeat themselves each year. The unit of time
reported is either quarterly or monthly.
 Many analysts prefer to subdivide the irregular
variation into episodic and residual variations.
 Episodic fluctuations are unpredictable, but
they can be identified. The initial impact on the
economy of a major strike or a war can be
identified, but a strike or war cannot be
predicted.
 After removing the episodic fluctuations, the
remaining variation is called the residual
variation. The residual fluctuations, often called
chance fluctuations, are unpredictable, and they
cannot be identified.
 Of course, neither episodic nor residual variation
can be projected into the future.
 Two ways to remove fluctuations: AMV and WAMV
 A moving average uses the same weight for each
observation. For example, a three-year moving
total is divided by the value 3 to yield the three-
year moving average.
 A weighted moving average involves selecting a
possibly different weight for each data value and
then computing a weighted average of the most
recent n values as the smoothed value.
 To summarize the technique of using moving
averages, its purpose is to help identify the long-
term trend in a time series (because it smooths
out short-term fluctuations).
 It is used to reveal any cyclical and seasonal
fluctuations.
 LINEAR TREND the long-term trend of many
business series, such as sales, exports, and
production, often approximates a straight line. If
so, the equation to describe this growth is: 𝑌̂= a
+ bt
 Data that increase (or decrease) by increasing
amounts over a period of time appear curvilinear
when plotted on an arithmetic scale.
 The trend equation for a time series that does
approximate a curvilinear trend, such as the one
portrayed above, is computed by using the
logarithms of the data and the least squares
method. The general equation for the logarithmic
trend equation is: 𝑌̂ = log(a) + log b(t)
 The method most commonly used to compute the
typical seasonal pattern is called the ratio-to-
moving-average method which eliminates the
trend, cyclical, and irregular components from
the original data.
 The reason for deseasonalizing the sales series is
to remove the seasonal fluctuations so that the
trend and cycle can be studied.
 The deseasonalized revenues are found by
dividing the Revenue by their Seasonal Index.
 Because the seasonal component has been
removed (divided out) from the quarterly
revenue, the deseasonalized revenue figure
contains only the trend (T), cyclical (C), and
irregular (I) components.
 The procedure for identifying trend and the
seasonal adjustments can be combined to yield
seasonally adjusted forecasts. To identify the
trend, we determine the least squares trend
equation on the deseasonalized historical data.
Then we project this trend into future periods,
and finally we adjust these trend values to
account for the seasonal factors.
 AUTOCORRELATION Successive residuals are
correlated.
 Successive residuals are correlated in time series
data because an event in one time period often
influences the event in the next period.
 Sale → Ad → Effect on next month
 If the residuals are correlated, problems occur
when we try to conduct tests of hypotheses about
the regression coefficients.
 Also, a confidence interval or a prediction
interval, where the multiple standard error of
estimate is used, may not yield the correct
results.
 The r has the same meaning as the coefficient of
correlation.
 The value of the Durbin-Watson statistic can
range from 0 to 4.
 The value of d is 2.00 when there is no
autocorrelation among the residuals.
 When the value of d gets close to 0, this indicates
positive autocorrelation.
 Values beyond 2 indicate negative
autocorrelation. (rare)
 necessary.
 Values less than dl cause the rejection of the null
hypothesis.
 Values greater then du will result in the null
hypothesis not being rejected.
 Values of d between dl and du yield inconclusive
results.
 The subscript l refers to the lower limit of d and
the subscript u the upper limit.
 How do we interpret the various decisions for the
test for residual correlation? If the null hypothesis
is not rejected, we conclude that autocorrelation
is not present. The residuals are not correlated,
there is no autocorrelation present, and the
regression assumption has been met.
 If the result falls in the inconclusive range, more
sophisticated tests are needed, or conservatively,
we treat the conclusion as rejecting the null
hypothesis.
 If residuals are autocorrelated, what do we do?
 The presence of autocorrelation usually means
that the regression model has not been correctly
specified. It is likely we need to add one or more
independent variables that have some time-
ordered effects on the dependent variable. The
simplest independent variable to add is one that
represents the time periods.
 NON PARAMETRIC TESTS
 There are tests available in which no assumption
regarding the shape of the population is
necessary.
 These tests are nonparametric; means the
assumption of a normal population is not
 Nominal data is the “lowest” or most primitive.
For this type of measurement, data are classified
into categories where there is no natural order.
 The goodness-of-fit test is one of the most
commonly used statistical tests. It is particularly
useful because it requires only the nominal level
of measurement.
 So we are able to conduct a test of hypothesis on
data that has been classified into groups.
 The purpose of the goodness-of-fit test is to
compare an observed distribution to an expected
distribution.
 If there is no difference in the popularity of the
five courses, we would expect the observed
frequencies to be equal—or nearly equal.
(𝑓0−𝑓𝑒)2
 X2 = Σ[ 𝑓𝑒
]
 with k - 1 degrees of freedom; k is the number of
categories.
 The chi-square distribution has the following
characteristics.
 Chi-square values are never negative.
 There is a family of chi-square distributions.
 The chi-square distribution is positively skewed.
 However, as the number of degrees of freedom
increases, the distribution begins to approximate
the normal probability distribution.

LAW & PRACTICE OF BANKING (Review Banking Notes)

 The Banking Companies Act: A bank is a financial institution which accepts money from the public/for
the purpose of lending or investment/repayable on demand or otherwise/withdrawable by cheques,
drafts or order or otherwise
 Banks: (1) Commercial (2) Central
MACROECONOMICS

 OVERVIEW
 Macroeconomics is the study of the performance and behavior of the economy as a whole.
 Business Cycle: the short-term fluctuations in output, employment, financial conditions, and prices.
 Economic Growth: the long-term trends in output and living standards.
 OBJECTIVES INSTRUMENTS
Output: Fiscal policy:
High level and rapid growth of output Government expenditures
Taxation
Employment: Monetary policy:
High level of employment Quantitative: Bank rate, Open market,
Low involuntary unemployment Variable reserve ratio policy
Stable Prices Qualitative: Moral suasion, Direct action,
A stable or gently rising price level Credit rationing, Consumer credit, Margin
Requirements
 % growth rate of real GDP in year 1 = (GDP1-GPD0)/GDP0
 Potential GDP represents the maximum sustainable level of output that the economy can produce.
 Output rises above potential output, price inflation tends to rise. (expansion)
 Output below-potential output leads to high unemployment. (recession)
 Potential output is determined by the economy’s
 productive capacity, which depends upon the inputs available (L, L, K)
 technological efficiency.
 Potential GDP tends to grow steadily because inputs like (L, K, T) increase quite slowly over time.
 A recession is a period of significant decline in total output, income, and employment, usually lasting more
than a few months.
 ↓Output ↓Labor demand ↑Unemployment and ↑Output ↑Labor demand ↓Unemployment
 Price stability = low and stable inflation rate and %change of CPI = inflation
 Deflation = prices decline = rate of inflation is negative
 A policy instrument is an economic variable under the control of government that can affect one or more
of the macroeconomic goals.
 Tax affects the overall economy in two ways = people’s income + price of goods
 Open Economy is an economic system whose borders are open to goods, services, and financial flows.
 In an “open economy” the exchange-rate system is also a central part of monetary policy.
 Forex rate represents the price of its own currency in terms of the currencies of other nations.
 Aggregate supply refers to the total quantity of goods and services that the nation’s businesses willingly
produce and sell in a given period.
 AS depends on the price, the productive capacity, and the level of costs.
 Aggregate demand refers to the total amount that different sectors in the economy willingly spend in a
given period.

 LRAS is perfectly vertical because it is the level of output an economy can produce when its physical
capital and labor are working at full capacity. (economy’s potential growth rate = Solow growth rate)
 In the long run output is determined by aggregate supply alone and prices are determined by both
aggregate supply and aggregate demand.
 In the long run, very high inflation rates are always due to changes in aggregate demand.
 In the short run output is determined by AD alone and prices are unaffected by the level of output.
 Full employment of factors of production is an economic, not a physical, concept.
 Full employment of labor = everyone who wants a job; finds a job within a reasonable time.
 Labor is fully employed when the unemployment rate is 5 percent.
 Output can rise above trend because people work overtime and machinery is used for several shifts.
 Output gap = actual output - potential output
 CPI is the cost of a given basket of goods representing typical day-to-day products.
 Unemployment = potential output is going to waste
 Inflation = no obvious output loss; upsets familiar price relationships; reduces efficiency of price system.
 Endogenous variables are those variables that a model tries to explain.
 Exogenous variables are those variables that a model takes as given.
 Model shows how the exogenous variables affect the endogenous variables.

Inflation increase in the general price level of goods and services in an economy over a
period of time.
Deflation decrease in the general price level of goods and services in an economy over a
period of time
Hyperinflation very high accelerating inflation (1000%)
Galloping inflation that occurs when the prices of goods and services increase at two-digit or
Inflation three-digit rate per annum (100%)
Recession a business cycle contraction of 6 months when there is a general decline in
economic activity.
Contraction no significant difference between recession and contraction.
Depression a business cycle contraction of longer term when there is a severe decline in
economic activity.
Stagflation period of slow or declining economic growth and relatively high unemployment,
accompanied by rising prices, or inflation. (economic stagnation)

 National Accounts
 National accounts are a body of statistics that enables policymakers to determine whether the economy
is contracting or expanding and whether a severe recession or inflation threatens.
 We can measure GDP in two ways: flow-of-income approach and income/cost approach.
 Flow-of-income approach = GDP = C + I + G + X
 income/cost approach = Wages + Rents + Interest + Profit
 National accountants use market prices as weights in valuing different commodities because market prices
reflect the relative economic value of diverse goods and services.
 That is, the relative prices of different goods reflect how much consumers value their marginal units of
consumption of these goods.
 A final product is one that is produced and sold for consumption or investment.
 Statisticians are very careful to include in goods in GDP only when firm’s value added
 The following table presents the major components of the two sides of the national accounts.

 Real GDP is calculated by tracking quantity of production after removing the influence of inflation.
 Nominal GDP is calculated using changing prices
 GDP deflator = difference between nominal GDP and real GDP is the price of GDP.
 GDP deflator = P1/P0 [deflator = GDP price index]
 Real GDP = Nominal GDP/GDP deflator
 When relative prices of different goods and quantity bought are changing very rapidly, using prices of a
constant year will give a misleading estimate of real GDP growth.
 Solution: Use chain weights instead of constant year dollars.
 Real GD𝑃𝑐ℎ𝑎𝑖𝑛𝑒𝑑 = P0(1+g) + P1(1+g) + … … … + Pn(1+g)
 Net investment = gross investment - depreciation.
 Some government purchases are consumption-type goods (like food for the military), while some are
investment-type items (such as schools or roads).
 Government transfer payments are payments to individuals that are not made in exchange for goods or
services supplied. (old-age or disability benefits)
 The money paid as tax to government from income/production is also a part of GDP.
 NI/NDP = GDP – Depreciation [depreciation = difficult to estimate]
 Gross national product (GNP) is the total final output produced with inputs owned by the residents of a
country during a year.
 Rent income of persons includes rents received by landlords. In addition, if you own your own home, you
are treated as paying rent to yourself.
 DI = Income + Transfer Payments – Personal Tax – Net Business Savings
 Net business saving = profits after depreciation less dividends [?]
 Drawbacks of GDP = Externalities no accounted + Omitted non-market activities
 Inflation (with symbol , or “pi”) denotes a rise in the general level of prices.
 A price index is constructed by weighting each price according to the economic importance of the
commodity in question. % change in CPI in period t = ∑𝐴𝑙𝑙 𝑖𝑡𝑒𝑚𝑠[𝑊𝑖0 × %∆𝑃𝑖]

 CONSUMPTION
 High consumption relative to income spells low investment and slow growth; high saving leads to high
investment and rapid growth.
 Consumption is the largest single component of GDP.
 Engel's law is an observation in economics stating that, as income rises, the proportion of income spent on
food falls―even if absolute expenditure on food rises.
 Personal saving is that part of disposable income that is not consumed; saving = income - consumption.
 The marginal propensity to consume (MPC) is the extra amount that people consume when they receive
an extra dollar of disposable income.
 The marginal propensity to save (MPS) is the fraction of an extra dollar of DI that goes to extra saving.
 Permanent income is the trend level of income; after removing temporary or transient influences due to
windfall gains or losses.
 APC = consumption / income
 Following are the views of 4 prominent economists showing the diverse approaches to explain
consumption:
 Absolute Income Theory (K)
 Relative Income Theory (D)
 Permanent Income Theory (M)
 Life Cycle Hypothesis (F)
 Absolute Income Theory: marginal propensity to consume is between zero and one; average propensity to
consume falls as income rises; income is the primary determinant of consumption
 Kuznet Puzzle: Keynes’s conjecture that the APC would fall as income rose appeared not to hold.

 INVESTMENT
 Investment” or “real investment” to mean additions to the stock of productive assets or capital goods.
 Financial investments = one person is buying, someone else is selling = the net effect is zero.
 Investment plays two roles = changes in aggregate demand and affects the business cycle + capital
accumulation and increases the nation’s potential output. (+growth)
 I is but one component of total social investment, which also includes foreign investment, government
investment, and intangible investments in human capital and improved knowledge.
 Gross private domestic investment are the building of residential structures; investment in business fixed
equipment, software, and structures; and additions to inventory.
 Why do businesses invest? Revenues, costs, and expectations.
 Investment shifts up due to lower tax, higher GDP, higher euphoria.
 Bathtub theory (see sheets)
 AS depends on net investment, since in the long run net investment determines the capital stock.
 AD depends on gross investment—a job building an additional/replacement machine is still a job.
 Depreciation = physical wear and tear + technologically obsolete (typewriter)
 Focus on private sector = excludes govt. investment + human capital
 The demand for private homes depends on three factors: income, mortgage interest rates, and taxes.
 Loose monetary policy = ↓ interest rates, ↓ cost of capital, and ↑ demand for capital.
 Loose fiscal policy = ↓taxes on capital, directly ↑investment.
 The MPC is the increase in output produced by using 1 additional unit of capital in production.
 The rental (user) cost of capital is the cost of using 1 additional unit of capital in production.
 Add capital as long as, MPC > Cost of Capital
 rental cost is, rc = r + d = i - 𝜋𝑒 + 𝑑 [d=depreciation, real interest rate = i - 𝜋𝑒]
 Desired capital, K = g(rc, Y) where, ↑rc = ↓K and ↑GDP = ↑K
 Equation K = g(rc, Y) states: ↑desired capital stock when ↑expected level of output; ↓cost of capital.
 ↓cost of capital when ↓real interest rate; ↓rate of depreciation; ↑investment tax credit.
 ↑corporate tax rate is likely, through the equity route, ↓the desired capital stock.
 The major significance of these results: monetary and fiscal policy affect the desired capital stock.
 The q theory of investment emphasizes this connection between investment and the stock market.
 the market value of a firm
Tobin’s q =
the replacement cost of capital
 Whenever q is greater than 1, a firm should add physical capital because for each dollar’s worth of new
machinery, the firm can sell stock for q dollars and pocket a profit (q – 1).
 Flexible Accelerator Model: If the desired capital stock changes, the capital stock adjusts to the new level
over time, with investment in each period determined by the speed-of-adjustment parameter, λ
 The accelerator model asserts that investment spending is proportional to the change in output and is not
affected by the cost of capital, I = α (Y – Y-1)
 Investment = fixed + residential + inventory
 Unanticipated inventory investment is a result of unexpectedly low aggregate demand. By contrast,
planned inventory investment adds to aggregate demand.

 BUSINESS CYCLE
 Keynesian economics emphasizes that changes in aggregate demand can have powerful impacts on the
overall levels of output, employment, and prices in the short run.
 Business cycles are economy-wide fluctuations in total national output, income, and employment, usually
lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in the economy.
 Economists typically divide business cycles into two main phases: recession and expansion.
 Peaks and troughs mark the turning points of the cycle.
 Recession → Profit falls → Stock prices fall
 Reasons for business fluctuations: Exogenous (war, oil price) or Endogenous (policy)
 Every expansion breeds contraction, and every contraction breeds revival and expansion.
 Imports are determined by 1) domestic income and output, 2) ratio of domestic to foreign prices, and
3) foreign exchange rate of the dollar.
 Exports (which are imports of other countries) are the mirror image of imports, and they are determined
by foreign incomes and outputs, by relative prices, and by foreign exchange rates.
 What is the reason for the downward slope of AD? When the price level goes up 1) real disposable
income falls, 2) the real value of wealth declines, leading to a decline in real consumption expenditures
3) and interest rates rise, reducing investment spending

VARIABLE IMPACT ON AGGREGATE DEMAND

Policy Variables
Monetary Monetary expansion may lower interest rates and loosen credit conditions, inducing
Policy higher levels of investment and consumption of durable goods.
In an open economy, monetary policy also affects the exchange rate and net exports.
Fiscal Policy Increases in government purchases of goods and services directly increase spending;
tax reductions or increases in transfers raise disposable income and induce higher
consumption.
Tax incentives like an investment tax credit can induce higher spending in a particular
sector
Exogenous Variables
Foreign Output growth abroad leads to an increase in net exports.
Output
Asset Values Rise in stock market increases household wealth and thereby increases consumption;
also, higher stock prices lower the cost of capital and thereby increase business
investment.
Technology Technological advances can open up new opportunities for business investment.
Advancement Important examples have been the railroad, the automobile, and computers.
Other Defeat of a socialist government stimulates foreign investment; peace breaks out, with
an increase in world oil production, and lowers oil prices; good weather leads to lower
food prices.
 The total expenditure curve (TE) shows the level of expenditure desired or planned by consumers and
businesses corresponding to each level of output.

 The multiplier model shows that an increase in investment will increase GDP by an amplified or multiplied
amount—by an amount greater than itself.
𝟏
 Change in output = 𝟏 × ∆𝐈 = × ∆𝐈
𝐌𝐏𝐒 𝟏− 𝐌𝐏𝐂
 A key assumption in the multiplier analysis is that prices and wages are fixed in the short run.
 The marginal propensity to import, MPM, is the increase in the dollar value of imports for each $1
increase in GDP. (MPM = 0 means no import)
 Open economy multiplier output generated by an additional dollar of government spending,
investment, or exports.

 AGGREGATE SUPPLY
 Aggregate supply describes the behavior of the production side of the economy.
 The aggregate supply curve, or AS curve, is the schedule showing the level of total national output
that will be produced at each possible price level, other things held constant.
 In analyzing AS, we will make the central distinction between the long run and the short run.
  The short run, corresponding to the behavior over periods of a few months to a few years, involves
the short-run aggregate supply schedule.
 In the short run, prices and wages have elements of inflexibility.
 As a result, higher prices are associated with higher production of goods and services.
 This is shown as an upward-sloping AS curve.
 The long run refers to periods associated with economic growth, after most of the elements of business
cycles have damped out; it refers to a period of several years or decades.
 In the long run, prices and wages are perfectly flexible.
 Output is determined by potential output and is independent of the price level.
 We depict the long-run aggregate supply schedule as vertical.
 AD determined by potential output, price level and cost, factors of production, import costs.
 Potential output is the maximum sustainable output that can be produced without triggering rising
inflationary pressures.
 Potential GDP is the highest sustainable level of national output. It is the level of output that would
be produced if we remove business-cycle influences.
 Shortrun: SRAS → upward-sloping; ∆AD → ∆Y; ↓AD → ↓Y and ↓P
 Longrun: LRAS → vertical; ∆AD → ∆P not real Y; ↓AD → ↓Y and ↓P; prices and wages adjust fully to ∆AD

 MONEY
 Money is anything that serves as a commonly accepted medium of exchange
 Barter consists of the exchange of goods for other goods
 Two monetary transactions are simpler than one barter transaction
 Successful barter transaction = double coincidence of wants
 History of money: Barter, commodity money, modern money.
 Commodity money = cattle, olive oil, beer or wine, copper, gold, silver, rings, diamonds, and cigarettes.
 Commodity money had intrinsic value, meaning that they had use value in themselves.
 Regulated by the market through the supply and demand; failed if new gold mines were discovered.
 Currency is defined as coins and paper money held outside the banking system.
 Fiat money: something declared to be money by the government even if it has no intrinsic value.
 When people use gold as money (or use paper money that is redeemable for gold), the economy is said to
be on a gold standard.
 Bank money: demand deposits and other checkable deposits.
 Money’s functions: medium of exchange, unit of account, store of value.
 As a store of value, money is a way to transfer purchasing power from the present to the future.
 Money is also used as the unit of account, the unit by which we measure the value of things.
 The cost of holding money is the interest forgone from not holding other assets.
 Everyone values fiat money because they expect everyone else to value it.
 Four main quantity theories of money: (1) Classical, (2) Neo-classical, (3) Keynesian and (4) Modern.
 Three motives behind the demand for money: the transactions motive, the precautionary motive, and the
speculative motive.

 UNEMPLOYMENT
 The definition of labor-force status used by the government is the following: People with jobs are
employed; people without jobs but looking for work are unemployed.
 People without jobs who are not looking for work are outside the labor force.
Employed These are people who perform any paid work, as well as those who have
jobs but are absent from work because of illness, strikes, or vacations.
 Unemployed. Persons are classified as unemployed if they do not have a job, have
actively looked for work in the prior 4 weeks, and are currently available
for work. An important point to note is that unemployment requires
more than being without a job—it requires taking steps to find a job.
Not in the This includes the people who are retired, too ill, disabled or simply not
labor force looking for work.
Labor force. This includes all those who are either employed or unemployed.

 the number of unemployed

Unemployment rate =
the total labor force
 Unemployment is
 an economic problem = represents waste of a valuable resource.
 a major social problem = causes enormous suffering + workers struggle with reduced incomes.
 The unemployment rate usually moves inversely with output over the business cycle. This co-movement is
known as Okun’s Law.
 Okun’s Law states that for every 2 percent that GDP falls relative to potential GDP, the unemployment
rate rises about 1 percentage point.
 Equilibrium unemployment arises when people become unemployed voluntarily as they move from job
to job or into and out of the labor force.
 Frictional unemployment because people cannot move instantaneously between jobs.
 Structural unemployment signifies a mismatch between the supply of and the demand for workers.
 Cyclical unemployment exists when the overall demand for labor declines in business-cycle downturns,
as described in the Keynesian business-cycle theory.

 INFLATION
 The consumer price index (CPI) measures the cost of a market basket of consumer goods and services
relative to the cost of that bundle during a particular base year.
 There are mainly three strains of inflation: low, galloping, hyperinflation.
 Low inflation is characterized by prices that rise slowly and predictably.
 Inflation in the double-digit or triple-digit range of 20, 100, or 200 percent per year is called galloping
inflation or “very high inflation.”
 Hyperinflation = real money stock falls + relative prices become unstable.
 Real money stock = money stock ÷ price level
 Two definite effects of inflation are: redistribution of income and wealth + distortion of relative prices
 Unanticipated inflation redistributes wealth from creditors to debtors, helping borrowers and hurting
lenders. An unanticipated deflation has the opposite effect.
 Low inflation has little impact on productivity or real output.
 Galloping/hyperinflation can harm productivity and redistribute income and wealth in an arbitrary fashion.
 A gradual rise in prices will help avoid the deadly liquidity trap.
 Inflation has a high degree of inertia in a modern economy. People form an expected rate of inflation, and
that rate is built into labor contracts and other agreements.
 The expected rate of inflation tends to persist until a shock causes it to move up or down.
 Demand-pull inflation occurs when aggregate demand rises more rapidly than the economy’s potential
production, pulling prices up to equilibrate aggregate supply and demand.
 Inflation increases because of increases in costs rather than because of increases in demand is known as
cost-push or supply-shock inflation. (oil price increase)
 AD shifts cannot simultaneously increase output and lower prices and inflation.
 Phillips curve shows the relationship between the unemployment rate and inflation.
 When output is high and unemployment is low, wages and prices tend to rise more rapidly.
 In the long run, the Phillips curve is vertical, not downward-sloping.
 When inflation is higher/lower than what people expect, inflation expectations adjust.
 The changed inflation expectations will generally shift the SRPC up or down.
 This approach implies that in the long-run there is a minimum unemployment rate that is consistent with
steady inflation. This is the nonaccelerating inflation rate of unemployment or NAIRU.
 NAIRU is unemployment rate consistent with a constant inflation rate.
 Per unit labor cost, P = WL/Q
 %∆ average labor costs = %∆ wages – %∆ productivity
 The idea behind the NAIRU is that the state of the economy can be divided into three situations:

Excess demand  markets are extremely tight

 with low unemployment and high utilization of capacity,
 prices and wages will be subject to demand-pull inflation.
Excess supply  In recessionary situations, with high unemployment and idled factories
 firms tend to sell at discounts
 workers push less aggressively for wage increases.
 wage and price inflation tend to moderate.
Neutral  wage @ equilibrium
pressures  no supply shocks from oil or other exogenous sources
 the economy is at the NAIRU, and inflation is constant

 Unemployment < NAIRU = Inflation rises

 Unemployment > NAIRU = Inflation falls
 Unemployment @ NAIRU = Inflation constant (+ inflation stabilize +the shifts of D/S in different labor
markets be in balance)
 Remains controversial: (1) stable NAIRU for a country exists? (2) extended period of high unemployment
leads to higher NAIRU!
 The sacrifice ratio is the cumulative loss in output, measured as a percent of 1 year’s GDP, associated
with a 1-percentage point permanent reduction in inflation.
 Anti-inflationary policy dilemmas = long run, cost of disinflation, credibility, policies to lower
unemployment, reduce voluntary unemployment, training, reduce disincentives.

 IS-LM CURVE
 The IS curve (or schedule) shows combinations of interest rates and levels of output such that planned
spending equals income.
 Here are the major points about the IS curve:
o The IS curve is the schedule of combinations of the interest rate and level of income such that the
goods market is in equilibrium.
o The IS curve is negatively sloped because an increase in the interest rate reduces planned
investment spending and therefore reduces aggregate demand, thus reducing the equilibrium level
of income.
o The smaller the multiplier and the less sensitive investment spending is to changes in the interest
rate, the steeper the IS curve.
o The IS curve is shifted by changes in autonomous spending. An increase in autonomous spending,
including an increase in government purchases, shifts the IS curve out to the right.
 The LM schedule, or money market equilibrium schedule, shows all combinations of interest rates and
levels of income such that the demand for real balances is equal to the supply.
 Along the LM schedule, the money market is in equilibrium.
 The following are the major points about the LM curve:
o The LM curve is the schedule of combinations of interest rates and levels of income such that the
money market is in equilibrium.
o The LM curve is positively sloped. Given the fixed money supply, an increase in the level of income,
which increases the quantity of money demanded, has to be accompanied by an increase in the
 interest rate. This reduces the quantity of money demanded and thereby maintains money market
equilibrium.
o The LM curve is steeper when the demand for money responds strongly to income and weakly to
interest rates.
o The LM curve is shifted by changes in the money supply. An increase in the money supply shifts the
LM curve to the right.

 Epilogue
 In the long run, a country’s capacity to produce goods and services determines the standard of living of
its citizens.
 In the short run, aggregate demand influences the amount of goods and services that a country produces.
 In the long run, the rate of money growth determines the rate of inflation, but it does not affect the rate
of unemployment.
 In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation
and unemployment.
 How should policymakers try to promote growth in the economy’s natural level of output?
 Should policymakers try to stabilize the economy? If so, how?
 How costly is inflation, and how costly is reducing inflation?
 How big a problem are government budget deficits?

FINANCIAL MANAGEMENT
 INTRODUCTION TO FM
 Careers in finance: (1) financial services and (2) managerial finance.
 Financial services is the area of finance concerned with the design and delivery of financial product and
services to individuals, businesses, and governments.
 Managerial finance is concerned with the duties of the financial manager working in a business.
 The three most common legal forms of business organization are the sole proprietorship, the partnership,
and the corporation.
 Sole form of organization appeals to entrepreneurs who enjoy working independently
 A major drawback to the sole proprietorship is unlimited liability.
 Stockholders are sometimes referred to as residual claimants, meaning that stockholders are paid last.
 Wealth maximization = stockholders + stakeholders happy.
 The financial press has reported many such violations in recent years, involving such well-known companies
as Enron, JP Morgan and Capital One.
 Does profit maximization lead to the highest possible share price? For at least three reasons. Timing,
Cash flow, Risk.
Cfi
 NPV = Σ − 𝐶𝑓0
(1+𝑖)2
 Risk↑ Rate↑ NPV↓ Share Price↓ and Cf↑ NPV↑ Share Price↑
 The treasurer (the chief financial manager) typically manages the firm’s cash, investing surplus funds when
available and securing outside financing when needed. (hedging, forex operations)
 The controller (the chief accountant) typically handles the accounting activities, such as corporate
accounting, tax management, financial accounting, and cost accounting.
 The treasurer’s focus tends to be more external, whereas the controller’s focus is more internal.
 Major difference between finance and accounting: cash flow, decision making
 Generally accepted accounting principles, the accountant prepares financial statements that recognize
revenue at the time of sale (whether payment has been received or not) and recognize expenses when
they are incurred. This approach is referred to as the accrual basis.
 Investment decisions generally refer to the items that appear on the left-hand side of the balance sheet,
and financing decisions relate to the items on the right-hand side.
 Corporate governance refers to the rules, processes, and laws by which companies are operated,
controlled and regulated.
o rights and responsibilities of the corporate participants (such as the shareholders, board of
directors, managers, and other stakeholders)
o rules and procedures for making corporate decisions.
 Institutional investors are investment professionals that are paid to manage and hold large quantities of
securities on behalf of individuals, businesses, and governments.
 Agency problems arise when managers deviate from the goal of maximization of shareholder wealth by
placing their personal goals ahead of the goals of shareholders.
 These problems in turn give rise to agency costs. Agency costs are costs borne by shareholders due to the
presence or avoidance of agency problems and in either case represent a loss of shareholder wealth.
 The conventional goal of a firm is profit maximization.
 Wealth = Number of Share X Price Per Share
 Profit maximization represents the process or the approach by which profits (EPS) of the business are
increased.
 Profit maximization = vague, TVM, Risk, Quality, Stakeholder
 Wealth or Value of a business is defined as the market price of the capital invested by shareholders.
 A wealth of a shareholder maximizes when the net worth of a company maximizes.
 Wealth = Present Value of cash inflows – Cost.
 WM Advantages: Cashflow, Long-term, TVM, Risk, Stakeholders.
 individual or organization, called an agent, to perform some service and delegate decision-making
authority to that agent.
 An agency problem is a potential conflict of interests that can arise between a principal and an agent.
Two important agency relationships are (1) those between the owners of the firm and its management and
(2) those between the managers, acting for stockholders, and the debt-holders.
 In financial management, the primary agency relationships are those between (1) stockholders and
managers and (2) managers and debt-holders.
 Some specific mechanisms used to motivate managers to act in shareholders’ best interests include (1)
managerial compensation, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the
threat of takeover.
 If a firm is to take on a large new project that is far riskier than was anticipated by the creditors. This
increased risk will cause the required rate of return on the firm’s debt to increase, and that will cause the
value of the outstanding debt to fall. (Uses bond covenants to stop this)

 FINANCIAL MARKETS
 A mechanism that facilitates the flow of funds from the surplus unit to the deficit unit
 Importance: flow of funds and market efficiency
 A direct transfer of money and securities occurs when a business sells its stocks or bonds directly to savers
(investors) without going through any type of intermediary or financial institution
 A transfer can also go through an investment banking house, which serves as a middleman that facilitates
the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn
sells these same securities to savers.
 ICB is the largest investment bank in Bangladesh.
 Transfers can also be made through a financial intermediary, such as a bank or a mutual fund. In this case,
the intermediary obtains funds from savers and then uses the money to lend out or to purchase another
business’s securities.
 Market efficiency means either economic efficiency or informational efficiency.
 The financial markets are said to have economic efficiency if funds are allocated to their optimal use at
the lowest transaction costs.
 Informational efficiency generally is classified into one of the following three categories:
 Weak-form
 Weak-form efficiency implies that past price movements do not affect stock prices.
 Fundamental analysis can be used to identify undervalued and overvalued stocks, and investors
can earn profits by gaining insight from financial statements, but technical analysis is invalid.
 The future price cannot be predicted from a study of historic prices.
 The fact that an investment has risen for the past three days, for example, gives us no clues as
to what it will do today or tomorrow.

Semi strong-form
 Semi strong-form efficiency states that current market prices reflect all publicly available
information.
 In this case, it does no good to scrutinize such published data as a corporation’s financial
statements because market prices will have adjusted to any good or bad news contained in such
reports as soon as they were made public.
 Even under semi strong-form efficiency, insiders (for example, the executives of companies) can
still earn abnormal returns on their own companies’ investments (stocks).
 An investor earns an abnormal return when the return he or she receives is greater than is
justified by the risk associated with the investment.
 If you and all of your friends invest in securities of similar risk, you should all earn about the
same return. If the return you earn on your investment is 20 percent and the return your friends
earn is 12 percent, the additional 8 percent is considered an abnormal return.

Strong-form
 Strong-form efficiency states that current market prices reflect all pertinent information,
whether it is publicly available or privately held.
 If this form of efficiency holds, even insiders would find it impossible to earn abnormal returns
in the financial markets
 Among financial markets are: Money Markets versus Capital Markets, Debt Markets versus Equity Markets,
Primary Markets versus Secondary Markets, Derivatives Markets, Stock Market

 The markets for short-term financial instruments are termed the money markets, and the markets for
long-term financial instruments are called the capital markets.
 By definition, then, money markets include only debt instruments because equity instruments (stocks)
have no specific maturities, whereas capital markets include both equity instruments and such long-term
debt instruments as mortgages, corporate bonds, and government bonds.
 The existence of money market instruments with different maturities permits us to better match our
cash inflows with cash outflows in the short run. (graduate mortgaging a house)
 The debt markets are markets in which loans are traded, and the equity markets are markets in which
stocks are traded.
 A debt instrument is a contract specifying the amounts and the dates, a borrower must repay a lender.
 Equity represents ‘‘ownership’’ in a corporation; it entitles the stockholder to share in future cash
distributions generated from income and from liquidation of the firm.
 The primary markets are markets in which ‘‘new’’ securities are traded, and the secondary markets are
markets in which ‘‘existing’’ securities are traded.
 Options, forwards, futures, and swaps are some of the securities traded in the derivatives markets.
 These securities are called derivatives because their values are derived from other underlying assets.
 A call option allows the option buyer to purchase a certain number of shares of stock (or some other
security) from the option seller at a pre specified price for a particular period of time.
 A put option is a contract that gives the owner of the option the right to sell a stock (or some other
security) at a specified price during some period in the future.
 Futures contract, which is a contract for the ‘‘future’’ delivery of an item where the price, amount,
delivery date, place of delivery, and so forth are specified.
  We can classify general stock market activities into three distinct categories: Primary (IPO), Primary
(additional) and Secondary Market.
 Exchange members are charged with different trading responsibilities: Broker and Specialist.
 Floor brokers act as agents for investors who want to buy or sell securities. (house/independent)
 Specialists’ role is to bring buyers and sellers together, oversees a particular group of stocks, buy stock
when not enough sellers exist or sell stock when not enough buyers exist at varying prices. (bid/ask price)
 Over-the-counter(OTC) market is an intangible trading system that consists of a network of brokers and
dealers around the country.
 ECNs are electronic systems that transfer information about securities transactions to facilitate the
execution of the orders by automatically matching the buy and sell orders by price for a large number of
investors.
 Dual listing increases liquidity because a stock has more exposure through a greater number of outlets
than if it was listed on only one exchange.
 Sales of new securities, such as stocks and bonds, as well as operations in the secondary markets, are
regulated by the BSEC in Bangladesh to ensure that investors receive fair disclosure of financial and
nonfinancial information from publicly traded companies and to discourage fraudulent and misleading
behavior by firms’ investors, owners, and employees to manipulate stock prices.
 Corporate insiders include the officers, directors, and major stockholders of a company.
 Investment banker perform three types of tasks: 1. they help corporations design securities (with the
features that are most attractive to investors given existing market conditions) 2. they buy these securities
from the corporations; and 3. they resell the securities to investors (savers).
 Raising Capital: Stage I Decisions are made by the corporation on its own, including the following: 1.
Dollars to be raised 2. Type of securities used 3.Competitive bid versus Negotiated deal 4.Selection of an
investment banker
 Raising Capital: Stage II decisions are made jointly by the firm and its selected investment banker, include
the following: 1. Reevaluation 2. Best effort or Underwriting 3. Issuance cost 4. Setting offering price.
 Financial intermediaries facilitate the transfer of funds from those who have funds (savers) to those who
need funds (borrowers) by manufacturing a variety of financial products.


The advantages of financial intermediaries in a financial system are listed below: 1.Economic Efficiency
2. Reduced costs 3. Risk/diversification. 4. Funds divisibility/pooling. 5. Financial flexibility. 6.Related
services.
 Types of financial intermediaries: 1.Commercial Banks 2.Credit Unions 3.Thrift Institutions 4.Mutual
Funds 5. Whole Life Insurance Companies 6.Pension Funds
 A credit union is a depository institution that is owned by its depositors, who are members of a common
organization or association, such as an occupation, a religious group, or a community.
 Thrift institutions cater to savers, especially individuals who have relatively small savings or need long-
term loans to purchase houses. Thrifts including savings and loan associations (S&Ls).
 Mutual funds are investment companies that accept money from savers and then use these funds to buy
various types of financial assets, including stocks, long-term bonds, short-term debt instruments etc.
 Investors who prefer to receive current income can invest in income funds, which include financial
instruments that generate fairly constant annual incomes (bonds with constant annual interest payments
and stocks with constant dividend payments).
 Investors who are willing to accept higher risks in hopes of obtaining higher returns can invest in growth
funds, which include investments that generate little or no income each year but exhibit high growth
potential that could result in significant increases in the values of the investments (that is, capital gains)
in the future.
 A money market mutual fund includes short-term, low-risk securities and generally allows investors to
write checks against their accounts.
 Term life insurance is a relatively short-term contract that provides protection for a temporary period—
perhaps for one year or for five years at a time and it must be renewed to continue such protection.
 Whole life insurance is a long-term contract that provides lifetime protection.

 COST OF CAPITAL
 Cost of capital is the minimum rate of return expected by the suppliers of funds collected from various
sources; such as equity, loan, bond or retained earnings.
 The firm’s cost of capital represents the minimum rate of return that must be earned from investments,
such as capital budgeting projects, to ensure that the value of the firm does not decrease.
 For example, if investors provide funds to a firm for an average cost of 15 percent,
 wealth will decrease, Returns < Cost of Capital
 wealth will be same, Returns = Cost of Capital
 wealth will increase, Returns > Cost of Capital
 The after-tax cost of debt, rdT, is the interest rate on debt, rd, less the tax savings that result because
interest is deductible. 𝑟𝑑𝑇 = 𝑟𝑑 (1 – t)
 Components of cost of capital = Kr, Ke, Kd, Kb
 The cost of retained earnings is the rate of return stockholders require on equity capital the firm obtains
by retaining earnings that otherwise could be distributed to common stockholders as dividends.
 Three methods are commonly used for finding the cost of retained earnings:
 The CAPM approach (left side) Rs = 𝑹𝒇 + (𝑹𝒎-𝑹𝒇) × β
 DCF approach (right side) 𝐫𝐬 = 𝑫𝟏 + g × 100; or 𝑫𝟎(𝟏+𝒈) + g × 100
𝑷𝟎 𝑷𝟎
 The bond-yield-plus-risk-premium approach (Bond+3/5%)
 Average the three methods to get best results.
 re = 𝐷1 + g × 100; or 𝐷0(1+𝑔) + g × 100
𝑃0−𝑓 𝑃0 (1−𝑓)
 Break point (BP) is defined as the dollar of new total capital that can be raised before an increase in the
firm’s weighted average cost of capital occurs.
 Total amount of lower cost of capital of a given type
BP =
Proportion of the type of capital in the capital structure

 CAPITAL STRUCTURE
 Therefore, the optimal capital structure is the one that strikes a balance between risk and return to
achieve the ultimate goal of maximizing the price of the stock.
 Factors influencing capital structure: Business Risk, Tax Position, Financial Flexibility, Managerial Attitude
 The greater the firm’s business risk, the lower the amount of debt is optimal.
 If much of a firm’s income is already sheltered from taxes by accelerated depreciation or tax loss carry
forwards from previous years, its tax rate will be low, and debt will not be as advantageous as it would
be to a firm with a higher effective tax rate.
 Financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions.
 The fourth debt-determining factor has to do with managerial attitude with regard to borrowing.
 Aggressiveness: more inclined to use debt in an effort to boost profits.
 Conservatism: less inclined to use debt in an effort to minimize risk
 Business risk is defined as the uncertainty inherent in estimates of future returns on assets or equity, if
the firm uses no debt; it is the risk associated with the firm’s operations, ignoring any financing effects.
 Financial risk is defined as the additional risk placed on common stockholders that results from using funds
with fixed periodic payments: debt and preferred stock; it is the risk associated with using debt or
preferred stock in the capital structure
 Business risk depends on a number of factors, the more important of which include the following:
 Sales variability (quantity and price).
 Input price variability.
 Ability to adjust output prices for changes in input prices.
 The extent to which costs are fixed (operating leverage)
 The objective of our analysis is to determine the capital structure at which value is maximized; this point
is then used as the target capital structure.
 If a firm changes the percentage of debt used to finance existing assets, we would expect the earnings per
share (EPS) and, consequently, the stock price to change as well.
 It has been demonstrated both theoretically and empirically that a firm’s beta increases with its degree
of financial leverage
 However, the financial risk premium varies depending on the debt level—the higher the debt level, the
greater the premium for financial risk.
 Leverage is created when a firm has fixed costs associated either with its sales and production operations
or with the types of financing it uses.
 These two types of leverage, called operating leverage and financial leverage, are interrelated.
 The degree of operating leverage (DOL) is defined as the percentage change in operating income (EBIT)—
associated with a given percentage change in sales.
 DOL = 2 = for every 1 percent change in sales there will be a 2 percent change in EBIT.
 In general, if a firm is operating at close to its breakeven level, the degree of operating leverage will
be high, but DOL declines the higher the base level of sales is above breakeven sales.
 All else equal, a lower (higher) DOL suggests that lower (higher) risk is associated with the firm’s normal
operating activities.
 Operating leverage affects earnings before interest and taxes (EBIT), whereas financial leverage affects
earnings after interest and taxes, or the earnings available to common stockholders.
 Financial leverage takes over where operating leverage leaves off, further magnifying the effects on
earnings per share of changes in the level of sales.
 The degree of financial leverage (DFL)is defined as the percentage change in earnings per share (EPS)
 This equation applies only if the firm has no preferred stock.
 We have observed the following two outcomes:
↑DOL → ↑FCoperating → ∆EBIT for ∆Sales
↑DFL → ↑FCfinancial → ∆EPS for ∆EBIT
 Therefore, if a firm uses a considerable amount of both operating and financial leverage, then even small
changes in sales will lead to wide fluctuations in EPS.
 Managers give considerable weight to financial strength indicators such as the times-interest-earned (TIE)
ratio, which is computed by dividing earnings before interest and taxes by interest expense.
 TIE = EBIT / I; (A measure of how well the firm can cover its interest payments with operating income)
 Two important theory: Trade-off (MM) Theory & Signaling Theory
 When two parties in an economic transaction have different information, we say that there is asymmetric
information.

 RISK & RETURN

 Risk is the variation of outcome.
 An event’s probability is defined as the chance that the event will occur.
 Debt investment has two possible outcomes: (1) the issuer makes the interest payments, or (2) the issuer
fails to make the interest payments.
 The riskier the stock—that is, the greater the variability of the possible payoffs—the higher the stock’s
expected return must be to induce you to invest in it.
 Simply stated, the expected value (return) is the weighted average of the outcomes, with each
outcome’s weight being its probability of occurrence.
 We designate the expected rate of return, 𝒓̂, which is termed ‘‘r hat.’’
 The tighter the probability distribution, the less variability there is and the more likely it is that
the actual outcome will approach the expected value. Consequently, under these conditions, it
becomes less likely that the actual return will differ dramatically from the expected return.
 The coefficient of variation shows the risk per unit of return.
 The higher a security’s risk, the higher the return investors demand, and thus the less they are willing
to pay for the investment. (lower the price)
 In a market dominated by risk-averse investors, riskier securities must have higher expected returns, as
estimated by the average investor, than less risky securities.
 Banks, pension funds, insurance companies, mutual funds, and other financial institutions are required by
law to hold diversified portfolios.
 The expected return on a portfolio, 𝒓̂p, is simply the weighted average of the expected returns on the
individual stocks in the portfolio, with each weight being the proportion of the total portfolio invested in
each stock.
 Unlike returns, the riskiness of a portfolio (σP) generally is not a weighted average of the standard
deviations of the individual securities in the portfolio. Instead, the portfolio’s risk usually is smaller than
the weighted average of the individual stocks’ standard deviations.
 When they are combined to form Portfolio WM, however, they are not risky at all.
 In statistical terms, we say that the returns on Stock W and Stock M are perfectly negatively correlated,
with r = 1.0. The opposite of perfect negative correlation is perfect positive correlation—that is, r = +1.0.
 Returns on two perfectly positively correlated stocks would move up and down together, and a portfolio
consisting of two such stocks would be exactly as risky as the individual stocks.
 As you can see, there is no diversification effect in this case—that is, risk is not reduced if the portfolio
contains perfectly positively correlated stocks.
 In reality, most stocks are positively correlated, but not perfectly so. On average, the correlation
coefficient for the returns on two randomly selected stocks would be about +0.4.
 For most pairs of stocks, r would lie in the range of +0.3 to +0.6. Under such conditions, combining stocks
into portfolios reduces risk but does not eliminate it completely.
 Thus, the portfolio’s risk is not an average of the risks of its individual stocks—diversification has
reduced, but not eliminated, risk.
)(𝒀−𝒀
)
 Covariance = ∑(𝑿−𝑿 and Correlation = 𝑪𝒐𝒗𝒂𝒓𝒊𝒂𝒏𝒄𝒆
𝒏−𝟏 𝝈𝑿𝝈𝒀
 If we added enough stocks, could we completely eliminate risk? No! but the extent to which adding stocks
to a portfolio reduces its risk depends on the degree of correlation among the stocks: The smaller the
positive correlation among stocks included in a portfolio, the lower its total risk.
 A portfolio consisting of all of the stocks in the market, which is called the market portfolio, would have
a standard deviation, σM,
 That part of the risk of a stock that can be eliminated is called diversifiable, or firm-specific, or
unsystematic, risk; that part that cannot be eliminated is called non diversifiable, or market, or
systematic risk.
 The measure of a stock’s sensitivity to market fluctuations is called its beta coefficient, designated with
the Greek letter β.
 An average-risk stock is defined as one that tends to move up and down in step with the general market
as measured by some index.
 A stock’s risk consists of two components: market risk and firm-specific risk.
 Firm-specific risk can be eliminated through diversification.
 Investors must be compensated for bearing systematic risk only.
 A portfolio consisting of low-beta securities will itself have a low beta because the beta of any set of
securities is a weighted average of the individual securities’ betas:
 Let’s assume that at the current time, Treasury bonds yield rRF = 5% and an average share of stock has a
required return of rM = 11%. In this case, the market risk premium is 6 percent:
 RPM = rM – rRF = 11 – 5 = 6%
 Risk-free rate as measured by the rate on Treasury securities is called the nominal, or quoted, rate, and
it consists of two elements: (1) a real inflation-free rate of return, r*, and (2) an inflation premium, IP,
equal to the anticipated average rate of inflation. Thus, rRF = r* + IP.
 If the expected rate of inflation rose by 2 percent, rRF would also increase by 2 percent.
 If there was no risk aversion, there would be no risk premium, so the SML would be horizontal. As risk
aversion increases, so does the risk premium and, therefore, so does the slope of the SML.
 External factors, such as increased competition within a firm’s industry or the expiration of basic patents,
can also alter a company’s beta.
 When such changes occur, the required rate of return, r, changes as well, and this change will affect the
price of the firm’s stock.
 A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns
with unknown risks. In other words, among various investments giving the same return with different level
of risks, this investor always prefers the alternative with least interest.
 Realized rate of return in Period t, and r ̅ (‘‘r bar’’) is the arithmetic average of the annual returns earned
during the last n years
 The CAPM shows how the relevant risk of an investment as measured by its beta coefficient is used to
determine the investment’s appropriate required rate of return. Here,
Terms Explanation
𝑟̂𝑗  Expected rate of return on the jth stock
 Based on the probability distribution for the stock’s returns.
rj  Required rate of return on the jth stock;
 the rate that investors demand for investing in Stock j.
 𝑟̂𝑗 > rj → buy the stock
 𝑟̂𝑗 < rj → not purchase this stock / sell it
 𝑟̂𝑗 = rj → be indifferent
rRF  Risk-free rate of return.
 rRF = return on long-term treasury securities.
β  Beta coefficient of the jth stock.
 Beta of an average stock = 1.0
rM  The market portfolio
 RRR on a portfolio consisting of all stocks.
 rM is also the required rate of return on an average (βA = 1.0) stock.
RPM  rM – rRF
 Market risk premium.
  Additional return above the risk-free rate required to compensate an
average investor for assuming an average amount of risk (βA = 1.0)
RPj  (rM – rRF) × βj
 RPM × βj
 Risk premium on the jth stock
 βj = βA = 1.0 → RPj = RPM
 βj > βA → RPj > RPM
 βj < βA → RPj < RPM
 The stock’s risk premium is less than, equal to, or greater than the
premium on an average stock, depending on whether its relevant risk as
measured by beta is less than, equal to, or greater than an average stock,
respectively.
Terms Explanation
r  Quoted, or nominal, rate of interest on a given security.
 There are many different securities, hence many different quoted interest
rates.
rRF  Nominal risk-free rate of return.
r*  Real risk-free rate of interest
 The interest rate that would exist on a security with a guaranteed payoff
if inflation is expected to be zero during the investment period.
IP  Inflation premium
 Equals the average inflation rate expected over the life of the security.
DRP  Default risk premium
 Reflects the chance of the borrower not paying debt’s interest or principal
on time.
LP  Liquidity, or marketability, premium
 Reflects the fact that some investments are more easily converted into
cash on a short notice at a ‘‘reasonable price’’ than are other securities.
MRP  Maturity risk premium
 Accounts for the fact that longer-term bonds experience greater price
reactions to interest rate changes than do short-term bonds.
 DIVIDEND POLICY
 Dividends are cash distributions made to stockholders from the firm’s earnings, whether those earnings
were generated in the current period or in previous periods.
 dividend irrelevance theory = form (d/g) does not matter, only return matters
 Thus, if the dividend irrelevance theory is correct, there exists no optimal dividend policy because
dividend policy does not affect the value of the firm.
 Thus, depending on his or her tax situation, an investor might prefer either a payout of
o current earnings as dividends, which would be taxed in the current period, or
o capital gains linked with growth in stock value, taxed when the stock is sold in the future.
 Some views concerning investors’ reactions to dividend policy changes and why firms have particular
dividend policies. [signaling, clientele, free cashflow]
 Signaling: a larger-than-expected dividend increase is taken by investors as a signal that the firm’s
management forecasts improved future earnings, whereas a dividend reduction signals a forecast of poor
earnings.
  A clientele effect might exist if stockholders are attracted to companies because they have particular
dividend policies. Those investors who desire current investment income can purchase shares in high-
dividend-payout firms, whereas those who do not need current cash income can invest in low-payout
firms. Consequently, we would expect the stock price of a firm to change if the firm changes its
dividend policy because investors will adjust their portfolios to include firms with the desired dividend
policy.
 According to the free cash flow hypothesis, the firm should distribute any earnings that cannot be
reinvested at a rate at least as great as the investors’ required rate of return, rs—that is, payout, the
free cash flows. (IRR < rs → pay dividend)
 Everything else equal, firms that retain free cashflows will have lower values than firms that distribute
free cash flows because the firms that retain free cash flows actually decrease investors’ wealth by
investing in projects with IRR < rs. (shareholders could’ve invested the dividend elsewhere)
 Types of dividend payments in practice: residual, stable dividend/growth rate, constant payout, low
regular plus extra
 Inflationary pressures plus reinvested earnings = switch to a ‘‘stable growth rate’’ policy.
 There are two good reasons for following stable, predictable dividends than residual dividend policy.
 First, a fluctuating payment policy would lead to greater uncertainty, signaling a higher rs and
a lower stock price, than would exist under a stable policy.
 Second, the stockholders using dividends for current consumption would be put to trouble and
expense if they had to sell part of their shares to obtain cash if the company cut the dividend.
 As a rule, stable, predictable dividends imply more certainty than variable dividends, thus a lower rs and
a higher firm value. So, it is this dividend policy that most firms favor.
 It would be possible for a firm to pay out a constant percentage of earnings, but because earnings surely
will fluctuate, this policy would mean that the dollar amount of dividends would vary.
 Payout Ratio = DPS/EPS = (Total Dividend)/NOPAT
 Therefore, with the constant payout ratio dividend policy, ∆earnings → uncertainty↑ → rs↑ → price↓
 A policy of paying a low regular dividend plus a year-end extra in good years is a compromise between a
stable dividend (or stable growth rate) and a constant payout rate.
 Dividends are paid semiannually or quarterly, and, when conditions permit, the dividend is increased.
Declaration date Ex-dividend date Holder-of-record Payment date
date
Oct. 17 Oct. 30 Nov. 1 Dec.14
New holder will receive New holder won’t receive Payments made
dividend dividend
(if buys within 17 – 30) P1 = P0 – $dividend
 Most large companies offer dividend reinvestment plans (DRIPs), whereby stockholders can automatically
reinvest dividends they receive in the stock of the paying corporation.
 The factors firms take into account can be grouped into these five broad categories:
o Constraints on dividend payments (restrictions, impairmentk, cash availability, tax authority)
o Investment opportunities (𝗍acceptable i.o → ↓payout)
o Alternative sources of capital (𝗍external cost → use Re → ↓payout)
o Ownership dilution (↓new stocks → 𝗍retention)
o Effects of dividend policy on rs (current vs future, dividend vs capital gain, tax, signaling)
 ‘‘Optimal’’ means that if the price is within this range, the P/E ratio, the firm’s value will be maximized.
 Stock dividends are similar to stock splits in that they ‘‘divide the pie into smaller slices’’ without affecting
the fundamental position of the current stockholders.
 If a firm wants to reduce the price of its stock, should it use a stock split or a stock dividend? Stock
splits generally are used after a sharp price run-up to produce a large price reduction.Stock dividends are
used on a regular annual basis to keep the stock price more or less constrained.
 On a 2-for-1 split, the shares outstanding are doubled, and the stock’s par value is halved.
 If stock dividends and splits are accompanied by higher earnings and cash dividends, then investors will
bid up the price of the stock. However, if stock dividends are not accompanied by increases in earnings
and cash dividends, the dilution of earnings and dividends per share causes the price of the stock to drop
by the same percentage as the stock dividend.

 CAPITAL BUDGETING
 The capital budget is an outline of planned expenditures on fixed assets, and capital budgeting is the
process of analyzing projects and deciding 1. which are acceptable investments and 2. which actually
should be purchased.
 Factors: long-term decision, timing, substantial expenditure.
 Effective capital budgeting can improve both the timing of asset acquisitions and the quality of assets
purchased. A firm that forecasts its needs for capital assets in advance will have an opportunity to purchase
and install the assets before they are needed.
 Capital budgeting decisions generally are termed either replacement decisions or expansion decisions.
 Replacement projects are necessary to maintain or improve profitable operations using the existing
production levels. But, increase operations by adding capital projects to existing assets that will help
produce either more of its existing products or entirely new products, expansion decisions are made.
 Some capital budgeting decisions involve independent projects, whereas others will involve mutually
exclusive projects. Independent projects are projects whose cash flows are not affected by one another,
so the acceptance of one project does not affect the acceptance of the other project(s).
 If a capital budgeting decision involves mutually exclusive projects, then when one project is taken on,
the others must be rejected.
 Capital budgeting involves the same steps used in general asset valuation: Cf, Risk, PV, Comparison.
 There is a direct link between capital budgeting and stock values: The more effective the firm’s capital
budgeting procedures, the higher the price of its stock.
 There is a direct link between capital budgeting and stock values: The more effective the firm’s capital
budgeting procedures, the higher the price of its stock.
 A project is considered acceptable if its NPV is positive; it is not acceptable if its NPV is negative.
 YTM (yield to maturity) is the average return that can be expected to be earned on a bond by holding the
investment till maturity.
 The IRR is defined as the discount rate that equates the present value of a project’s expected cash flows
to the initial amount invested.
 IRR can also be estimated with the below formula easily:
LDR = Lower Discount Rate
HDR = Higher Discount Rate
IRR = LDR + 𝑵𝑷𝑽𝑳 × (𝑯𝑫𝑹 − 𝑳𝑫𝑹) NPVL = NPV @ lower rate
𝑵𝑷𝑽𝑳−𝑯
NPVH = NPV @ higher rate
NPVL-H = Difference of 2 NPVs

 IRR Decision Rule: A project is acceptable if IRR > r (r = firm’s required rate of return)
 A graph that shows a project’s NPV at various discount rates (required rates of return) is termed the
project’s net present value (NPV) profile.
 Mathematically, the NPV and IRR methods will always lead to the same accept/reject decisions for
independent projects.
 Two basic conditions can cause NPV profiles to cross and thus lead to conflicts between NPV and IRR: Size
& Timing difference.
 NPV method assumes reinvestment rate = r
 IRR method implies reinvestment rate = IRR.
 Which is the better assumption—that cashflows can be reinvested at the required rate of return or
that they can be reinvested at the project’s IRR? To reinvest at the IRR associated with a capital project,
 the firm would have to be able to reinvest the project’s cash flows in another project with an identical
IRR. Such projects generally do not continue to exist. Thus, we conclude that the more realistic
reinvestment rate assumption is the required rate of return, which is implicit in the NPV method.

 A project has a conventional cash flow pattern if it has cash outflows (costs) in one or more consecutive
periods at the beginning of its life followed by a series of cash inflows. Projects with unconventional
cashflow patterns present unique difficulties when the IRR method is used, including the possibility of
multiple IRRs.
 Traditional payback period (PB), which is defined as the expected number of years required to recover the
original investment (the cost of the asset).
 Traditional Payback Period (PB) Decision Rule: A project is acceptable if PB < n* ; where n* is the
recovery period that the firm has determined is appropriate.
 Discounted Payback (DPB) Decision Rule: A project is acceptable if DPB < Project’s life
 An important aspect of the capital budgeting process is the post audit, which involves
(1) comparing actual results with those predicted by the project’s sponsors and
(2) explaining why any differences occurred.
 The post-audit has two main purposes: 1. Improve forecasts. 2. Improve operations.
 The post audit is not a simple process—a number of factors can cause complications: Uncertainty,
Uncontrollable, Indivisible, Delayed Results

MARKETING
 Marketing: Creating and Capturing Customer Value
 Marketing is a process by which companies create value for customers and build strong customer
relationships to capture value from customers in return.
 “Marketing mix”—a set of marketing tools that work together to satisfy customer needs and build
customer relationships.
 Needs: states of deprivation. Wants are the form human needs take as they are shaped by culture and
individual personality. Wants are shaped by one’s society and are described in terms of objects that will
satisfy those needs. When backed by buying power, wants become demands.
 Market offerings—some combination of products, services, information, or experiences offered to a market
to satisfy a need or a want.
 Exchange is the act of obtaining a desired object from someone by offering something in return.
 Market which is the set of actual and potential buyers of a product or service.
 Marketing means managing markets to bring about profitable customer relationships.
 Marketing myopia is focusing only on existing wants and losing sight of underlying consumer needs.
 Market segmentation refers to dividing the markets into segments of customers
 Target marketing refers to which segments to go after
 Value proposition: Set of benefits or values a company promises to deliver to customers to satisfy their
needs.
 The marketing mix: set of tools (four Ps) the firm uses to implement its marketing strategy. It includes
product, price, promotion, and place.
 Supply chain is a channel that stretches from raw materials to components to final products to final buyer
 Customer equity is the total combined customer lifetime values of all of the company’s customers

 Company and Marketing Strategy Partnering to Build Customer Relationships

 Strategic planning is the process of developing and maintaining a strategic fit between the organization’s
goals and capabilities and its changing marketing opportunities
 The mission statement is the organization’s purpose, what it wants to accomplish in the larger environment
 The business portfolio is the collection of businesses and products that make up the company
 BCG Matrix
 Stars. Stars are high-growth, high-share businesses or products. They often need heavy investments to
finance their rapid growth. Eventually their growth will slow down, and they will turn into cash cows.
 Cash Cows. Cash cows are low-growth, high-share businesses or products. These established and successful
SBUs need less investment to hold their market share. Thus, they produce a lot of the cash that the
company uses to pay its bills and support other SBUs that need investment.
 Question Marks. Question marks are low-share business units in high-growth markets. They require a lot of
cash to hold their share, let alone increase it. Management has to think hard about which question marks
it should try to build into stars and which should be phased out.
 Dogs. Dogs are low-growth, low-share businesses and products. They may generate enough cash to
maintain themselves but do not promise to be large sources of cash
 Product/Market Expansion Grid Strategies
 Market penetration is a growth strategy increasing sales to current market segments without changing the
product Market development is a growth strategy that identifies and develops new market segments for
current products
 Product development is a growth strategy that offers new or modified products to existing market
segments Diversification is a growth strategy through starting up or acquiring businesses outside the
company’s current products and markets

 Downsizing is the reduction of the business portfolio by eliminating products or business units that are not
profitable or that no longer fit the company’s overall strategy
 Value chain is a series of departments that carry out value-creating activities to design, produce, market,
deliver, and support a firm’s products
 Market segmentation is the division of a market into distinct groups of buyers who have different needs,
characteristics, or behavior and who might require separate products or marketing mixes
 Market segment is a group of consumers who respond in a similar way to a given set of marketing efforts
 Market targeting is the process of evaluating each market segment’s attractiveness and selecting one or
more segments to enter
 Market positioning is the arranging for a product to occupy a clear, distinctive, and desirable place relative
to competing products in the minds of the target consumer
 Marketing mix is the set of controllable tactical marketing tools—product, price, place, and promotion—
that the firm blends to produce the response it wants in the target market
 Return on marketing investment (Marketing ROI) is the net return from a marketing investment divided by
the costs of the marketing investment.

 Analyzing the Marketing Environment

 The marketing environment includes the factors and forces outside marketing that affect marketing
management’s ability to build and maintain successful relationships with customers
 Customers = Consumer markets + Business markets + Government markets + International markets

 Consumer Markets and Consumer Buyer Behavior

 Consumer buyer behavior : the buying behavior of final consumers, individuals and households, who buy
goods and services for personal consumption
 Opinion leaders are people within a reference group who exert social influence on others
 Perception is the process by which people select, organize, and interpret information to form a meaningful
picture of the world from three perceptual processes
 Selective attention is the tendency for people to screen out most of the information to which they are
exposed. Selective distortion is the tendency for people to interpret information in a way that will support
what they already believe. Selective retention is the tendency to remember good points made about a
brand they favor and forget good points about competing brands
 Sources of Information: • Personal sources—family and friends • Commercial sources—advertising, Internet
• Public sources—mass media, consumer organizations • Experiential sources—handling, examining, using
the product
 Customer satisfaction is a key to building profitable relationships with consumers— to keeping and growing
consumers and reaping their customer lifetime valu
 Business buyer behavior refers to the buying behavior of the organizations that buy goods and services for
use in production of other products and services that are sold, rented, or supplied to others.
 Straight rebuy is a routine purchase decision such as reorder without any modification
 Modified rebuy is a purchase decision that requires some research where the buyer wants to modify the
product specification, price, terms, or suppliers
 New task is a purchase decision that requires thorough research such as a new product
 Buying center is all of the individuals and units that participate in the business decision-making process
 Gatekeepers control the flow of information

 Customer-Driven Marketing Strategy

 Market segmentation is the process that companies use to divide large markets into smaller segments with
distinct needs, characteristics or behavior that might require separate marketing strategies or mixes.
 Market Targeting is the process of evaluating the different market segments attractiveness and selecting
one or more segments to enter.
 Differentiation involves actually differentiating the firm’s market offering relative to competitors market
offering in order to create superior customer value.
 Positioning consists of arranging for a market offering to occupy a clear, distinctive and desirable place
relative to the competing products in the minds of target customers.
 Product is anything that can be offered in a market for attention, acquisition, use, or consumption that
might satisfy a need or want.
 Services refer to any benefit or activity offered by one party to another, that is intangible and does not
result in ownership of anything.
 Consumer products are products and services purchased by users for personal consumption.
 Unsought products are consumer products that the consumer usually does not know about or knows about
but does not normally think of buying.

 Brand is the name, term, sign, or design—or a combination of these—that identifies the maker or seller of
a product or service. It signifies a company’s promise to deliver a specific set of features, benefits,
services, and experiences consistently to the buyers
 Product line is a group of products that are closely related because they function in a similar manner, are
sold to the same customer groups, are marketed through the same types of outlets, or fall within given
price ranges.
 A Product mix (product portfolio) consists of all the product lines and items that a particular seller offers
for sale.
 A company has four options while deciding on a brand development strategy. These are as follows: Line
Extension, Brand Extension, Multi Brands, New brands

 New-Product Development and Product Life-Cycle Strategies

 Acquisition refers to the buying of a whole company, a patent, or a license to produce someone else’s
product
 New product development refers to original products, product improvements, product modifications, and
new brands developed from the firm’s own research and development
 Crowdsourcing is one for of external sourcing of ideas. Crowdsourcing can be defined as involving broad
communites of people- customers, employees, independent scientists and researchers and the broad
public into the new product innovation program.
 Product development involves the creation and testing of one or more physical versions by the R&D or
engineering department
 Fads are temporary periods of unusually high sales driven by consumer enthusiasm and immediate product
or brand popularity
 Price is the consideration paid for a product or service.
 Value-based pricing uses the buyers’ perceptions of value, not the sellers cost, as the key to pricing.
 ost-based pricing involves setting prices based on the costs for producing, distributing, and selling the
product plus a fair rate of return for its effort and risk.
 Average cost is the per unit cost determined by dividing the total cost by the total units produced.
 As a firm becomes more experienced in producing a product, it gets the benefit of learning curve. Learning
curve refers to the drop in the average per-unit production cost due to experience increasing worker
efficiency, reducing worker mistakes etc.
 Inelastic demand occurs when demand hardly changes when there is a small change in price
 Elastic demand occurs when demand changes greatly for a small change in price

 Pricing
 Market-skimming pricing is a strategy with high initial prices to “skim” revenue layers from the market
 Market-penetration pricing sets a low initial price in order to penetrate the market quickly and deeply to
attract a large number of buyers quickly to gain market share
 Product line pricing takes into account the cost differences between products in the line, customer
evaluation of their features, and competitors’ prices
 Optional-product pricing takes into account optional or accessory products along with the main product
 Captive-product pricing involves products that must be used along with the main product
 By-product pricing refers to products with little or no value produced as a result of the main product.
Producers will seek little or no profit other than the cost to cover storage and delivery.
 Product bundle pricing combines several products at a reduced price
 Discount and allowance pricing reduces prices to reward customer responses such as paying early or
promoting the product
 Segmented pricing is used when a company sells a product at two or more prices even though the
difference is not based on cost
 Psychological pricing occurs when sellers consider the psychology of prices and not simply the economics
 Reference prices are prices that buyers carry in their minds and refer to when looking at a given product
 Promotional pricing is when prices are temporarily priced below list price or cost to increase demand
 Geographical pricing is used for customers in different parts of the country or the world
 FOB-origin (free on board) pricing means that the goods are delivered to the carrier and the title and
responsibility passes to the customer
 Uniformed-delivered pricing means the company charges the same price plus freight to all customers,
regardless of location
 Zone pricing means that the company sets up two or more zones where customers within a given zone pay
a single total price
 Basing-point pricing means that a seller selects a given city as a “basing point” and charges all customers
the freight cost associated from that city to the customer location, regardless of the city from which the
goods are actually shipped
 Freight-absorption pricing means the seller absorbs all or part of the actual freight charge as an incentive
to attract business in competitive markets
 Dynamic pricing is when prices are adjusted continually to meet the characteristics and needs of the
individual customer and situations
 International pricing is when prices are set in a specific country based on country-specific factors
 Predatory pricing: Selling below cost with the intention of punishing a competitor or gaining higher long-
term profits by putting competitors out of business
 Retail (or resale) price maintenance is when a manufacturer requires a dealer to charge a specific retail
price for its products
 Deceptive pricing occurs when a seller states prices or price savings that mislead consumers or are not
actually available to consumers

FINANCIAL ACCOUNTING AND REPORTING

 IFRS INTRODUCTION
 Accounting is the process of identifying, measuring and communicating economic or financial information
of a specific period about entities to interested users through the preparation of financial statements.
 A single set of high-quality global accounting standards, called International Financial Reporting Standards
(IFRS), is now being used by over 115 countries.
 The financial statements most frequently provided are: (1) statement of financial position (2) statement
of comprehensive income (3) statement of cash flows (4) statement of changes in equity. (5) notes to
accounts (an integral part of aforementioned four financial statement)
 HQ Standards = relevant information + faithful representation + comparability.
 Users = present and potential equity investors, lenders, and other creditors
 UK + 115 = IASB = issues International Financial Reporting Standards (IFRS)
 US = GAAP
 The two organizations that have a role in international standard-setting are the IOSCO and the IASB.
 IOSCO = International Organization of Securities Commissions
 IOSCO does not set accounting standards. Members are generally the main financial regulator for a given
country i.e. BSEC
 IOSCO supports the development and use of IFRS as the single set of high-quality international standards
in cross-border offerings & listings; recommends that its members allow multinational issuers to use IFRS
in cross-border offerings and listings.
 The standard-setting structure internationally is composed of the following four organizations:

 Financial reporting challenges:

o IFRS in a Political Environment (cannot escape politics and political pressures)
o The Expectations Gap (what public thinks accountants should do and what accountants think they
can do)
o Significant Financial Reporting Issues
 Non-financial measurements (customer satisfaction)
 Soft assets (goodwill)
 Forward-looking information (based on historical cost)
 Timeliness (real time info)
o Ethics in the Environment of Financial Accounting
o International Convergence
 CONCEPTUAL FRAMEWORK
 A conceptual framework establishes the concepts that underlie financial reporting

 The objective of general-purpose financial reporting is to provide financial information about the reporting
entity that is useful to present and potential equity investors, lenders, and other creditors in making
decisions about providing resources to the entity.
 Qualitative characteristics are either fundamental or enhancing characteristics, depending on how they
affect the decision-usefulness of information.
 However, providing useful financial information is limited by a pervasive constraint on financial reporting—
cost should not exceed the benefits of a reporting practice.
 Information is said to have relevancy when it influences the decision of the users by helping them evaluate
an entity’s past, present and future or confirming or correcting past evaluation.
 Financial information has predictive value if it has value as an input to predictive processes used by
investors to form their own expectations about the future.
 Relevant information also helps users confirm or correct prior expectations; it has confirmatory value.
 Assessing materiality is one of the more challenging aspects of accounting because it requires evaluating
both the relative size and importance of an item.
 Companies and their auditors generally adopt the rule of thumb that anything under 5% of net income is
considered immaterial.
 Information is immaterial, and irrelevant, if it would have no impact on a decision-maker.

 Faithful representation means that the numbers and descriptions match what really happened and existed.
 Completeness means that all the information that is necessary for faithful representation is provided.
 Neutrality = company cannot select information to favor one set of interested parties over another.
 Free from error = info will be a more accurate (faithful) representation of a financial item.

 Enhancing qualitative characteristics, distinguish more-useful information from less-useful information,

are complementary to the fundamental qualitative characteristics.
 Comparability enables users to identify the real similarities and differences in economic events between
companies.
 Consistency is present when a company applies the same accounting treatment to similar events, from
period to period.
 Verifiability occurs when independent measurers, using the same methods, obtain similar results.
 Timeliness means having information available to decision-makers before it loses its capacity to influence
decisions.

 There are five basic assumptions: (1) economic entity, (2) going concern, (3) monetary unit, (4) periodicity,
and (5) accrual basis.
 The economic entity assumption means that economic activity can be identified with a particular unit of
accountability. In other words, a company keeps its activity separate and distinct from its owners and any
other business unit.
 Most accounting methods rely on the going concern assumption—that the company will have a long life.
 The monetary unit assumption means that money is the common denominator of economic activity and
provides an appropriate basis for accounting measurement and analysis.
 The periodicity (or time period) assumption implies that a company can divide its economic activities into
artificial time periods. Users need to know a company’s performance and economic status on a timely
basis so that they can evaluate and compare companies, and take appropriate actions. Therefore,
companies must report information periodically.
 Accrual basis accounting means that transactions that change a company’s financial statements are
recorded in the periods in which the events occur. Under the accrual basis, companies recognize expenses
when incurred and revenues when product is sold or service is rendered.

 There are four basic principles of accounting to record and report transactions: (1) measurement, (2)
revenue recognition, (3) expense recognition, and (4) full disclosure.
 The most commonly used measurements are based on historical cost and fair value.
 Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.”
 The revenue recognition principle requires that companies recognize revenue in the accounting period in
which the performance obligation is satisfied.
 Recognize expenses when incurred.
 FD = An account or an amount or a transaction is to be reported by supporting detailed calculations.
 The cost constraint is that companies must weigh the costs of providing the information against the
benefits that can be derived from using it. MB>MC

 INVESTMENTS BY OWNERS. Increases in net assets of a particular enterprise resulting from transfers to it
from other entities of something of value to obtain or increase ownership interests (or equity) in it. Assets
are most commonly received as investments by owners, but that which is received may also include
services or satisfaction or conversion of liabilities of the enterprise.
 DISTRIBUTIONS TO OWNERS. Decreases in net assets of a particular enterprise resulting from transferring
assets, rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners
decrease ownership interests (or equity) in an enterprise
 COMPREHENSIVE INCOME. Change in equity (net assets) of an entity during a period from transactions
and other events and circumstances from non-owner sources. It includes all changes in equity during a
period except those resulting from investments by owners and distributions to owners.
 GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from
all other transactions and other events and circumstances affecting the entity during a period except
those that result from revenues or investments by owners.
 LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from
all other transactions and other events and circumstances affecting the entity during a period except
those that result from expenses or distributions to owners.

 PROPERTY, PLANT, AND EQUIPMENT (IAS16)

 Property, plant, and equipment are tangible assets that are held for use in production or supply of goods
and services, for rentals to others, or for administrative purposes and are expected to be used during more
than one period.
 The major characteristics of property, plant, and equipment are as follows: 1. They are acquired for use
in operations and not for resale. 2. They are long-term in nature and usually depreciated. 3. They possess
physical substance.

 Cost method = Acquisition Cost – Accumulated Depreciation

 Revaluation = Fair Value – Accumulated Depreciation
 Companies can handle overhead in one of two ways: 1. Assign no fixed overhead to the cost of the
constructed asset. 2. Assign a portion of all overhead to the construction process.
 Three approaches have been suggested to account for the interest incurred in financing the construction
of property, plant, and equipment: 1. Capitalize no interest charges during construction. 2. Charge
construction with all costs of funds employed, whether identifiable or not. 3. Capitalize only the actual
interest costs incurred during construction.
 Capitalization Period: 1. Expenditures for the asset are being incurred. 2. Activities to get the asset ready
for its intended use or sale are in progress. 3. Interest cost is being incurred.
 Avoidable Interest = WAAE × Appropriate Interest Rate
 Repairs of assets can be classified under two headings: 1. Ordinary Repairs 2. Major Repairs

 Assets are said to be impaired when companies are not able to recover the asset’s carrying amount either
through using or by selling the assets.
 Carrying amount > Recoverable amount = impairment loss.
 Carrying amount < Recoverable amount = no impairment.
 Recoverable amount = the higher of fair value less costs to sell or value-in-use.

 When companies choose to fair value fixed assets subsequent to acquisition, they account for the change
in the fair value by adjusting the appropriate asset account and recording an unrealized gain on the
revalued long-lived tangible asset, which is recorded in other comprehensive income.
 This unrealized gain is often referred to as revaluation surplus.

 INTANGIBLE ASSET
 Intangible assets are identifiable, non-monetary assets without physical substance.

 Intangible assets have three main characteristics: 1. They are identifiable. 2. They lack physical existence.
3. They are not monetary assets.
 Intangibles are either purchased or internally generated.
 There are six major categories: GMC-CAT i. Goodwill ii. Marketing-related intangible assets. iii. Customer-
related intangible assets. iv. Contract-related intangible assets. v. Artistic-related intangible assets. vi.
Technology-related intangible assets.
 Bargain Purchase In a few cases, the purchaser in a business combination pays less than the fair value of
the identifiable net assets. Such a situation is referred to as a bargain purchase.
 IFRS requires that all research costs be expensed as incurred. Development costs may or may not be
expensed as incurred.
 Many costs have characteristics similar to research and development costs. Examples are: 1. Startup costs
for a new operation. 2. Initial operating losses. 3. Advertising costs.

 PROVISIONS
 A provision is a liability of uncertain timing or amount (estimated liability).
 Companies accrue an expense and related liability for a provision only if the following three conditions
are met: 1. A company has a present obligation (legal or constructive) as a result of a past event; 2. It is
 probable that an outflow of resources embodying economic benefits will be required to settle the
obligation; and 3. A reliable estimate can be made of the amount of the obligation
 In determining the best estimate, the management of a company must use judgment, based on: 1. past
or similar transactions 2. discussions with experts 3. any other pertinent information.
 Here are some common areas for which provisions may be recognized in the financial statements: 1.
Lawsuits 2. Warranties 3. Consideration payable 4. Environmental 5. Onerous contracts 6. Restructuring.
 Companies often provide one of two types of warranties to customers: 1. Assurance Type: warranty that
the product meets agreed-upon specifications in the contract at the time the product is sold. This type of
warranty is included in the sales price of a company’s product. 2. Service Type: warranty that provides an
additional service beyond the assurance-type warranty. This warranty is not included in the sales price
but it is recorded as a separate performance obligation.
 Onerous contracts are ones in which “the unavoidable costs of meeting the obligations exceed the
economic benefits expected to be received.”
 An example of an onerous contract is a loss recognized on unfavorable non-cancelable purchase
commitments related to inventory items.
 However, IFRS uses the term “contingent” for liabilities and assets that are not recognized in the financial
statements.
 Contingent liabilities are not recognized in the financial statements because they are: (1) a possible
obligation (not yet confirmed as a present obligation) (2) not probable that payment will be made (3)
reliable estimate of the obligation cannot be made. i.e. liability from lawsuit
 A contingent asset is a possible asset that arises from past events and whose existence will be confirmed
by the occurrence or non-occurrence of uncertain future events not wholly within the control of the
company. i.e. assets from lawsuit