1 FINANCE FINAL NOTES Chapter 5.1 An Overview Of The Capital Allocation Process A.

Three different ways money flows from one to another 1. Direct Transfers- Securities (stocks or bonds) are transferred directly to the savers. In return money goes to the firm giving the securities. 2. Indirect Transfers (through investment bankers)Securities go to an investment-banking house first (Merrill Lynch) and they act like the middleman in the process. The money then goes from the banking house to the business, and from the savers to the investment house. 3. Indirect Transfers (through financial intermediaries)Business sends securities to the bank in return for money, and the bank send their own (intermediary) securities to the savers for money. Chapter 5.2 Financial Markets A. Types of Markets 1. Physical asset versus financial asset markets The physical asset one or real markets- are those for products such as wheat, computers, real estate, machinery. Financial asset markets- are ones that deal with stocks, bonds, notes, and mortgages. 2. Spot versus future markets Spot Markets- markets in which assets are bought or sold for on the spot delivery (few days). Future Markets- participants agree to buy or sell an asset at some future date. 3. Money versus capital markets Money markets- short-term, funds or borrowed or loaned for short periods.

2 Capital markets- stocks for intermediate or long-term debt (1+yr.) 4. Primary versus secondary markets Primary markets- markets in which corporations raise capital by issuing new securities. Secondary Markets- markets in which securities and other financial assets are traded among investors after corporations have issued them. New York Stock Exchange is a secondary market. 5. Private versus public markets Private markets- transactions and negotiations are directly between two parties. Ex.-bank loans, private debt placements, insurance companies. Public markets- where standardized contracts are traded on organized exchanges. Ex.-common stock and corporate bonds because held by many people. Summary of Major Market Instruments, Market Participants, and Characteristics 1. US Treasury Bills- Money Market, 91 days- year. Default-free= Lowest Yield 2. Commercial Papers- Money, up to 180 days, low risk 3. CDs- Money, up to 270 days, low default risk 4. US Treasury notes and bonds- Capital Market, 2-30 yrs. 5. Mortgages- Capital, up to 30 yrs. 6. State and local govt bonds- Capital, up to 30 yrs. 7. Corporate bonds-up to 40 yrs. 8. Preferred stock- unlimited, riskier than corp. but less than common 9. Common stock- unlimited, given by corporations to investors, riskiest bond= Highest Yield Chapter 5.3 Financial Institutions

3 1. Investment Banking Houses- organization that underwrites and distributes new investment securities and helps businesses obtain financing (Merrill Lynch, Morgan Stanley, Goldman Sachs). They help businesses design securities, then buy them from the corporation and then resell it to the savers. 2. Commercial Banks- they serve a variety of savers and borrowers (Bank of America, Wachovia, J. P. Morgan Chase). 3. Financial Services Corporation- a firm that offers a wide range of financial services, including banking, brokerage operations, insurance, and commercial banking (Citigroup, Fidelity, Prudential). 4. Saving and Loan Associates- they served individual savers by taking funds of small savers and lending them to homebuyers and other borrowers. 5. Mutual Savings Bank- similar to #4, but long-term 6. Credit Unions- are cooperative associations whose members are supposed to have common bond, such as being employees of the same firm. 7. Pension Funds- retirement plans for workers 8. Life Insurance Companies- take savings in the form of annual premiums; invest it in stocks, bonds, real estate; then payout the beneficiaries of the insured parties. 9. Mutual Funds- corporations that accept money from savers and then use the funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or govt. They pool funds and thus reduce risks by diversification. 10. Hedge Funds- similar to mutual funds b/c they accept money from savers and use it to buy securities but have some differences. These are not regulated by the SEC unlike mutual funds, mutual funds target small investors but these have only large investments (1+ million). Chapter 5.7 Stock Market Efficiency Efficient Market Hypothesis (EMH)- security prices reflects all publicly available information on each security. Three types: 1. Weak Form Efficiency- all information contained in the past stock price movements is fully reflected in current market prices.

4 (Review sheet question #4 answer about this: information about recent trends in stock prices would not be useful when it comes to selecting stocks, and a trading strategy exploiting the past information on a companys trends and financials would not yield an excess profit.) 2. Semistrong-Form Efficiency- current market prices reflect all publicly available information. 3. Strong-Form Efficiency- current market prices reflect all pertinent information Chapter 7.1 Who issues Bonds? Bond- a long-term contract (10+ yrs.), therefore have high risk or high yield A. Treasury Bonds- Bonds issued by the govt (also called govt bonds), therefore no risk. B. Corporate Bonds- Bonds issued by corporations, have risk depending on corp. C. Municipal Bonds- Bonds issued by state or local govt, some risk, and interest is exempt from federal taxes. D. Foreign Bonds- Bonds issued by foreign govt or foreign corporations, of course exposed to some risk. Chapter 7.2 Key Characteristics of Bonds Key Terms 1. Par Value- face value of the bond 2. Coupon Payment- the specific number of dollars of interest paid each yr. 3. Coupon Interest Rate- the stated annual interest on a bond. 4. Floating-Rate Bond- bonds interest fluctuates with shifts in the general level of interest rates. 5. Zero Coupon Bond- a bond that pays no annual interest but is sold at a discount below par, thus providing compensation to investors in the form of capital appreciation.

5 6. Original Issue Discount (IOD)- a bond originally offered at a price below its par value. 7. Maturity Date- specified date on which the par value of a bond is to be repaid. 8. Original Maturities- the number of yrs. to maturity at the time bond is issued. 9. Call Provision- most municipal land corporate (not treasury) issue these. A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal date. 10. Sinking Fund Provision- a provision that requires the issuer to retire a portion of the bond issue each yr. 11. Convertible Bond- a bond that is exchangeable at the option of the holder, for the issuing firms common stock. 12. Warrant- a long-term option to buy a stated number of shares of common stock at a specified price. 13. Putable Bond- a bond with provisions that allow its investors to sell it back to the company prior to maturity at a prearranged price. 14. Income Bond- a bond that pays interest only if it is earned.

15. Indexed or Purchasing Power Bond- a bond that has interest payments based on an inflation index so as to protect the holder from inflation. 16. Discount Bond- a bond that sells below par value (happens if rate of interest is above the coupon rate). (Question 12 on the review sheet) 17. Premium Bond-a bond that sells above par value (happens if rate of interest is below the coupon rate). (Question 12 on the review sheet) Chapter 7.4 Bond Yields (4 lines underneath taken from swapnotes) PV=market value PMT=Coupon Payment= (%1000)/M FV=1000

6 YTM=APR

Yield To Maturity (YTM)- rate of return earned on a bond if held to maturity 14 year, 10 percent annual coupon, 1,000 par value bond at a price of 1,494.93 n=14 pv= -1494.93 pmt= 100 fv= 1000 i=??=5% Yield To Call- rate of return earned on a bond if it is called before its maturity date. Current Yield= annual interest (annual coupon payment) / bonds current price You have 10 percent coupon bonds currently selling at $985 = $100 / $985= 10.15%

Chapter 9.2 Common Stock Valuation Common Stock represents an ownership interest in a corporation, but to the typical investor a share of it is a piece of paper characterized by two features. 1. It entitles the owner to dividends but only if the company has earnings and if management wants to pay it rather than reinvesting all the earnings whereas a bond contains a promise to pay interest. 2. Stock can be sold, hopefully at a price greater than the purchase price. If it is sold at higher price known as capital gain. Most people buy stock in order to make capital gain otherwise they wont buy it originally. If sell for less known as capital loss. Definitions and Terms

Dt= dividend that the stockholder expects to receive at the end

of the yr.

D0= the most recent dividend D1= the first dividend expected

D2= the dividend expected at the end of two years and so forth Po= actual market price of the stock today Pt= expected price of the stock at year t G= expected growth rate in dividends as predicted by the
marginal investor

Rs= required rate of return on the stock or minimum rate of

return

Rs= expected rate of return a stockholder expects in the future (pg. 294) Rs= actual or realized rate of return (look at page 294 for thing over the R) D1/PO= expected dividend yield (look at pg 294 for an example) P1-Po / Po= expected capital gains yield on the stock during
the coming yr. (Look at pg. 294 for thing over the first P) Expected Total Return= the sum of expected dividend yield and expected capital gains yield. FORMULAS (Nam gave us at the review) 1. Po=D1 / K-G

= D2 X (1+G) / K-G Po
X

2. P1=D2 / K-G = 3. K=D1/P0 4. D1=D0 5. D2= D1

X X X

(1+G)

(1+G)

(1+G) (can be Po or P1 also) (1+G) = D0 X (1+G) (dy= dividend yr. D1/Po)

6. K= dy+ g

IF

THEN

CR>YTM PRICE>1000 CR=YTM PRICE=1000

CR<YTM PRICE<1000