XFINMAR PRELIMS REVIEWER by Kirsten Manalili 1

CHAPTER 1: Introduction to Financial Management

1. Corporate Finance – Business Finance
2. Investments
3. Financial Institutions
4. International Finance
Corporate Finance – Business Finance
Investments
Financial Institutions
(4) Areas of Finance
- area of finance that deals with sources of funding, capital structure, and actions to increase the
value of the firm
- is a broad description of the planning, management, and control of a company's money.
- includes working capital management, financial statement analysis, cash budgeting, capital
budgeting, and more. In a small business, the owner/manager conducts the daily financial operations
of the company. In larger businesses, daily finance decisions may be made by the owner/manager,
along with a finance committee. Larger financial transactions may need to be approved by the Board
of Directors of the firm.
- includes the management of the following areas of the finance function:
 Working Capital Management
 Cash Budgeting
 Financial Analysis
 Financial Statement Development
 Capital Budgeting
• Dividend Policy
- deals with financial assets such as stocks and bonds
- or the investment decision, which also involves the financial markets and financial institutions.
This type of marketplace and company, respectively, makes easy transfer of money possible when
investments are made.
- Here are some examples of investments that a small business may make.
• Stocks - Businesses can invest in the stocks, or equity securities, of other businesses. The return
may include dividends and capital gains.
• Bonds - Businesses can invest in the bonds, or debt securities, issued by other companies. The
return will include the return of the principal at maturity and interest payments.
• Marketable Securities - These are short-term, liquid investments, usually made at a bank or
other financial institution, that have a maturity of one year or less.
• Commodities - Commodities are products with relatively volatile price swings, like pork bellies
or coffee. Their prices rise and fall rapidly.
 Derivatives - Derivatives are products from adjacent markets. The trade is conducted in the
form of a contract between two parties, and the value of the derivative is based on the value of
the original investment.
- businesses that deal primarily in financial matters
- is a company engaged in the business of dealing with financial and monetary transactions such as
deposits, loans, investments, and currency exchange.
- encompass a broad range of business operations within the financial services sector including
banks, trust companies, insurance companies, brokerage firms, and investment dealers.
- types of financial institutions:
• Commercial Banks - is a type of financial institution that accepts deposits, offers checking
account services, makes business, personal, and mortgage loans, and offers basic financial
products like certificates of deposit (CDs) and savings accounts to individuals and small
businesses
• Investment Banks - specialize in providing services designed to facilitate business operations,
such as capital expenditure financing and equity offerings, including initial public offerings
(IPOs).
• Insurance Companies - among the most familiar non-bank financial institutions are insurance
companies. Providing insurance, whether for individuals or corporations, is one of the oldest
financial services.
• Brokerage Firms - Investment companies and brokerages, such as mutual fund and exchange-
traded fund (ETF) provider Fidelity Investments, specialize in providing investment services
that include wealth management and financial advisory services. They also provide access to
investment products that may range from stocks and bonds all the way to lesser-known
alternative investments, such as hedge funds and private equity investments.

- international aspect of first 3 areas.

- an area of specialization
- sometimes known as international macroeconomics, is the study of monetary interactions between
International Finance
two or more countries, focusing on areas such as foreign direct investment and currency exchange
rates. International finance deals with the economic interactions between multiple countries, rather
than narrowly focusing on individual markets.
Importance of Finance – Why Study Finance?
Marketing - marketers work with budgets, marketing research, and cost-benefit analyses
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- marketing financial services require finance knowledge

a. Financial Management Provides Funds for the Right Campaign at the Right Time - by keeping a
check on various marketing spends, a financial manager can save funds on marketing
investments that matter.
b. Financial Management Helps Keep Marketers on a Budget - financial managers can help
forecast the marketing spends and plan for various marketing elements. They also help the
marketing team in compliance of the best practices in accounting.
c. Financial Management Adds Financial Acumen to Creativity - financial management enables
marketing and advertising function to stay on track, manage the financial aspects of business
accurately and avoid any financial blunders that may cost the company
- implications of many of the newer types of financial contracts on financial statements
Accounting
- understand what is valuable and how accounting knowledge is used
a. Financial implications in business plans – management need to know the financial needs for
business planning.
Management
b. Management roles should be aware of their effect is profitability – the financial implications or
costs of business plans affects the profitability of the entity.
- personal finance
You
- everyday financial decisions
The Financial Manager
Financial Manager - they try to answer some or all the corporate finance questions.
Chief Financial Officer (CFO) - top financial manager within a firm
- oversees cash management, credit management, capital expenditures, and financial planning
Treasurer
- in custody of assets
- highest accounting related position in an organization
Controller - oversees taxes, cost accounting, financial accounting, and data processing
- concerned with the recording of financial assets
Financial Management Decisions
- process of planning and managing a firm’s long-term investment
- cash flow generated > cost of asset
Capital Budgeting
- evaluating the size, timing, and risk of cash flows
- What long-term investments or projects should the business take on?
- mixture of debt and equity maintained by the firm
- how much to borrow, what to borrow, and where to borrow
Capital Structure
- How should we pay for our assets?
- Should we use debt or equity?
- firm’s short-term assets and liabilities
Working Capital - sufficient resources to continue operations and avoid costly interruptions
- How do we manage the day-to-day finances of the firm?
- business owned by a single individual
- most small businesses start out as sole proprietorships.
- are owned by one person, usually, the individual who has day-to-day responsibility for running the
business.
- can be independent contractors, freelancers, or home-based businesses.
Advantages Disadvantages
Sole Proprietorship  Easiest to start and least expensive form of  Limited to life of owner
ownership to organize  Equity capital limited to owner’s personal
 Least regulated (owner makes all decisions wealth (Limited in raising funds and may
and is in complete control of the company; have to acquire consumer loans)
could also be a disadvantage)  Unlimited liability
 Single owner keeps all of the profits  Difficult to sell ownership interest
 Taxed once as personal income  No separate legal status
Partnership - business formed by two or more individuals or entities
- two or more people share ownership of a single business.
- like proprietorships, the law does not distinguish between the business and its owners.
- the partners should have a legal agreement that sets forth how decisions will be made, profits will
be shared, disputes will be resolved, how future partners will be admitted to the partnership, how
partners can be bought out or what steps will be taken to dissolve the partnership when needed.
Advantages Disadvantages
 Two or more owners (partners may have  Unlimited Liability
complementary skills)  General Partnership
 More capital available  Limited Partnership
 Relatively easy to start (with the exception  Profits must be shared with the partners.
of developing a partnership agreement)  Divided decision making
 Income taxed once as personal income  Partnership dissolves when one partner dies
 Separate legal status to give liability or wishes to sell
protection.  Difficult to transfer ownership
 Business can suffer if the detailed
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partnership agreement is not in place

- business created as a distinct legal entity owned by one or more individuals or entities
- is considered by law to be a unique entity, separate from those who own it.
- can be taxed, sued, and enter into contractual agreements. The corporation has a life of its own and
does not dissolve when ownership changes.
- Three types of Corporations:
1. C-corporation - is a corporation that is taxed separately from its owners. It gives the owners
limited liability encouraging more risk-taking and potential investment.
Advantages Disadvantages
•Limited liability  Double taxation (corporation and
•Transfer of ownership, shareholders can sell shareholder earnings taxed)
their shares.  Can be costly to form.
•Capital is easier to raise through the sale of  More administrative duties - required
stock. by law to have annual meetings, notify
•Company paid fringe benefits. stockholders of the meeting, must keep
•Tax benefits minutes of meetings, and turn in.
• Pay corporate taxes at a different time
than other forms of business

2. S-Corporation - also known as subchapter S-corporation offers limited liability to the

owners. S-corporations do not pay income taxes rather the earnings and profits are treated as
distributions. The shareholders must report their income on their individual income tax returns
Advantages Disadvantages
• Limited liability  Can be costly to form.
• Avoids double taxation.  Stockholders limited to individuals,
Corporation • Profits taxed only once. estates, or trustees.
• Capital is easier to raise through the sale  Required administrative duties.
of stock.  Cannot provide company paid fringe
• Transfer of ownership. benefits.
 Stockholders are limited to citizens or
resident aliens of the United States.

3.Limited Liability Company (LLC) - is a hybrid business structure that provides the limited
legal liability of a corporation and the operational flexibility of a partnership or sole
proprietorship. However, the formation is more complex and formal than that of a general
partnership.
Advantages Disadvantages
• Most common business structure and  Can be costly to form.
specifically created for small businesses.  Yearly administrative costs.
• Must have insurance in case of a suit.  Personal tax liability.
• Separate legal entity.  Legal and accounting assistance is
• Usually taxed as a sole proprietorship. recommended.
• Unlimited number of owners
Advantages
 Limited Liability Disadvantages
 Unlimited Life  Separation of ownership and management
 Separation of ownership and management  Double Taxation
 Transfer of ownership is easy
 Easier to raise capital
Goal of Business Finance/Corporate Finance
- goal of financial management
- For any business, it is important that the finance it procures is invested in a manner that the returns
from the investment are higher than the cost of finance. In a nutshell, financial management –
Maximize the market value of the existing owner’s
• Endeavors to reduce the cost of finance.
equity
• Ensures sufficient availability of funds.
 Deals with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds.
- intended to strengthen protection against accounting fraud and financial malpractice
Sarbanes-Oxley Act of 2002 - compliance very costly
- firms driven to: Go public outside the U.S. or Go private (“go dark”)
Agency Theory
- relationship between stockholders and management
- is a principle that is used to explain and resolve issues in the relationship between business
Agency Theory
principals and their agents. Most commonly, that relationship is the one between shareholders, as
principals, and company executives, as agents.
Agency Relationship - relationship between stockholders and management
Agency - is any relationship between two parties in which one, the agent, represents the other, the principal,
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in day-to-day transactions. The principal or principals have hired the agent to perform a service on
their behalf
- delegate decision-making authority to agents. Because many decisions that affect the principal
Principals financially are made by the agent, differences of opinion, and even differences in priorities and
interests, can arise.
- is using the resources of a principal. The principal has entrusted money but has little or no day-to-
day input.
Agent
- is the decision-maker but is incurring little or no risk because any losses will be borne by the
principal
- possibility of conflict of interest between the owners and management of a firm (goal
Agency Problem
incongruence)
(Principal-Agent Problem)
- agency theory assumes that the interests of a principal and an agent are not always in alignment.
Agency Costs - costs incurred as a result of agency (conflict of interest)
Managers and the Stockholder’s Interest
 Compensation tied to financial performance/share value
Managerial Compensation
 Best performers within the firm get promoted/can demand higher salaries
 Proxy Fight – mechanism by which unhappy stockholders can act to replace management
 Takeover – acquisition of a firm by another firm
 Stakeholders – someone other than the stockholder or creditor who potentially has a claim on
the cash flows of the firm
Control of the Firm

Financial Markets and the Corporation

A. Firm issues securities to

raise cash
B. Firm invests in assets
C. Firm’s operations
generate cash flow
D. Cash is paid to
government as taxes.
Other stakeholders may
receive cash.
E. Reinvested cash flows
are plowed back into
firm
F. Cash is paid out to
investors in the form of
interest and dividends

Financial Markets
- original sale of securities
- the corporation/government is the seller
- is where securities are created.
- it is in this market that firms sell (float) new stocks and bonds to the public for the first time.
Primary Markets
- these trades provide an opportunity for investors to buy securities from the bank that did the initial
underwriting for a particular stock.
- an initial public offering, or IPO, is an example of a primary market. An IPO occurs when a private
company issues stock to the public for the first time.
- securities are ought and sold after the original sale
- involves one owner to another
- for buying equities, the secondary market is commonly referred to as the "stock market."
Secondary Markets
• Auction Markets
• Dealer Markets
• Over-the-counter Markets
Auction Markets - unlike dealer markets, has physical location
- primary purpose is to match those who wish to sell with those who wish to buy
- in the auction market, all individuals and institutions that want to trade securities congregate in one
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area and announce the prices at which they are willing to buy and sell.
- these are referred to as bid and ask prices. The idea is that an efficient market should prevail by
bringing together all parties and having them publicly declare their prices.
- market where a dealer buys and sells for themselves
- in contrast, a dealer market does not require parties to converge in a central location. Rather,
participants in the market are joined through electronic networks.
Dealer Markets
- the dealers hold an inventory of security, then stand ready to buy or sell with market participants.
These dealers earn profits through the spread between the prices at which they buy and sell
securities.
- dealer markets in stocks and long-term debt
Over-the-counter Markets - nowadays, the term "over-the-counter" generally refers to stocks that are not trading on a stock
exchange.

CHAPTER 10: Some lessons from Capital Market History

 The risk-return tradeoff is an investment principle that indicates that the higher the risk, the
higher the potential reward.
 To calculate an appropriate risk-return tradeoff, investors must consider many factors, including
Understanding Risk-Return Tradeoff
overall risk tolerance, the potential to replace lost funds and more.
 Investors consider the risk-return tradeoff on individual investments and across portfolios when
making investment decisions.
- uncertainties involved in the investment we are opting to undertake
Risk
- higher risks have higher returns
Return - inflows we expect from taking risks
Return on Investment - gain (or loss) from your investment (e.g., if you buy an asset)
Income Component - cash received directly while you own the investment
- change in value of the investment you purchased
Capital Gain (Loss)
- realized when you sell a stock
- sum of dividend income and capital gain (loss)
Total Dollar Return - on a nondollar investment, which includes the sum of any dividend/interest income, capital gains or
losses, and currency gains or losses on the investment.
- dividend as a percentage of the beginning stock
- expressed as a percentage, is a financial ratio (dividend/price) that
Dividend Yield
shows how much a company pays out in dividends each year relative to its stock price.
- the reciprocal of the dividend yield is the price/dividend ratio.
- change in price during the year divided by the beginning price
- is the percentage price appreciation on an investment.
Capital Gains Yield
- it is calculated as the increase in the price of an investment, divided by its original acquisition
cost.
1. Stocks
2. Bonds (3) Financial Investments
3. Treasury Bills

The Historical Record

The Historical Record - Observations

 Small company investment did best over-all
 T-bills and Government bonds grew more slowly, but they also grew more steadily
- add-up yearly returns over the years observed
Average Returns
- ex. small cap ave. return 16.7% - 3.5% t-bills ave. return (risk free return) = 13.2%
 XFINMAR PRELIMS REVIEWER by Kirsten Manalili
There is a REWARD for bearing RISK
Frequency Distribution
Variance
Standard Deviation
Normal Distribution
The greater the potential REWARD, the greater is
the RISK
Geometric Average Return
Arithmetic Average Return
Efficient Capital Market
Efficient Market Hypothesis
Efficient Market Reaction
Delayed Reaction
Overreaction and correction
Strong Form Efficiency
Semi-strong Form Efficiency
Weak Form Efficiency
Efficient Market Hypothesis Misconception
6
- risk-free return - type of debt that is virtually free of any default risk
- risk premium – excess return required from an investment in a risky asst over that required from a
risk-free investment
- first lesson
Variability of Returns
- number of instances in which a variable takes each of its possible values
- average squared differences between the actual return and the average return
- the bigger the variance, the more actual returns differ from average returns
- the positive square root of the variance
- a way to understand more of the variance
- symmetric, bell-shaped
frequency distribution that is
completely defined by its
average and standard deviation
- second lesson
Average Returns
- it is a more useful for long-term periods.
- average compound return earned per year over a multiyear period
- what was your average compound return per year over a particular period?
- it is a more useful for short-term periods
- return earned in an average year over a particular period
- what was your return in an average year over a particular period?
Capital Market Efficiency
- market in which security prices reflect available information
- hypothesis that actual capital markets are efficient
- price instantaneously adjusts to and fully
reflects new information
- there is no tendency for subsequent increases
and decreases
- price partially adjusts to the new information
- eight days elapse before the price completely
reflects the new information
- price over adjusts to the new information
- it overshoots the new price and subsequently
correct
Forms of Market Efficiency
- all information of every kind is reflected in stock prices
- all public information is reflected in the stock price
- the current price of a stock reflects its own past prices
 EMH does not mean that you can’t make money
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 On average, you will earn a return appropriate for the risk undertaken
 There is no bias in prices that can be exploited to earn excess returns
 Market efficiency will not protect you from wrong choices if you do not diversify
Capital Market History
 Prices do no appear to respond very rapidly to new information, and the response is at least not grossly different from what we would expect in an
efficient market
 The future of market prices, particularly in the short run, is very difficult to predict based on publicly available information
 If mispriced stocks do exist, then there is no obvious means of identifying them

SUMMARY OF FORMULAS
Capital Gains Yield Dividend Yield
Capital Gains
current value−original value Dividend
CG=current value−original value CG= Yield=
original value Current Price
Total Percentage Return
Total Peso Return
Dividend +Capital Gains
TPR=Dividend+ Capital Gains TPR %=
Original value∨Invested value
Standard Deviation
S2= √ S
Variance

S=
2∑ ( x−x )2
n−1
To Square a number
Press “x” sign twice, then press “=” to get n2
For odd exponents, after pressing “x” twice and once for “=”, press 1 and use
= for # times to get desired exponent

Geometric Average
−1 /n
GAR=[ ( 1+ x 1 ) ∙ ( 1+ x 2 ) … ( 1+ x n ) ] −1
Interpolation
4
Difference of inner ( 1+i ) −Lower Percentage
Arithmetic Average
=
Difference of outer Higher Percentage−Lower Percentage
AA=
∑ Percentage returns Using Square Root Function
4
n Compute for ( 1+i ) , then press √ key
1
1st √ ❑ key =
n2
1
2nd √ ❑ key = 4
n

Fisher Equation
( 1+i )=( 1+ r)(1+ π )
Where i = normal interest
r = real interest or risk-free interest
π = inflation