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 Table of Contents

I. Capital Markets 04 V. Financial Analysis and Reporting 24 VIII. Bonds and their Valuation 99
Stock Markets Financial Statements Analysis Bond Basics
Equity Valuation Ratio Analysis Bond Valuation
Capital Structure Cash Flow Analysis Bond Yields and Prices
Financial Modeling Bond Risks
II. Behavioral Finance 08 Financial Reporting and Disclosure Fixed Income Portfolio Management
Emotion and Investing IX. Investment and Portfolio 111
Behavioral Finance and Investment Strategy VI. Banking and Financial Institutions 41 Management
Behavioral Finance and Capital Markets Banking Regulation Portfolio Theory
Risk Management in Banks Asset Allocation
III. Interest Rates 12 Financial Institutions and Markets Security Analysis
Interest Rate Determination Bank Operations and Management Investment Strategies
Interest Rate Risk Risk Management
Performance Evaluation
Interest Rate Derivatives VII. Fundamentals of Corporate Finance 56
Monetary Policy
Yield Curve
Capital Budgeting X. Cash and Working Capital 129
Cost of Capital Management
Inflation and Interest Rates Capital Structure Cash Flow Management
Dividend Policy Accounts Receivable and Payable Management
IV. Income and Business Taxation 20 Mergers and Acquisitions Inventory Management
Corporate Taxation Corporate Governance Short-term Financing
Individual Taxation Working Capital Optimization
Tax Planning and Optimization Liquidity Management
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Updated as of February 2025

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Capital Markets
I. CAPITAL MARKETS
A. Stock Markets
The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock
market is important to anyone involved in managing a business.

1. Physical Location Stock Exchanges

2. Over-The-Counter (OTC)
Formal organizations having tangible physical
A large collection of brokers and dealers, connected
locations that conduct auction markets in designated
electronically by telephones and computers, that
(“listed”) securities.
2 Basic Types provides for trading in unlisted securities.
Physical location exchanges are tangible entities.
of Market Procedures Although the stocks of most large companies trade on
Each of the larger exchanges occupies its own
the NYSE, a larger number of stocks trade off the
building, allows a limited number of people to trade on
exchange in what was traditionally referred to as the
its floor, and has an elected governing body – its
over-the-counter (OTC) market.
board of governors.

Dealer Markets – A dealer market includes all facilities needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer
market system consists of:

The relatively few dealers who hold inventories The thousands of brokers who act as agents The computers, terminals, and electronic
1 of these securities and who are said to "make a 2 in bringing the dealers together with 3 networks that provide a communication link
market" in these securities; investors; and between dealers and brokers.

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I. CAPITAL MARKETS
B. Equity Valuation
The main purpose equity valuation is to estimate the value of a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity
or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day.

There are a number of different methods of valuing a company with one of the primary ways being the comparable (or comparables) approach.

Comparables Approach. A company’s equity value should bear some resemblance to other equities in a similar class. This entails comparing a
company’s equity to competitors or other firms in the same sector.

Discounted Cash Flow. A company’s equity value is determined by the future cash flow projections using net present value. This approach is most useful
if the company has strong data to support future operating forecasts.

Precedent Transactions. A company’s equity depends on historical prices for completed M&A transactions involving similar companies. This approach
is only relevant if similar entities have been recently valued and/or sold.

Asset-Based Valuation. A company’s equity value is determined based on the fair market value of net assets owned by the company. This method is
most often used for entities with a going concern, as this approach emphasizes outstanding liabilities determining net asset value.

Book-Value Approach. A company’s equity value is determined based on its previous acquisition cost. This method is only relevant for companies with
minimal growth that might have undergone a recent acquisition.

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I. CAPITAL MARKETS
C. Capital Structure

The term capital refers to investor- A firm’s capital structure is typically The optimal capital structure is the
supplied funds—debt, preferred stock, defined as the percentage of each type mix of debt, preferred stock, and
common stock, and retained earnings. of investor supplied capital, with the total common equity that maximizes the
Accounts payable and accruals are not being 100%. stock’s intrinsic value. The capital
included in our definition of capital structure that maximizes the intrinsic
because they are not provided by value also minimizes the weighted
investors—they come from suppliers, average cost of capital (WACC).
workers, and taxing authorities as a
result of normal operations, not as
investments by investors.

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Behavioral Finance
II. BEHAVIORAL FINANCE
Behavioral Finance is the study of various psychological factors that can affect financial markets. Behavioral finance typically encompasses five main concepts:

Self-attribution:
Emotional gap: This refers to a tendency to make choices
The emotional gap refers to decision-making based on overconfidence in one’s own
based on extreme emotions or emotional strains knowledge or skill. Self-attribution usually
Mental accounting: such as anxiety, anger, fear, or excitement. stems from an intrinsic knack in a particular
Mental accounting refers to the propensity for Oftentimes, emotions are a key reason why area. Within this category, individuals tend to
people to allocate money for specific people do not make rational choices. rank their knowledge higher than others, even
purposes. when it objectively falls short.

Herd behavior: Anchoring:

Herd behavior states that people tend to mimic Anchoring refers to attaching a spending level to a
the financial behaviors of the majority of the herd. certain reference. Examples may include
Herding is notorious in the stock market as the spending consistently based on a budget level or
cause behind dramatic rallies and sell-offs. rationalizing spending based on different
satisfaction utilities.

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II. BEHAVIORAL FINANCE
A. Emotion and Investing
Some Biases Revealed by Behavioral Finance. Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis. Some of
these include:

Confirmation Bias Experiential Bias

Confirmation bias is when investors have a bias This occurs when investors’ memory of recent events
toward accepting information that confirms their makes them biased or leads them to believe that the
already-held belief in an investment. If information event is far more likely to occur again. For this reason,
surfaces, investors accept it readily to confirm that it is also known as recency bias or availability bias.
they’re correct about their investment decision—even
if the information is flawed.

Loss Aversion Familiarity Bias

Loss aversion occurs when investors place a greater The familiarity bias is when investors tend to invest in
weighting on the concern for losses than the pleasure what they know, such as domestic companies of
from market gains. In other words, they’re far more locally owned investments. As a result, investors are
likely to try to assign a higher priority to avoiding not diversified across multiple sectors and types of
losses than making investment gains. As a result, investments, which can reduce risk. Investors tend to
some investors might want a higher payout to go with investments that they have a history or have
compensate for losses. If the high payout isn’t likely, familiarity with.
they might try to avoid losses altogether even if the
investment’s risk is acceptable from a rational
standpoint.

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II. BEHAVIORAL FINANCE
B. Behavioral Finance and Investment Strategy C. Behavioral Finance and Capital Markets
Market Timing and Technical Analysis
Asset bubbles and market crashes are largely a matter of timing. If you could
anticipate a bubble and invest just before it began and divest just before it burst, you
would get maximum return. That sort of precise timing, however, is nearly impossible
to achieve. To time events precisely, you would constantly have to watch for new
information, and even then, the information from different sources may be
contradictory, or there may be information available to others that you do not have.
Taken together, your chances of profitably timing a bubble or crash are fairly slim. The efficient market hypothesis (EMH) says that at any given time in a highly liquid
market, stock prices are efficiently valued to reflect all the available information.
Market timing – an asset allocation strategy. However, many studies have documented long-term historical phenomena in
securities markets that contradict the efficient market hypothesis and cannot be
captured plausibly in models based on perfect investor rationality.
The EMH is generally based on the belief that market participants view stock prices
rationally based on all current and future intrinsic and external factors. When studying
the stock market, behavioral finance takes the view that markets are not fully efficient.
This allows for the observation of how psychological and social factors can influence
the buying and selling of stocks.
The understanding and usage of behavioral finance biases can be applied to stock
and other trading market movements on a daily basis. Broadly, behavioral finance
theories have also been used to provide clearer explanations of substantial market
anomalies like bubbles and deep recessions. While not a part of EMH, investors and
portfolio managers have a vested interest in understanding behavioral finance trends.
These trends can be used to help analyze market price levels and fluctuations for
speculation as well as decision-making purposes.

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Interest Rates
III. INTEREST RATES
Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are
established. The interest rate is the price that lenders receive, and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which
represents the cost of equity.

A. The Determinants of Market Interest Rates

The Real Risk-Free Rate of Interest, R* - the rate of interest that Liquidity Premium (LP) - a premium added to the equilibrium
would exist on default-free US Treasury if no inflation were interest rate on a security if that security cannot be converted
expected. to cash on short notice and at close to its “fair market value.”

The Nominal, or Quoted, Risk-Free Rate of Interest - the rate of

Interest Rate Risk - the risk of capital losses to which investors
interest on a security that is free of all risk; rRF is proxied by the
are exposed because of changing interest rates.
T-bill rate or the T-bond rate; rRF includes an inflation premium.

Inflation Premium (IP) - a premium equal to expected inflation Maturity Rate Premium - a premium that reflects interest
that investors add to the real risk-free rate of return. rate risk.

Default Risk Premium (DRP) - the difference between the Reinvestment Rate Risk - the risk that a decline in interest rates
interest rate on a US Treasury bond and a corporate bond will lead to lower income when bonds mature and funds are
of equal. reinvested.

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III. INTEREST RATES People use money as a medium of exchange. When money is used, its value in the
The Cost of Money future, which is affected by inflation, comes into play. The higher the expected rate of
inflation, the larger the required dollar return.
Interest rate paid to savers depends on:
Time Preferences for
Production Consumption – The 1 the rate of return that producers expect to earn on invested capital
Opportunities – The preferences of
investment opportunities consumers for current
2 savers’ time preferences for current versus future consumption
in productive (cash- consumption as
generating) assets. opposed to saving for
future consumption. 3 the riskiness of the loan, and

4 the expected future rate of inflation.

4 Most Fundamental
Factors Affecting the Producers’ (borrowers) expected returns on their business investments set an upper
Cost of Money limit to how much they can pay for savings, while consumers’ time preferences for
consumption establish how much consumption they are willing to defer and hence
how much they will save at different interest rates. Higher risk and higher inflation
also lead to higher interest rates.
Risk – In a financial
Interest Rate Levels
market context, the Inflation – The amount by
chance that an which prices increase Term Structure of Interest Rates – the relationship between
investment will provide a over time. long-term and short-term rates.
low or negative return.
Long-term rates primarily reflect long-run expectations for inflation.

Short-term rates are responsive to current economic conditions.

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III. INTEREST RATES
Term Structure of Interest Rates

The relationship between bond yields and maturities.

It describes the relationship between long- and short-term rates.
The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding where to buy long- or
short-term bonds.

Yield Curve – a graph showing the relationship between bond yields and maturities.
Yield

Yield

Yield
Maturity Maturity Maturity

Normal Yield Curve – an upward-sloping Inverted (Abnormal) Yield Curve – a Humped Yield Curve – a yield curve where interest rates on
yield curve. downward-slopping yield curve. intermediate-term maturities are higher than rates on both short-
and long-term maturities.

B. Interest Rate Risk

Interest Rate Risk – is the risk of capital Reinvestment Rate Risk – the risk that a
Maturity Risk Premium (MRP) – a premium
losses to which investors are exposed decline in interest rate will lead to lower income
that reflects interest rate risk.
because of changing interest rates. when bonds mature and funds are reinvested.

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III. INTEREST RATES
C. Interest Rate Derivatives
The Real Risk-Free Rate of Interest, R*
Is the interest rate that would exist on a risk-less security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury
securities in an inflation-free world. The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on (1) the rate of return
that corporations and other borrowers expect to earn on productive assets and (2) people’s time preferences for current versus future consumption. Borrowers’
expected returns on real assets set an upper limit on how much borrowers can afford to pay for funds, whereas savers’ time preferences for consumption
establish how much consumption savers will defer—hence, the amount of money they will lend atdifferentt interest rates.

The Nomimal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP

The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate of the T-bond rate; rRF includes an inflation premium.
To be strictly correct, the risk-free rate should be the interest rate on a totally risk-free security—one that has no default risk, maturity risk, no liquidity risk, no risk of
loss if inflation increases, and no risk of any other type.
If the term risk-free rate is used without the modifiers real or nominal, people generally mean the quoted (or nominal) rate; and we follow that convention in this
book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected
inflation rate over the remaining life of the security.

Inflation Premium (IP)

A premium equal to expected inflation that investors add to the real risk-free rate of return.

Default Risk Premium (DRP)

The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also affects the market interest rate on a
bond: The greater the bond’s risk of default, the higher the market rate.

Liquidity Premium (LP)

A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but different financial assets vary
in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on different debt securities.

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III. INTEREST RATES
D. Monetary Policy
Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest
rates and changing bank reserve requirements.

Types of Monetary Policy

Contractionary – is policy that increases interest rates and Expansionary – during times of slowdown or a recession, an
limits the outstanding money supply to slow growth and expansionary policy grows economic activity. By lowering
decrease inflation, where the prices of goods and services in interest rates, saving becomes less attractive, and consumer
an economy rise and reduce the purchasing power of money. spending and borrowing increase.

Goals of Monetary Policy

Inflation Unemployment Exchange Rates

Contractionary monetary policy is used to An expansionary monetary policy decreases The exchange rates between domestic and
temper inflation and reduce the level of money unemployment as a higher money supply and foreign currencies can be affected by monetary
circulating in the economy. Expansionary attractive interest rates stimulate business policy. With an increase in the money supply, the
monetary policy fosters inflationary pressure and activities and expansion of the job market. domestic currency becomes cheaper than its
increases the amount of money in circulation. foreign exchange.

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III. INTEREST RATES
Tools of Monetary Policy

Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to
change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of
reserve balances to manipulate the short-term interest rates and that affect other interest rates.

Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate.
Banks will loan more or less freely depending on this interest rate.

Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their
customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or buy other assets.
Increasing the requirement curtails bank lending and slows growth.

E. Yield Curve
A graph showing the relationship between bond yields and maturities. The yield curve changes in position and in slope over time.

Humped Yield Curve – a yield curve where

Yield

Yield

Yield
“Normal” Yield Curve – an upward- Inverted (“Abnormal”) Yield Curve – a interest rates on intermediate-term
sloping yield curve. downward-sloping yield curve. maturities are higher than rates on both
Maturity Maturity Maturity short- and long-term maturities.

What Determines the Shape of the Yield Curve?

Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds.

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III. INTEREST RATES
F. Inflation and Interest Rates
Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.
In the U.S. the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits.
Higher interest rates are generally a policy response to rising inflation.
Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy.

How Changes in Interest Rates Affect Inflation?

In general, rising interest rates curb inflation while declining interest
How Do Interest Rates Affect Stocks?
rates tend to speed inflation. When interest rates decline, consumers
In general, rising interest rates hurt the performance of stocks. If interest
spend more as the cost of goods and services is cheaper because
rates rise, that means individuals will see a higher return on their
financing is cheaper. Increased consumer spending means an increase
savings. This removes the need for individuals to take on added risk by
in demand and increases in demand increases prices. Conversely,
investing in stocks, resulting in less demand for stocks.
when interest rates rise, consumer spending and demand decline,
money-flows reverse, and inflation is somewhat tempered.

The Bottom Line

Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate
change and its effect on the economy. Some sectors may react quickly, such as the stock market, while the effect on other sectors such as mortgages and auto loans can take
longer to be felt.
By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will
allow investors to understand the big picture and make better investment decisions.
Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal
Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as
to how the market will react to any given interest rate change.

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Income and
Business Taxation
IV. INCOME AND BUSINESS TAXATION
A. Corporate Taxation
What is a Corporate Tax?
Corporate taxes are collected by the government as a source of income. It is based on taxable income after expenses have been deducted.

Corporate Tax Deductions Special Considerations Advantages of a Corporate Tax

Corporations are permitted to reduce taxable income A central issue relating to corporate taxation is the Paying corporate taxes can be more beneficial for
by certain necessary and ordinary business concept of double taxation. Certain corporations are business owners than paying additional individual
expenditures. All current expenses required for the taxed on the taxable income of the company. income tax. Corporate tax returns deduct medical
operation of the business are fully tax-deductible. If this net income is distributed to shareholders, these insurance for families as well as fringe benefits,
Investments and real estate purchased with the intent of individuals are forced to pay individual income taxes including retirement plans and tax-deferred trusts. It is
generating income for the business are also deductible. on the dividends received. Instead, easier for a corporation to deduct losses, too.
A corporation can deduct employee salaries, health a business may register as an S corporation and have A corporation may deduct the entire amount of
benefits, tuition reimbursement, and bonuses. In all income pass-through to the business owners. As S losses, while a sole proprietor must provide evidence
addition, a corporation can reduce its taxable income by corporation does not pay corporate tax, as all taxes regarding the intent to earn a profit before the losses
deducting insurance premiums, travel expenses, bad are paid through individual tax returns. can be deducted. Finally, profit earned by a
debts, interest payments, sales taxes, fuel taxes, and corporation may be left within the corporation,
excise taxes. Tax preparation fees, legal services, allowing for tax planning and potential future tax
bookkeeping, and advertising costs can also be used to advantages.
reduce business income.

The Bottom Line

The corporate tax rate is a tax levied on a corporation's profits, collected by a government as a source of income. It applies to a company's income, which is revenue minus expenses.
In the U.S., the federal corporate tax rate is a flat rate of 21%. States may also impose a separate corporate tax on companies. Companies often seek to lower their corporate tax
obligations through taking advantage of deductions, loopholes, subsidies, and other practices.

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IV. INCOME AND BUSINESS TAXATION
B. Individual Taxation
Individual Income Tax
Also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes.
Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income. While a deduction can lower your taxable income and the tax rate used to
calculate your tax, a tax credit reduces your income tax obligation. Tax credits help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for middle-
income and lower-income households.

How Can I Calculate Income Tax?

What Percent of Income is Taxed?
To calculate income tax, you’ll need to add up all sources of
The percent of your income that is taxed depends on how much
taxable income earned in a tax year. The next step is calculating
you earn and your filing status. In theory, the more you earn, the
your adjusted gross income (AGI). Once you have done this,
more you pay.
subtract any deductions for which you are eligible from your AGI.

The Bottom Line

All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which
means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions.

C. Tax Planning and Optimization

Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you
pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to
contribute to retirement plans are crucial for success.

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IV. INCOME AND BUSINESS TAXATION
Tax planning covers several considerations. Considerations include timing of income, size, and
timing of purchases, and planning for other expenditures. Also, the selection of investments and
types of retirement plans must complement the tax filing status and deductions to create the
best possible outcome.

Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of
investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome.
Tax Planning vs. Tax Gain-Loss Harvesting
Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to offset overall capital gains.
According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type.
In other words, long-term losses offset long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at
ordinary income rates.

How Do High-Income Earners Reduce Taxes?

There are many ways to reduce taxes that are not only available to
What Are Basic Tax Planning Strategies?
high-income earners but to all earners. These include contributing
Some of the most basic tax planning strategies include reducing
to retirement accounts, contributing to health savings accounts
your overall income, such as by contributing to retirement plans,
(HSAs), investing in stocks with qualified dividends, buying muni
making tax deductions, and taking advantage of tax credits.
bonds, and planning where you live based on favorable tax
treatments of a specific state.

The Bottom Line

Tax planning involves utilizing strategies that lower the taxes that you need to pay. There are many legal ways in which to do this, such as utilizing retirement plans, holding on to
investments for more than a year, and offsetting capital gains with capital losses.

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Financial Analysis
and Reporting
V. FINANCIAL ANALYSIS AND REPORTING
A. Financial Statements Analysis
Financial statement analysis is the process of analyzing a company’s financial statements for decision-making purposes. External stakeholders use it to understand the overall health
of an organization and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

How to Analyze Financial Statements

The financial statements of a company record important financial data on every aspect of a
business’s activities. As such, they can be evaluated on the basis of past, current, and projected
performance.
In general, financial statements are centered around generally accepted accounting principles
(GAAP) in the United States. These principles require a company to create and maintain three
main financial statements: the balance sheet, the income statement, and the cash flow
statement. Public companies have stricter standards for financial statement reporting. Public
companies must follow GAAP, which requires accrual accounting. Private companies have
greater flexibility in their financial statement preparation and have the option to use either
accrual or cash accounting.
Several techniques are commonly used as part of financial statement analysis. Three of the
most important techniques are horizontal analysis, vertical analysis, and ratio analysis.
Horizontal analysis compares data horizontally, by analyzing values of line items across two or
more years. Vertical analysis looks at the vertical effects that line items have on other parts of
the business and the business’s proportions. Ratio analysis uses important ratio metrics to
calculate statistical relationships.

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V. FINANCIAL ANALYSIS AND REPORTING
Types of Financial Statements

Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three
statements are interconnected and create different views of a company’s activities and performance.

Balance Sheet Income Statement Cash Flow Statement

The balance sheet is a report of a company’s The income statement breaks down the revenue The cash flow statement provides an overview of
financial worth in terms of book value. It is broken that a company earns against the expenses the company’s cash flows from operating activities,
into three parts to include a company’s assets, involved in its business to provide a bottom line, investing activities, and financing activities. Net
liabilities, and shareholder equity. Short-term assets meaning the net profit or loss. The income income is carried over to the cash flow statement,
such as cash and accounts receivable can tell a lot statement is broken into three parts that help to where it is included as the top line item for
about a company’s operational efficiency; liabilities analyze business efficiency at three different operating activities. Like its title, investing activities
include the company’s expense arrangements and points. It begins with revenue and the direct costs include cash flows involved with firm-wide
the debt capital it is paying off; and shareholder associated with revenue to identify gross profit. It investments. The financing activities section
equity includes details on equity capital then moves to operating profit, which subtracts includes cash flow from both debt and equity
investments and retained earnings from periodic indirect expenses like marketing costs, general financing. The bottom line shows how much cash a
net income. The balance sheet must balance costs, and depreciation. Finally, after deducting company has available.
assets and liabilities to equal shareholder equity. interest and taxes, the net income is reached. Basic
This figure is considered a company’s book value analysis of the income statement usually involves
and serves as an important performance metric the calculation of gross profit margin, operating
that increases or decreases with the financial profit margin, and net profit margin, which each
activities of a company. divide profit by revenue. Profit margin helps to
show where company costs are low or high at
different points of the operations.

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V. FINANCIAL ANALYSIS AND REPORTING

Free Cash Flow and Other Valuation Statements Financial Performance

Companies and analysts also use free cash flow statements and other Financial statements are maintained by companies daily and used internally
valuation statements to analyze the value of a company. Free cash flow for business management. In general, both internal and external
statements arrive at a net present value by discounting the free cash flow stakeholders use the same corporate finance methodologies for
that a company is estimated to generate over time. Private companies may maintaining business activities and evaluating overall financial performance.
keep a valuation statement as they progress toward potentially going public. When doing comprehensive financial statement analysis, analysts typically
use multiple years of data to facilitate horizontal analysis. Each financial
statement is also analyzed with vertical analysis to understand how different
categories of the statement are influencing results. Finally, ratio analysis can
be used to isolate some performance metrics in each statement and bring
together data points across statements collectively.

Below is a breakdown of some of the most common ratio metrics:

Balance sheet: Income Statement: Cash flow: Comprehensive:

This includes asset turnover, This includes gross profit margin, This includes cash and earnings before This includes return on assets
quick ratio, receivables turnover, operating profit margin, net profit interest, taxes, depreciation, and (ROA) and return on equity
days to sales, debt to assets, margin, tax ratio efficiency, and amortization (EBITDA). These metrics (ROE), along with DuPont
and debt to equity. interest coverage. may be shown on a per-share basis. analysis.

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V. FINANCIAL ANALYSIS AND REPORTING
What are the advantages of financial statement analysis?
The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By
using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile.

What are the different types of financial statement analysis?

Most often, analysts will use three main techniques for analyzing a company’s financial statements.

First, horizontal analysis involves comparing Second, vertical analysis compares items on a Finally, ratio analysis, a central part of fundamental
historical data. Usually, the purpose of financial statement in relation to each other. equity analysis, compares line-item data. Price-to-
1 horizontal analysis is to detect growth trends
2 For instance, an expense item could be
3 earnings (P/E) ratios, earnings per share, or
across different time periods. expressed as a percentage of company sales. dividend yield are examples of ratio analysis.

What is an example of financial statement analysis?

An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit
margin will show the difference between revenues and the cost of goods sold. If the company has a higher gross profit margin than its competitors, this may indicate a positive sign
for the company. At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s
operating trends.

B. Ratio Analysis
Ratios help us evaluate financial statements. For example, at the end of 2015, Allied Food Products had $860 million of interest-bearing debt and interest charges of $88 million, while
Midwest Products had $52 million of interest-bearing debt and interest charges of $4 million. Which company is stronger? The burden of these debts and the companies' ability to
repay them can best be evaluated by comparing each firm's total debt to its total capital and comparing interest expense to the income and cash available to pay that interest. Ratios
are used to make such comparisons. We calculate Allied's ratios for 2015 using data from the balance sheets and income statements given in Tables 3.1 and 3.2. We also evaluate the
ratios relative to food industry averages, using data in millions of dollars.' As you will see, we can calculate many different ratios, with different ones used to examine different aspects
of the firm's operations. You will get to know some ratios by name, but it's better to understand what they are designed to do than to memorize names and equations.

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V. FINANCIAL ANALYSIS AND REPORTING
We divide the ratios into five categories.

1. Liquidity ratios, which give an 2. Asset management ratios, 3. Debt management ratios, 4. Profitability ratios, which give 5. Market value ratios, which
idea of the firm's ability to pay which give an idea of how which give an idea of how the an idea of how profitably the give an idea of what investors
off debts that are maturing efficiently the firm is using its firm has financed its assets as firm is operating and utilizing its think about the firm and its
within a year. assets. well as the firm's ability to repay assets. future prospects.
its long-term debt.

Satisfactory liquidity ratios are necessary if the firm is to continue operating. Good asset management
ratios are necessary for the firm to keep its costs low and thus its net income high. Debt management
ratios indicate how risky the firm is and how much of its operating income must be paid to bondholders
rather than stockholders. Profitability ratios combine the asset and debt management categories and
show their effects on ROE. Finally, market value ratios tell us what investors think about the company
and its prospects.
All of the ratios are important, but different ones are more important for some companies than for
others. For example, if a firm borrowed too much in the past and its debt now threatens to drive it into
bankruptcy, the debt ratios are key.
Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and manufacturing
capacity, the asset management ratios take center stage. The ROE is always important; but a high ROE
depends on maintaining liquidity, on efficient asset management, and on the proper use of debt.
Managers are, of course, vitally concerned with the stock price; but managers have little direct control
over the stock market's performance, while they do have control over their firm's ROE. So ROE tends to
be the main focal point.

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V. FINANCIAL ANALYSIS AND REPORTING
C. Cash Flow Analysis
Cash flow analysis is an important aspect of a company’s financial management because it underscores the cash that’s available to pay bills and make purchases—generally, money
it needs to run and grow the business.
Companies, investors, and analysts examine cash flow for various reasons, including for insight into a company’s financial stability and health and to inform decisions about possibly
investing in a company.

Why Cash Flow Analysis is Important

Cash is important to every business. Having enough money to pay the bills, purchase
needed assets, and operate a business to make a profit is vital to a company's success
and longevity.
A company must understand how well it is generating cash and how much it has. That
way, it can take corrective action, if needed. When you track your finances, including
where cash comes from and where it goes, you can place yourself in a better position to
plan business activities and company operations that lead to profits and growth.
Cash flow analysis examines the cash that flows into and out of a company—where it
comes from, what it goes to, and the amounts for each. The net cash flow figure for any
period is calculated as current assets minus current liabilities.
Ongoing positive cash flow points to a company that is operating on a strong footing.
Continued negative cash flow may indicate a company is in financial trouble.
A company’s cash flows can be determined by the figures that appear on its statement of
cash flows.

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V. FINANCIAL ANALYSIS AND REPORTING
Cash Flow Statement

Before it can analyze cash flow, a company must prepare a cash flow statement that shows all cash inflows that it receives from its ongoing operations and external investment
sources, as well as all cash outflows that pay for business activities and investments during a given quarter.
The three distinct sections of the cash flow statement cover cash flows from operating activities (CFO), cash flows from investing (CFI), and cash flows from financing (CFF) activities.

Cash Flow From Operations Cash Flow From Investing Cash Flow From Financing

This section reports the amount of cash from the This section records the cash flow from capital Debt and equity transactions are reported in this
income statement that was originally reported on expenditures and sales of long-term investments section. Any cash flows that include payment of
an accrual basis. A few of the items included in like fixed assets related to plant, property, and dividends, the repurchase or sale of stocks, and
this section are accounts receivable, accounts equipment. Specific items might include vehicles, bonds would be considered cash flow from
payable, and income taxes payable. If a client furniture, buildings, or land. Other expenditures financing activities. Cash received from taking
pays a receivable, it would be recorded as cash that generate cash outflows could include out a loan or cash used to pay down long-term
from operations. Changes in current assets or business acquisitions and the purchase of debt would also be recorded here. For investors
current liabilities (items due in one year or less) investment securities. Cash inflows come from who prefer dividend-paying companies, this
are recorded as cash flow from operations. the sale of assets, businesses, and securities. section is important because, as mentioned, it
Investors typically monitor capital expenditures shows cash dividends paid. Cash, not net
used for the maintenance of, and additions to, a income, is used to pay dividends to
company’s physical assets to support the shareholders.
company’s operation and competitiveness. In
short, investors want to see whether and how a
company is investing in itself.

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V. FINANCIAL ANALYSIS AND REPORTING

Cash Flow Analysis Operating Cash Flow/Net Sales

A company's cash flow is the figure that appears at the bottom of the cash This ratio, which is expressed as a percentage of a company's net operating
flow statement. It might be labeled as "ending cash balance" or "net change in cash flow to its net sales, or revenue (from the income statement), tells us how
cash account." Cash flow is also considered to be the net cash amounts from many dollars of cash are generated for every dollar of sales.
each of the three sections (operations, investing, financing).
There is no exact percentage to look for, but the higher the percentage, the
One can conduct a basic cash flow analysis by examining the cash flow better. It should also be noted that industry and company ratios will vary
statement, determining whether there is net negative or positive cash flow, widely. Investors should track this indicator's performance historically to
pinpointing how the outflows compare to inflows, and draw conclusions from detect significant variances from the company's average cash flow/sales
that. relationship along with how the company's ratio compares to its peers.

However, there is no universally-accepted definition of cash flow. For instance, It is also essential to monitor how cash flow increases as sales increase since
many financial professionals consider a company's net operating cash flow to it's important that they move at a similar rate over time.
be the sum of its net income, depreciation, and amortization (non-cash
charges in the income statement).1 While often coming close to net operating
cash flow, this interpretation can be inaccurate, and investors should stick with
using the net operating cash flow figure from the cash flow statement.

While cash flow analysis can include several ratios, the following indicators
provide a starting point for an investor to measure the investment quality of a
company's cash flow.

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V. FINANCIAL ANALYSIS AND REPORTING

Free Cash Flow

Free cash flow (FCF) is often defined as the net operating cash flow minus capital
expenditures. Free cash flow is an important measurement since it shows how efficient a
company is at generating cash. Investors use free cash flow to measure whether a
company might have enough cash, after funding operations and capital expenditures, to
pay investors through dividends and share buybacks.

To calculate FCF from the cash flow statement, find the item cash flow from operations—
also referred to as "operating cash" or "net cash from operating activities"—and subtract
capital expenditures required for current operations from it.

You can go one step further by expanding what's included in the free cash flow number.
For example, in addition to capital expenditures, you could include dividends for the
amount to be subtracted from net operating cash flow to arrive at a more comprehensive
free cash flow figure. This figure could then be compared to sales, as shown earlier.

As a practical matter, if a company has a history of dividend payments, it cannot easily

suspend or eliminate them without causing shareholders some real pain. Even dividend
payout reductions, while less injurious, are problematic for many shareholders. For some
industries, investors consider dividend payments to be necessary cash outlays similar to
capital expenditures.

It's important to monitor free cash flow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicate
the company can meet its obligations, including funding its operating activities and paying dividends.

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V. FINANCIAL ANALYSIS AND REPORTING
Comprehensive Free Cash Flow Coverage
You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again, the higher the percentage, the
better.
What Cash Flow Analysis Can Tell You
Cash flow analysis can lend insight into the financial vibrancy or financial instability of a company and its prospect as a good investment. Bear in mind these points when analyzing
cash flow:

Positive Cash Flow Negative Cash Flow Free Cash Flow

Positive cash flow is always the goal. When it Negative cash flow may indicate something Having free cash flow is a great advantage. It's
continues over a number of consecutive periods, other than financial trouble. For instance, the cash flow available after paying operating
it demonstrates that a company is capable of investing cash flow might be negative because a expenses and purchasing needed capital assets.
healthy operations and can grow successfully. company is spending money on assets that A company can use its free cash flow to pay off
improve operations and the products it sells. debt, pay dividends and interest to investors, and
However, keep an eye out for positive investing more.
cash flow and negative operating cash flow. This
could mean trouble ahead if, for instance, cash
flowing from the sale of investments is being
used to pay operating expenses.

Operating Cash Flow Margin

The operating cash flow margin ratio compares cash from operating activities to sales revenue in a particular period. A positive margin shows that a company is able to convert
sales to cash and can indicate profitability and earnings quality.

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V. FINANCIAL ANALYSIS AND REPORTING
Limitations of Cash Flow Analysis
The cash flow statement presents past data. It might not be a big help on its own to analysts and investors who want to properly size up a company as an
investment. For example, cash flow data that shows investments made point to an outflow (that could contribute to a negative cash flow). But those
investments may result in future positive cash flow, profits, and major growth.
It doesn't depict a company's net income because it doesn't include non-cash items. The income statement must be examined to determine these. It doesn't
present a full picture of a company's liquidity, just the cash available at the end of one period.

How Cash Flow Is Accounted For

There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting.

Accrual Accounting

Accrual accounting is used by most public companies. It reports revenue as income when it's earned rather than when the company receives payment. Expenses are reported
when incurred, even though no cash payments have been made.
For example, if a company records a sale, the revenue is recognized on the income statement, but the company may not receive cash until a later date. From an accounting
standpoint, the company would be earning a profit and pay income taxes on it. However, no cash would have been exchanged.
The transaction would likely involve an outflow of cash initially, since it costs money for the company to buy inventory and manufacture the product to be sold. It's common for
businesses to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be an accounts receivable with no impact on cash until collected.

Cash Accounting

Cash accounting is an accounting method in which payment receipts are recorded in the period they are received, and expenses are recorded in the period in which they are
paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.
A company's profit is shown as net income on the income statement. Net income is the bottom line for the company. However, because of accrual accounting, net income
doesn't necessarily mean that all receivables were collected from customers.
From an accounting standpoint, the company might be profitable, but if receivables become past due or uncollected, the company could run into financial problems. Even
profitable companies can fail to adequately manage their cash flow, which is why a cash flow statement is a critical tool for analysts and investors.

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V. FINANCIAL ANALYSIS AND REPORTING
What Is Cash Flow Analysis?
Cash flow analysis is the process of examining the amount of cash that flows into a company and the amount of cash that flows out to determine the net amount of cash that is held.
Once it's known whether cash flow is positive or negative, company management can look for opportunities to alter it to improve the outlook for the business.

What Are the 3 Types of Cash Flows? How Do You Calculate Cash Flow Analysis?
The three types of cash flow are cash flows from operations, cash flows from A basic way to calculate cash flow is to sum up figures for current assets and
investing, and cash flows from financing. subtract from that total current liabilities. Once you have a cash flow figure,
you can use it to calculate various ratios (e.g., operating cash flow/net sales)
for a more in-depth cash flow analysis.

The Bottom Line

If a company's cash flow is continually positive, it's a strong indication that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and
weather hard times.

Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and monitors the use of
cash for capital expenditures.

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V. FINANCIAL ANALYSIS AND REPORTING
D. Financial Modeling
What is Financial Modeling?
Financial Modeling is the process of creating a summary of a company’s expenses and earning in the form of a spreadsheet that can be used to calculate the impact of a future event
of decision.
A financial model has many uses for company executives. Financial analysts most often use it to analyze and anticipate how a company’s stock performance might be affected by
future events or executive decisions.

Example of Financial Modeling

The best financial models provide users with a set of basic assumptions. For example, one
commonly forecasted line item is sales growth. Sales growth is recorded as the increase (or
decrease) in gross sales in the most recent quarter compared to the previous quarter. These
are the only two inputs a financial model needs to calculate sales growth.
The financial modeler creates one cell for the prior year's sales, cell A, and one cell for the
current year's sales, cell B. The third cell, cell C, is used for a formula that divides the difference
between cells A and B by cell A. This is the growth formula. Cell C, the formula, is hard-coded
into the model. Cells A and B are input cells that can be changed by
the user.
In this case, the purpose of the model is to estimate sales growth if a certain action is taken or a
possible event occurs.
Of course, this is just one real-world example of financial modeling. Ultimately, a stock analyst is
interested in potential growth. Any factor that affects or might affect that growth can be
modeled.
Also, comparisons among companies are important in concluding a stock purchase. Multiple
models help an investor decide among various competitors in an industry.

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V. FINANCIAL ANALYSIS AND REPORTING

What Is Financial Modeling Used For?

What Information Should Be Included in a Financial Model?
A financial model is used for decision-making and financial analysis by people
To create a useful model that's easy to understand, you should include
inside and outside of companies. Some of the reasons a firm might create a
sections on assumptions and drivers, an income statement, a balance sheet, a
financial model include the need to raise capital, grow the business organically,
cash flow statement, supporting schedules, valuations, sensitivity analysis,
sell or divest business units, allocate capital, budget, forecast, or value a
charts, and graphs.
business.

How Is a Financial Model Validated?

What Types of Businesses Use Financial Modeling? Errors in financial modeling can cause expensive mistakes. For this reason, a
Professionals in a variety of businesses rely on financial modeling. Here are financial model may be sent to an outside party to validate the information it
just a few examples: Bankers use it in sales and trading, equity research, and contains. Banks and other financial institutions, project promoters,
both commercial and investment banking, public accountants use it for due corporations seeking funds, equity houses, and others may request model
diligence and valuations, and institutions apply financial models in private validation to reassure the end-user that the calculations and assumptions
equity, portfolio management, and research. within the model are correct and that the results produced by the model are
reliable.

The Bottom Line

Financial modeling is a set of numerical techniques used to forecast a company's future growth. Based on the information in a company's income statement, balance sheet, and
estimates of future economic conditions, analysts can create sophisticated projections of an investment's future performance.

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V. FINANCIAL ANALYSIS AND REPORTING
E. Financial Reporting and Disclosure
What is Financial Reporting? Definition, Types and Importance
Financial reporting is a crucial process for companies and investors, as it provides key information that shows financial performance over time. Government and private regulatory
institutions also monitor financial reporting to ensure fair trade, compensation and financial activities. Typically, you record financial activities on several key statements, which others
can use for review. In this article, we discuss what financial reporting is, why it's important, what financial statements are common and who uses and monitors these documents.

What is financial reporting?

Financial reporting is the process of documenting and communicating financial activities and performance over specific time periods, typically on a quarterly or yearly basis.
Companies use financial reports to organize accounting data and report on current financial status. Financial reports are also essential in the projections of future profitability,
industry position and growth, and many financial reports are available for public review. There are several primary statements to use when reporting financial data, and the
information you include in these documents fulfills several key objectives of financial reporting:

Tracking Evaluating assets Analyzing Measuring

cash flow and liabilities shareholder equity profitability

Importance of financial reporting

Monitors income and expense - Tracking income and expenses is another important process that financial reporting supports. Monitoring financial
documentation is necessary for effective debt management and budget allocation and provides insight into key areas of spending. Monitoring income and expenses
ensures companies track debts regularly to remain transparent in competitive markets. Therefore, financial reporting gives you documentation methods to track
current liabilities and assets. Accurate financial documentation is also necessary to measure important metrics, including debt-to-asset ratios, which investors use to
evaluate how effectively companies pay down debt and generate revenue.

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V. FINANCIAL ANALYSIS AND REPORTING
Ensures Compliance - Financial reporting encompasses specific processes that companies follow to comply with mandatory accounting regulations. Each
document you use to evaluate financial activities comes under the review of several financial regulatory institutions. This makes accurate documentation crucial to
ensure all financial reports comply with tax regulations and financial reporting criteria. Accurate financial reporting also simplifies tax, valuation and auditing
processes, reducing the time to complete necessary financial obligations and further validating financial compliance.

Communicates Essential Data - Key shareholders, executives, investors and professionals all rely on current financial data to make decisions, plan budgets and
monitor performance. The importance of open communication and transparency is necessary to support funding, investment opportunities and financial review.
Many investors and creditors rely on the information companies communicate in financial documentation to assess profitability, risk and future returns.

Supports Financial Analysis and Decision-Making - Financial reporting is crucial for performing analysis to support business decisions. Using financial
statements improves accountability and supports the analysis of critical financial data. Documents like the income statement and balance sheet provide real-time
information that you can use to track historical performance, identify key areas of spending and create forecasts more accurately. With better-developed data
models and detailed financial analysis, reporting helps businesses evaluate current activities and make decisions for future growth.

Who Regulates Financial Reporting

Regulatory entities, including the SEC, IRS and Financial Accounting Standards Board (FASB) establish standards that outline protocols and required practices relating to
financial activities and documentation. The SEC is responsible for overseeing capital markets and sets forth regulations for investment activities in stock markets.
Depending on the type of business, capital market activity and funding, the SEC requires public companies and market participants to disclose financial information
regularly for investors to review.
The FASB is a private regulatory entity that establishes and monitors the Generally Accepted Accounting Principles (GAAP). The GAAP provides a framework for financial
processes that supports efficiency in reporting and ensures regulatory compliance with other standards.

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Banking and
Financial Institutions
VI. BANKING AND FINANCIAL INSTITUTIONS
A. Banking Regulation

What is Bank Regulation?

Banking regulation imposes various requirements, restrictions, and guidelines on banks. Although legal requirements differ from country to country, banking
regulations pursue similar objectives, such as reducing systemic risk by, for example, creating unfavorable trading conditions for banks or preventing bank
fraud.

What is the main purpose of bank regulation?

Bank regulation is the process of setting and enforcing rules for banks and other financial institutions. The main purpose of bank regulation is to protect consumers, ensure the
stability of the financial system, and prevent financial crime.
Banking regulations are also designed to promote safe and sound banking practices by ensuring banks have enough capital to cover their risks, preventing them from
engaging in unfair or deceptive practices, and ensuring that consumers have access to information about their rights and options.
For example, regulations may ban certain types of fees or limit the amount of interest that banks can charge on loans. By promoting competition, bank regulation helps to keep
prices low for consumers and spurs innovation in the banking sector.
Furthermore, bank regulators also supervise the activities of banks and enforce compliance with regulations. By doing so, bank regulators help to ensure that banks operate in
a safe and sound manner and that consumers are protected from fraud and abuse.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Who regulates banks? Why is regulation important?

Being a heavily regulated industry worldwide, bank regulation varies from Banking is an essential part of the global economy, and bank regulation is a
country to country, but all countries have some form of regulation in place to critical tool for ensuring the stability and efficiency of the banking sector. Bank
ensure the stability of their banking systems. Typically, there is more than one regulation protects consumers by ensuring that banks maintain adequate
regulatory agency per country. capital levels, disclose risks inherent in their business activities, and follow
sound risk management practices.
Regulations typically come from both government agencies and central banks.
In the United States, bank regulation is primarily the responsibility of four federal Regulation is also important because it promotes financial stability by limiting
agencies: the Office of the Comptroller of the Currency, the Federal Deposit the ability of banks to engage in activities that could lead to a systemic crisis. In
Insurance Corporation insuring deposits, the Federal Reserve System addition, bank regulation helps to ensure that banks can serve as reliable
regulating state-chartered banks, and the Consumer Financial Protection sources of credit for businesses and households. Overall, bank regulation plays
Bureau. a vital role in ensuring the safety and soundness of the banking sector.

Other countries have similar agencies that oversee their banking systems. For
example, in Canada bank regulation is handled by the Office of the
Superintendent of Financial Institutions, while in the United Kingdom it is the role
of the Prudential Regulation Authority and the Financial Conduct Authority, a
division of the Bank of England. In Germany, the responsibility falls to BaFin.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Why are banks highly regulated? What are some examples of banking regulations?

Banks are highly regulated for a variety of reasons. First and foremost, banks Bank regulation is the process by which a government or other institution
deal with large amounts of money, which makes them a prime target for crime. supervises the activities of banks.
In addition, banks play a crucial role in the economy, and their failure could have
devastating consequences. Common bank regulations include reserve requirements, which dictate how
much money banks must keep on hand; capital requirements, which dictate
Additionally, banks act as intermediaries between borrowers and lenders, how much money banks can lend; and liquidity requirements, which dictate
helping to allocate capital to its most productive uses. Without bank regulation, how easily banks can convert their assets into cash. In addition, bank regulators
banks would be free to engage in risky behavior that could lead to bank failures often impose restrictions on bank activities, such as limitations on lending to
and a financial crisis. To prevent this, regulators must monitor banks’ activities related parties or investments in certain types of assets.
to ensure that they are sound and stable. Some of the things that are monitored
include the bank's financial stability, its compliance with anti-money laundering By ensuring that banks follow these and other regulations, bank regulators help
laws, and its lending practices. to protect depositors and maintain the stability of the banking system.

By regulating banks, authorities can help to prevent bank failures and protect
the economy.

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VI. BANKING AND FINANCIAL INSTITUTIONS
B. Risk Management in Banks

Risk management is an essential piece of banking operations. To demonstrate why, this guide will provide an overview of risk management in banking, discuss
specifically the types of risk management in commercial banks, detail risk management practices in banks, go over the process of risk management in banks,
and explain how to use enterprise risk management software for banks.

Risk Management in Banking Overview

Just like any business, banks face a myriad of risks. However, given how important the banking sector is and the government’s stake in keeping risks in check, the risks weigh heavier
than they do on most other industries. There are various types of risks that a bank may face and is important to understand how banks manage risk.

Types of Risk Management in Commercial Banks

Banking Risk Type #1: Credit Risk

Banks often lend out money. The chance that a loan recipient does not pay back that money can be measured as credit risk. This can result in an interruption of
cash flows, increased costs for collection, and more.

Banking Risk Type #2: Market Risk

This refers to the risk of an investment decreasing in value as a result of market factors (such as a recession). Sometimes this is referred to as “systematic risk.”

Banking Risk Type #3: Operational Risk

These are potential sources of losses that result from any sort of operational event; e.g. poorly-trained employees, a technological breakdown, or theft of
information.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Banking Risk Type #4: Reputational Risk

Let’s say a news story breaks about a bank having corruption in leadership. This may damage their customer relationships, cause a drop in share price, give
competitors an advantage, and more.

Banking Risk Type #5: Liquidity Risk

With any financial institution, there is always the risk that they are unable to pay back its liabilities in a timely manner because of unexpected claims or an
obligation to sell long-term assets at an undervalued price.

Risk Management Practices in Banks

Banks must prioritize risk management in order to stay on top (and ahead) of the various critical risks they face every day. Risk management in banks also goes
far beyond compliance, as banks must be on the lookout for strategic, operational, price, liquidity, and reputational risk. Staying on top of these risks demands a
powerful and flexible bank risk management program.

The number of individual regulatory changes that financial institutions and banks must track on a global scale has more than tripled since 2011. There are millions of proposed rules
and enforcement actions across multiple jurisdictions that organizations must follow. This requires regulatory change management to be a prominent practice within any bank’s risk
management program.
Regulatory change management can be described in the simplest terms as “managing regulatory, policy and or procedures applicable to your organization for your industry.”
Regulatory compliance can be a burdensome and costly task for financial institutions, so it is critical that organizations have the appropriate processes in place to identify changes to
existing regulations as well as new regulations that impact the ability of the organization to achieve objectives. It is equally important that organizations are informed of any potential
consequences or fines should they not meet the regulation.
Once a regulatory change has been made, it is essential for organizations to assess how they will implement the respective changes to their current policies, processes, and training
sessions. As changes are implemented, organizations should begin tracking compliance with the updated regulation going forward.

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VI. BANKING AND FINANCIAL INSTITUTIONS
Bonus Material: Financial Risk Assessment Template

Risk Management Process in Banking Industry

Having a clear, formalized risk management plan brings additional visibility into consideration. Standardizing risk management makes identifying systemic issues that affect the
entire bank simple. The ideal risk management plan for a bank serves as a roadmap for improving performance by revealing key dependencies and control effectiveness. With
proper implementation of a plan, banks ultimately should be able to better allocate time and resources towards what matters most.

Size, brand, market share, and many more characteristics all will prescribe a bank’s risk management program. That being said, all plans should be standardized, meaningful, and
actionable. The same process for defining the steps within your risk management plan can be applied across the board:

Risk Identification in Banks Assessment & Analysis Methodology

Banks must create a risk identification process across the organization in order to Assessing risk in a uniform fashion is the hallmark of a healthy risk management
develop a meaningful risk management program. Note that it’s not enough to simply system. It’s important to be able to collect and analyze data to determine the
identify what happened; the most effective risk identification techniques focus on root likelihood of any given risk and subsequently prioritize remediation efforts.
cause. This allows for identification of systemic issues so that controls can be
designed to eliminate the cost and time of duplicate effort.

Mitigate Monitor

Monitoring risk should be an ongoing and proactive process. It involves testing, metric
Risk mitigation is defined as the process of reducing risk exposure and minimizing the
collection, and incidents remediation to certify that the controls are effective. It also
likelihood of an incident. Top risks and concerns need to be continually addressed to
allows for addressing emerging trends to determine whether or not progress is being
ensure the bank is fully protected.
made on various initiatives.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Connect Report

Creating relationships between risks, business units,

Presenting information about how the risk
mitigation activities, and more paints a cohesive
management program is going – in a clear and
picture of the bank. This allows for recognition of engaging way – demonstrates effectiveness and can
upstream and downstream dependencies, rally the support of various stakeholders at the bank.
identification of systemic risks, and design of Develop a risk report that centralizes information and
centralized controls. Eliminating silos eliminates the gives a dynamic view of the bank’s risk profile.
chances of missing critical pieces of information.

Risk Management in Banking Conclusion

Whether you are managing risks defined by the OCC, CFPB, FDIC, or any of the other many regulatory agencies, it’s important to think of risk
management in banking as helping you accomplish more than just compliance. LogicManager’s solutions are designed to meet the needs of your unique
and dynamic industry.

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VI. BANKING AND FINANCIAL INSTITUTIONS
C. Financial Institutions and Markets
Financial institutions are organizations like banks, credit unions, and investment companies that help people manage and grow their money. Financial markets are places where
people can buy and sell things like stocks, bonds, and commodities, in order to make investments and trade with each other.

What are financial institutions? What are financial markets?

In our world of money and finance, there are special organizations that help us Imagine you want to buy or sell things like stocks, bonds, or other financial
save, invest, and manage our money. These organizations are called financial assets. To do this, you need a place where buyers and sellers can come
institutions. They include banks, credit unions, insurance companies, and together to trade these assets. That place is called a financial market. There
brokerage firms. Financial institutions play a big role in our lives, helping us do are different types of financial markets, such as stock markets, bond markets,
things like save for college, buy a car, or even start a business. and money markets. These markets are essential for the smooth functioning
of our economy and play a key role in helping businesses and governments
raise money.

Why do we need financial institutions and markets?

Financial institutions, like banks and credit unions, can be really helpful. They help you manage your money, build your credit, and get more money over time. Here are some ways they
can benefit you:

Imagine two friends, Alex and Jamie. They both work hard and make the same amount of money. But there's a big
difference in how they handle their money. Alex saves money under the mattress, has no bank account, and cashes
their paycheck at a local check-cashing place. Jamie, on the other hand, has a bank account and uses financial
institutions and markets for his own benefit.

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VI. BANKING AND FINANCIAL INSTITUTIONS
Everyday needs Investing Access to loans
Alex always carries cash because they don't have a Both Alex and Jamie want to grow their money, but they In the future, both Alex and Jamie might need to
bank account. This can be risky and inconvenient. have very different approaches. Alex doesn't know much borrow money, maybe for college or to buy a car.
When they need to pay a bill, Alex has to go to the about investing, so they stick to saving money under the Alex will have trouble getting a loan because they
post office or the store to pay in person. Jamie, mattress. Jamie, on the other hand, knows that investing don't have a bank account or a credit history.
however, has a bank account, which makes it easy can help him build wealth faster. Jamie uses financial Jamie, however, has a relationship with a bank and
to pay bills online or with a debit card. Plus, if Jamie institutions and markets to invest in stocks or bonds, which has built a credit history by using a credit card
ever loses his wallet, he can contact the bank to can potentially provide higher returns than just saving responsibly. This makes it easier for Jamie to get a
cancel the card and protect his money. money in a bank account. loan with a good interest rate.

Saving money Safety and protection

Since Alex keeps all their money under the mattress, they Alex's method of keeping money under the mattress is not
don't earn any interest on their savings. This means that if only outdated, but it's also risky. If there's a fire or a burglary,
Alex saves $1,000 for a year, it will still be worth only $1,000. Alex could lose all their savings. Jamie's money, on the
Jamie, however, has a savings account at a bank. This other hand, is protected by the bank's security measures
account earns interest, so if Jamie saves $1,000 for a year, and federal insurance. Even if the bank gets robbed or if the
he might earn $30 in interest, making the total $1,030. bank goes out of business, Jamie's money is insured up to
by the Federal Deposit Insurance Corporation (FDIC).

As you can see, financial institutions and markets play a crucial role in our lives and, if you take advantage of them, you can make your money work for you.

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VI. BANKING AND FINANCIAL INSTITUTIONS
How do we use financial institutions and markets?
Let's look at some examples of financial institutions and markets and how they serve different saving and investing needs.

Banks: Banks are a popular choice for people who want to save money in a secure place and earn interest. They also provide loans and credit cards to help
people finance large purchases, like homes and cars. Banks may also offer investment products and services, such as stocks and mutual funds. In reality, your
bank might be a one-stop shop, where you can take care of all your financial needs.

Lenders: Lenders are institutions that lend money to people and businesses. While most banks and credit unions do this, there are some companies who only
lend money and do not provide any other services, like checking or savings account. They charge interest on the borrowed amount, which is their main source of
income.

Credit unions: Credit unions are similar to banks, but they are member-owned and you typically have to qualify to become a member. For example, there are
teacher credit unions, or town credit unions (you have to live in a certain town to be a member). Credit unions usually offer better interest rates on savings and
lower interest rates on loans. They also provide a range of financial services, just like banks.

Brokerage firms and investment companies: These companies help people invest their money in stocks, bonds, and other financial assets. They often
charge fees or commissions for their services. For example, you might open an account with a brokerage firm to invest in a stock or mutual fund.

Insurance companies: Insurance companies provide protection against financial losses due to accidents, natural disasters, and other unexpected events.
They collect premiums from policyholders and use the money to pay out claims when needed. For example, you might buy homeowners insurance to protect
your house from damage due to a fire.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Financial advisers: Some financial institutions, like financial advisers and wealth managers, provide advice to help people make informed decisions about
saving, investing, and managing their money. They may charge fees for their services, or earn commissions based on the products they recommend.

Financial markets: Financial markets are where financial trades happen, but most people don't actually go there to trade stocks, bonds, or other securities.
Instead, they rely on financial institutions, like banks or investment firms, to act on their behalf. So even though you might buy stocks or invest in a mutual fund,
you're not actually the one making the trades—the financial institution is doing that work for you.

Stock markets: Stock markets are places where people can invest in shares of companies, like Apple or Amazon. They allow investors to buy and sell stocks,
which represent ownership in the company, and potentially earn profits as the company grows.

Bond markets: Bond markets are where people can invest in bonds, which are loans made to companies or governments. Investors who buy bonds receive
regular interest payments and get their principal amount back when the bond matures.

Money markets: Money markets are a type of financial market where people can invest in short-term debt securities, like Treasury bills and certificates of
deposit.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Conclusion
Understanding financial institutions and markets is essential for making smart decisions about saving and investing your money. By exploring the different
types and functions of these organizations, you can identify the best options for your needs and preferences. Whether you're saving for a rainy day,
investing in your future, or borrowing money for a big purchase, financial institutions and markets are there to help you achieve your financial goals.

D. Bank Operations and Management

Banking Operations and Management

Banking system is a crucial component of the global economy accounting for trillions in assets worldwide. Banks are just one part of the world of financial
institutions, standing alongside investment banks, insurance companies, finance companies, investment managers and other companies that profit from the
creation and flow of money. As financial intermediaries, banks stand between depositors who supply capital and borrowers who demand capital. Given the
importance in economy and individual wealth that rests on banks, it is also among the most stringently regulated businesses in the world.

Basic Functions:

Accept Deposits
or Make Loans

At the fundamental level banks accept deposits from customers, raise capital from investors or lenders and then use that money to make loans, buy securities and
provide other financial services to customers. These loans are then used by individuals and organizations to expand their operations, which in turn leads to more
deposited funds that make their way to banks.

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VI. BANKING AND FINANCIAL INSTITUTIONS

Provide Safety

Banks also provide security and convenience to their customers. At inception, part of the primary purpose of banks was to offer customers security for their money. This was
back in a time when an individual's wealth consisted of actual gold and silver coins, but to a large extent this function is still relevant. With banks, consumers no longer need to
keep large amounts of currency on hand; transactions can be treated with checks, debit cards or credit cards, instead. Many banks maintain vaults and rent out space to
customers, in the form of safe deposit boxes with subsidiary services.

Act as
Payment Agents

Banks also serve as payment agents within a country and between nations. Not only does banks issue debit cards that allow account holders to pay for goods with the swipe
of a card, they can also arrange wire transfers with other institutions. Banks underwrite financial transactions by lending their reputation and credibility to the transaction in the
form of banking instruments such as checks, pay orders, demand draft etc. As payment agents, banks make commercial transactions much more convenient.

Role of Banks in an Economy:

Settle Payments

Every day there are millions of financial transactions through banking channel, some conducted with paper currency, but countless done with checks, wire transfers and
various types of electronic payments. Banks play a valuable role in settling these payments, ensuring that proper accounts are credited or debited, in the proper amounts and
with relatively little delay.

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VI. BANKING AND FINANCIAL INSTITUTIONS
Credit
Intermediation
Banks play a major role as financial intermediaries. Banks collect money from depositors, in essence borrowing the money, and then concurrently lending it to other
borrowers, generating a chain of debts.

Maturity
Transformation
Maturity transformation is fundamental to what banks do on a daily basis. Many investors are willing to invest on short-term basis, but several projects require long-term
financial commitments. What banks do is borrow short-term, in the form of demand deposits and short-term certificates of deposit, but lend long-term. By doing this, banks
transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the difference in the rates as profit. However, they are also
exposed to the risk that short-term funding costs may rise much faster than they can recoup through lending.

Money Creation

One of the most vital roles of banks is in money creation achieved through fractional reserve banking. In this system only a fraction of bank deposits are backed by actual
cash-on-hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties.

Role of Central Bank

Primary Functions: include issue of notes, regulation and supervision of the financial system, bankers’ bank, lender of the last resort, banker to Government, and conduct of
monetary policy.
Secondary functions: include the agency functions like management of public debt, management of foreign exchange, etc.
Other functions like advising the government on policy matters and maintaining close relationships with international financial institutions. The non-traditional or promotional functions,
performed by the State Bank include development of financial framework, institutionalization of savings and investment, also provision of training facilities to bankers, and provision of
credit to priority sectors.

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Fundamentals of
Corporate Finance
VII. FUNDAMENTALS OF CORPORATE FINANCE
A. Capital Budgeting
What is Capital Budgeting?
Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything, including acquiring land or purchasing fixed
assets like a new truck or machinery. Companies use different metrics to track the performance of a potential project, and there are various methods to capital budgeting.

Understanding Capital Budgeting

Every year, companies often communicate between departments and rely on financial leadership to help
prepare annual or long-term budgets. These budgets are often operational, outlining how the company’s
revenue and expenses will shape up over the subsequent 12 months.

However, another aspect to this financial plan is capital budgeting. Capital budgeting is the long-term financial
plan for larger financial outlays.

Capital budgeting relies on many of the same fundamental practices as any other form of budgeting. However,
there are several unique challenges to capital budgeting. First, capital budgets are often exclusively cost
centers; they do not incur revenue during the project and must be funded from an outside source, such as
revenue from a different department. Second, due to the long-term nature of capital budgets, there are more
risks, uncertainty, and things that can go wrong.

Capital budgeting is often prepared for long-term endeavors, then reassessed as the project or undertaking is
under way. Companies will often periodically reforecast their capital budget as the project moves along. The
importance in a capital budget is to proactively plan ahead for large cash outflows that, once they start, should
not stop unless the company is willing to face major potential project delay costs or losses.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Why Do Businesses Need Capital Budgeting?

Capital budgeting is important because it Companies are often in a position where capital Businesses (aside from nonprofits) exist
creates accountability and measurability. is limited and decisions are mutually exclusive. to earn profits.

Any business that seeks to invest its resources Management usually must make decisions on The capital budgeting process is a measurable
in a project without understanding the risks and where to allocate resources, capital, and labor way for businesses to determine the long-term
returns involved would be held as irresponsible hours. Capital budgeting is important in this economic and financial profitability of any
by its owners or shareholders. Furthermore, if a process, as it outlines the expectations for a investment project. While it may be easier for a
business has no way of measuring the project. These expectations can be compared company to forecast what sales may be over
effectiveness of its investment decisions, against other projects to decide which one(s) is the next 12 months, it may be more di icult to
chances are the business would have little most suitable. assess how a five-year, $1 billion manufacturing
chance of surviving in the competitive headquarters renovation will play out. Therefore,
marketplace. businesses need capital budgeting to assess
risks, plan ahead, and predict challenges before
they occur.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Methods Used in Capital Budgeting
There is no single method of capital budgeting; in fact, companies may find it helpful to prepare a single capital budget using the variety of methods discussed below. This way, the
company can identify gaps in one analysis or consider implications across methods that it would not have otherwise thought about.

Discounted Cash Flow Analysis

Because a capital budget will often span many periods and potentially many years, companies often use discounted cash flow techniques to
assess not only cash flow timing but also implications of the dollar. As time passes, currencies often become devalued. A central concept in
economics facing inflation is that a dollar today is worth more than a dollar tomorrow, as a dollar today can be used to generate revenue or
income tomorrow.

Discounted cash flow also incorporates the inflows and outflows of a project. Most often, companies may incur an initial cash outlay for a project
(a one-time outflow). Other times, there may be a series of outflows that represent periodic project payments. In either case, companies may
strive to calculate a target discount rate or specific net cash flow figure at the end of a project.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Methods Used in Capital Budgeting

Payback Analysis Throughput Analysis

Instead of strictly analyzing dollars and returns, payback methods of capital A dramatically di erent approach to capital budgeting is methods that involve
budgeting plan around the timing of when certain benchmarks are achieved. For throughput analysis. Throughput methods often analyze revenue and expenses
some companies, they want to track when the company breaks even (or has across an entire organization, not just for specific projects. Throughput analysis
paid for itself). For others, they’re more interested in the timing of when a capital through cost accounting can also be used for operational or noncapital
endeavor earns a certain amount of profit. budgeting. Throughput methods entail taking the revenue of a company and
subtracting variable costs. This method results in analyzing how much profit is
For payback methods, capital budgeting entails needing to be especially careful earned from each sale that can be attributable to fixed costs. Once a company
in forecasting cash flows. Any deviation in an estimate from one year to the next has paid for all fixed costs, any throughput is kept by the entity as equity.
may substantially influence when a company may hit a payback metric, so this
method requires slightly more care on timing. In addition, the payback method Companies may be seeking to not only make a certain amount of profit but also
and discounted cash flow analysis method may be combined if a company want to have a target amount of capital available after variable costs. These
wants to combine capital budget methods. funds can be swept to cover operational expenses, and management may have
a target of what capital budget endeavors must contribute back to operations.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PB), internal
rate of return (IRR), and net present value (NPV) methods are the most common approaches to project selection.

Although an ideal capital budgeting solution is such that all three metrics will
indicate the same decision, these approaches will often produce contradictory
results. Depending on management’s preferences and selection criteria, more
emphasis will be put on one approach over another. Nonetheless, there are
common advantages and disadvantages associated with these widely used
valuation methods.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

Payback Period

The payback period calculates the length of Another major advantage of using the Such an error violates one of the fundamental
time required to recoup the original payback period is that it is easy to calculate principles of finance. Luckily, this problem can
investment. Payback periods are typically once the cash flow forecasts have been easily be amended by implementing a
used when liquidity presents a major concern. established. There are drawbacks to using the discounted payback period model. Basically,
If a company only has a limited amount of payback metric to determine capital the discounted payback period factors in
funds, it might be able to only undertake one budgeting decisions. First, the payback period TVM and allows one to determine how long it
major project at a time. Therefore, does not account for the time value of money takes for the investment to be recovered on a
management will heavily focus on recovering (TVM). Simply calculating the payback discounted cash f low basis.
their initial investment in order to undertake provides a metric that places the same
subsequent projects. emphasis on payments received in year one
and year two.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

A. Payback Period

Another drawback is that both payback There are other drawbacks to the payback Since the payback period does not reflect the
periods and discounted payback periods method that include the possibility that cash added value of a capital budgeting decision, it
ignore the cash flows that occur toward the investments might be needed at different is usually considered the least relevant
end of a project’s life, such as the salvage stages of the project. Also, the life of the asset valuation approach. However, if liquidity is a
value. Thus, the payback is not a direct that was purchased should be considered. If vital consideration, then payback periods are
measure of profitability. the asset’s life does not extend much beyond of major importance.
the payback period, then there might not be
enough time to generate profits from the
project.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

Internal Rate of Return

The internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with
the discount rate—if the discount rate increases, then future cash flows become more uncertain and thus become worth less in value—the benchmark for IRR calculations is the
actual rate used by the firm to discount after-tax cash flows.

An IRR that is higher than the weighted average cost of Despite the IRR being easy to compute with either a financial calculator or
capital suggests that the capital project is a profitable software packages, there are some downfalls to using this metric. Similar to the
endeavor and vice versa. The IRR rule is as follows: payback method, the IRR does not give a true sense of the value that a project will
add to a firm—it simply provides a benchmark figure for what projects should be
accepted based on the firm’s cost of capital.

1 IRR > Cost of Capital = Accept Project

The internal rate of return does not allow
for an appropriate comparison of mutually
exclusive projects; therefore, managers
2 IRR < Cost of Capital = Reject Project
might be able to determine that project A
and project B are both beneficial to the firm,
but they would not be able to decide which
The primary advantage of implementing the internal rate of return as a decision-making tool one is better if only one may be accepted.
is that it provides a benchmark figure for every project that can be assessed in reference to
a company’s capital structure. The IRR will usually produce the same types of decisions as
net present value models and allows firms to compare projects based on returns on
invested capital.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

Internal Rate of Return

Another error arising with the use of IRR analysis presents itself when the cash flow streams from a
project are unconventional, meaning that there are additional cash outflows following the initial
investment.
12.7% and 787.3%
Unconventional cash flows are common in capital budgeting, since many projects require future
capital outlays for maintenance and repairs. In such a scenario, an IRR might not exist, or there
might be multiple internal rates of return. In the example below, two IRRs exist:

The IRR is a useful valuation measure when analyzing individual capital budgeting projects,
not those that are mutually exclusive. It provides a better valuation alternative to the
payback method, yet falls short on several key requirements.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

Net Present Value

The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems. Discounting the after-tax cash flows by the weighted average
cost of capital allows managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison
with alternatives.

Example

The NVP Rule:

Project A Project B
VS
The NPV rule states that all projects with a
$137,236 $1,317,856
positive net present value should be accepted
while those that are negative should be rejected. If
funds are limited and all positive NPV projects
cannot be initiated, then those with the high
discounted value should be accepted. Assuming a discount rate of 10%, project A and project B have respective NPVs
of $137,236 and $1,317,856. These results signal that both capital budgeting
projects would increase the value of the firm, but if the company only has $1
million to invest at the moment, then project B is superior.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Metrics Used in Capital Budgeting

Net Present Value

Advantage

Some of the major advantages of the NPV approach include its overall usefulness and that the NPV provides a direct measure of added profitability. It allows one to
compare multiple mutually exclusive projects simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can typically
signal any overwhelming potential future concerns.

Criticism

Although the NPV approach is subject to fair criticism that the value-added figure does not factor in the overall magnitude of the project, the profitability index (PI), a
metric derived from discounted cash flow calculations, can easily fix this concern.

Calculation

The profitability index (PI) is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 indicates that the NPV is
positive, while a PI of less than 1 indicates a negative NPV. Weighted average cost of capital (WACC) may be hard to calculate, but it’s a solid way to measure
investment quality.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

What are Common Types of Budgets? How are Capital Budgets Different
Budgets can be prepared as incremental, activity-based, From Operational Budgets?
value proposition, or zero-based. While some types like Capital budgets are geared more toward the long term
zero-based start a budget from scratch, incremental or and often span multiple years. Meanwhile, operational
activity-based may spin off from a prior-year budget to budgets are often set for one-year periods defined by
have an existing baseline. Capital budgeting may be revenue and expenses. Capital budgets often cover
performed using any of the methods above, though zero- different types of activities such as redevelopments or
based budgets are most appropriate for new endeavors. 1 investments, whereas operational budgets track the day-
2 to-day activity of a business.

Are Companies Required to Prepare Capital The Bottom Line

3
Budgets? 4 A capital budget is a long-term plan that outlines the
Not necessarily. Capital budgets (like all other budgets) financial demands of an investment, development, or major
are internal documents used for planning. These reports purchase. As opposed to an operational budget that tracks
are not required to be disclosed to the public, and they revenue and expenses, a capital budget must be prepared
are mainly used to support management’s strategic to analyze whether or not the long-term endeavor will be
decision making. Though companies are not required to profitable. Capital budgets are often scrutinized using NPV,
prepare capital budgets, they are an integral part in IRR, and payback periods to make sure the return meets
planning and the long-term success of companies. management’s expectations.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
B. Cost of Capital

What is Cost of Capital?

Cost of capital is a calculation of the minimum return that would be necessary in order
to justify undertaking a capital budgeting project, such as building a new factory. It is
an evaluation of whether a projected decision can be justified by its cost. Many
companies use a combination of debt and equity to finance business expansion. For
such companies, the overall cost of capital is derived from the weighted average cost
of all capital sources. This is known as the weighted average cost of capital (WACC).
Understanding Cost of Capital

The cost of capital is key information used to determine a project's hurdle rate. A
company embarking on a major project must know how much money the project
will have to generate in order to o set the cost of undertaking it and then continue
to generate profits for the company.

The company may consider the capital cost using debt-levered cost of capital.
Alternatively, they may review the project costs without debt-unlevered. Cost of
capital, from the perspective of an investor, is an assessment of the return that
can be expected from the acquisition of stock shares or any other investment.
This is an estimate and might include best- and worst-case scenarios. An
investor might look at the volatility (beta) of a company’s financial results to
determine whether a stock’s cost is justified by its potential return.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Weighted Average Cost of Capital (WACC)

A firm’s cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and
equity capital. Each category of the firm’s capital is weighted proportionately to arrive at a blended rate, and the formula considers every
type of debt and equity on the company’s balance sheet, including common and preferred stock, bonds, and other forms of debt.

The Cost of Debt The Cost of Equity

The cost of capital becomes a factor in deciding which financing track to follow: debt, The cost of equity is more complicated since the rate of return demanded by equity
equity, or a combination of the two. Early-stage companies rarely have sizable assets investors is not as clearly defined as it is by lenders. The cost of equity is
to pledge as collateral for loans, so equity financing becomes the default mode of approximated by the capital asset pricing model as follows:
funding. Less-established companies with limited operating histories will pay a higher
cost for capital than older companies with solid track records.
CAPM (Cost of equity) = Rf + b (Rm – Rf)
The cost of debt is merely the interest rate paid by the company on its debt. However, where:
since interest expense is tax-deductible, the debt is calculated on an after tax basis as Rf = risk-free rate of return
follows: Rm = market rate of return

Cost of debt = ____________________

Interest expense x (1 - T)
Total debt x (1−𝑇) Beta is used in the CAPM formula to estimate risk, and the formula would require
where: a public company's own stock beta. For private companies, a beta is estimated
Interest expense – Int. paid on the firm’s current debt based on the average beta among a group of similar public companies. Analysts
T = the company’s marginal tax rate may refine this beta by calculating it on an after-tax basis. The assumption is that
The cost of debt can also be estimated by adding a credit spread to the risk-free a private firm's beta will become the same as the industry average beta.
rate and multiplying the result by (1 – T).

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VII. FUNDAMENTALS OF CORPORATE FINANCE

The firm’s overall cost of capital is based on

the weighted average of these costs. For
Cost of Debt + Cost
example, consider an enterprise with a
of Equity = Overall
capital structure consisting of 70% equity
Cost of Capital
and 30% debt; its cost of equity is 10% and
the after-tax cost of debt is 7%.

Therefore, its WACC would be:

Companies strive to attain the optimal financing mix based on the cost of capital
(0.7×10%)+(0.3×7%)=9.1%(0.7×10%)+(0.3×7%)=9.1% for various funding sources.

Debt financing is more tax-e icient than equity financing since interest expenses
This is the cost of capital that would be used to discount future cash flows from are tax-deductible and dividends on common shares are paid with after-tax
potential projects and other opportunities to estimate their net present value (NPV) dollars. However, too much debt can result in dangerously high leverage levels,
and ability to generate value. forcing the company to pay higher interest rates to o set the higher default risk.

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Cost of Capital vs Discount Rate

The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. The cost of capital is often calculated by a
company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.
That said, a company's management should challenge its internally generated cost of capital numbers, as they may be so conservative as to deter
investment. The cost of capital may also differ based on the type of project or initiative; a highly innovative but risky initiative should carry a higher cost
of capital than a project to update essential equipment or software with proven performance.

Importance of Cost of Capital

Businesses and financial analysts use the cost of capital to determine if funds Conversely, an investment whose returns are equal to or lower than the cost
are being invested e ectively. If the return on an investment is greater than the of capital indicates that the money is not being spent wisely.
cost of capital, that investment will end up being a net benefit to the The cost of capital can determine a company's valuation. Since a company
company's balance sheets. with a high cost of capital can expect lower proceeds in the long run, investors
are likely to see less value in owning a share of that company's equity.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Cost of Capital by Industry
Every industry has its own prevailing Why Is Cost of Capital Important?
average cost of capital. The numbers vary
widely. Most businesses strive to grow and expand. There may be many options: expand a factory, buy out a rival, or build a
new, bigger factory. Before the company decides on any of these options, it determines the cost of capital for each
For example, according to a compilation proposed project. This indicates how long it will take for the project to repay what it costs, and how much it will return in
from New York University's Stern School of the future. Such projections are always estimates, of course. However, the company must follow a reasonable
Business, homebuilding has a relatively high methodology to choose between its options.
cost of capital of 9.28%, while the retail
grocery business is much lower, at 5.31%.
What Is the Difference Between the Cost of Capital and the Discount Rate?
According to the Stern School of Business,
the cost of capital is highest among The two terms are often used interchangeably, but there is a di erence. In business, the cost of capital is generally
software Internet companies, paper/forest determined by the accounting department. It is a relatively straightforward calculation of the breakeven point for the
companies, building supply retailers, and project. The management team uses that calculation to determine the discount rate, or hurdle rate, of the project. That is,
semiconductor companies. Those they decide whether the project can deliver enough of a return to not only repay its costs but reward the company's
industries tend to require significant capital shareholders.
investment.

Industries with lower capital costs include

How Do You Calculate the Weighted Average Cost of Capital?
rubber and tire companies, power
companies, real estate developers, and
financial services companies (non-bank and The weighted average cost of capital represents the average cost of the company's capital, weighted according to the
insurance). Such companies may require type of capital and its share on the company balance sheet. This is determined by multiplying the cost of each type of
less equipment or may benefit from very capital by the percentage of that type of capital on the company's balance sheet and adding the products together.
steady cash flows.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
The Bottom Line

The cost of capital measures the cost that a business incurs to finance its operations. It measures the cost of borrowing money from creditors, or raising it from investors through
equity financing, compared to the expected returns on an investment. This metric is important in determining if capital is being deployed effectively.

Key Takeaways:

1 2 3

The cost of capital represents the return a The cost of capital encompasses the cost of A company’s investment decisions for new
company needs to achieve in order to justify both equity and debt, weighted according to projects should always generate a return that
the cost a capital project, such as purchasing the company’s preferred or existing capital exceeds the firm’s cost of the capital used to
new equipment or constructing a new structure. This is known as the weighted finance the project. Otherwise, the project will
building. average cost of capital (WACC) . not generate a return for investors.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
C. Capital Structure
What is Capital Structure?
Capital structure is the particular combination of debt and equity used by a company
to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future
cash flows and profits. Debt comes in the form of bond issues or loans, while equity
may come in the form of common stock, preferred stock, or retained earnings. Short
term debt is also considered to be part of the capital structure.

Dynamics of Debt and Equity

Both debt and equity can be found on the balance sheet. Company assets, also listed
on the balance sheet, are purchased with debt or equity. Capital structure can be a
mixture of a company's long-term debt, short-term debt, common stock, and
preferred stock. A company's proportion of short-term debt versus long-term debt is
considered when analyzing its capital structure.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are.
Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. This risk, however, may be the primary
source of the firm's growth.

Debt Equity

Debt is one of the two main ways a company can raise money in the Equity allows outside investors to take partial ownership of the
capital markets. Companies benefit from debt because of its tax company. Equity is more expensive than debt, especially when interest
advantages; interest payments made as a result of borrowing funds may rates are low. However, unlike debt, equity does not need to be paid
be tax-deductible. Debt also allows a company or business to retain back. This is a benefit to the company in the case of declining earnings.
ownership, unlike equity. Additionally, in times of low interest rates, debt is On the other hand, equity represents a claim by the owner on the future
abundant and easy to access. earnings of the company.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Optimal Capital Structure

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays
for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to
higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity
into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a firm's capital structure by tracking
the D/E ratio and comparing it against the company's industry peers.

Why Do Different Companies Have Different How Do Managers Decide on Capital

Capital Structure? Structure?

Assuming that a company has access to capital (e.g. investors and

Firms in different industries will use capital structures better suited
lenders), they will want to minimize their cost of capital. This can be
to their type of business. Capital-intensive industries like auto
done using a weighted average cost of capital (WACC) calculation.
manufacturing may utilize more debt, while labor-intensive or
To calculate WACC the manager or analyst will multiply the cost of
service-oriented firms like software companies may prioritize equity.
each capital component by its proportional weight.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

How Do Analysts and Investors Use Capital Structure? What Measures Do Analysts and Investors Use to Evaluate Capital
A company with too much debt can be seen as a credit risk. Too much equity, Structure?
however, could mean the company is underutilizing its growth opportunities or In addition to the weighted average cost of capital (WACC), several metrics
paying too much for its cost of capital (as equity tends to be more costly than can be used to estimate the suitability of a company's capital structure.
debt). Unfortunately, there is no magic ratio of debt to equity to use as Leverage ratios are one group of metrics that are used, such as the debt-to-
guidance to achieve real-world optimal capital structure. What defines a equity (D/E) ratio or debt ratio.
healthy blend of debt and equity varies depending on the industry the
company operates in, its stage of development, and can vary over time due to
external changes in interest rates and regulatory environment.

The Bottom Line

Capital structure is the specific mix of debt and equity that a company uses to finance its operations and growth. Debt consists of borrowed money that must be repaid, often with
interest, while equity represents ownership stakes in the company. The debt-to-equity (D/E) ratio is a commonly used measure of a company's capital structure and can provide
insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Key Takeaways:
Capital structure is how a company funds its overall operations and growth.
Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
Equity consists of ownership rights in the company, without the need to pay back any investment.
The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices.

D. Dividend Policy
A dividend policy outlines how a company will distribute its dividends to its shareholders. This policy details specifics about payouts including how often, when, and how much is
distributed. There are many types of dividend police including stable, constant, and residual policies.

Understanding Dividends

Before we jump into looking at divided policies, let’s talk about dividends. Dividends are a distribution of a portion of a company's earnings to its shareholders. A company
can choose to reinvest those earnings into itself to drive future growth, or it can distribute those earnings to whoever owns equity in the company. Dividends are usually
declared by a company's board of directors and are paid out on a per-share basis to all shareholders who own the stock.

The decision to pay dividends is influenced by the company's profitability, cash flow, financial health, and growth prospects. All else being equity, it’s usually best or at least
most attractive to investors if companies pay a consistent, steady amount of dividends on a periodic basis. For example, investors generally prefer knowing they’ll get $1
per share each quarter as opposed to getting a varying amount awarded each quarter. However, some investors may also prefer the potential of getting higher dividends
at the risk of maybe getting lower dividends as well.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Understanding Dividends (cont.)

Dividends usually vary based on the industry, size, and maturity of companies. Mature companies in stable industries may not need as much cash, so they
may be more likely to issue dividends. Growth-oriented companies in capital-intensive sectors like technology or biotechnology may prefer to hold onto their
cash and not issue dividends. In either case, the company needs to have a policy that outlines what it plans to do - we’ll talk about that policy next.

Having a dividend policy in place is important for dividend-paying companies.

How a Dividend Policy Works This is a structure that highlights several key points, including:

Some companies choose to reward their common stock How often dividends are paid out (monthly, quarterly, or annually)
1
shareholders by paying them a dividend. A dividend is paid on a
regular basis and usually represents a portion of the profits that
these companies earn. This gives shareholders a regular stream 2 When they are paid
of income, which is why dividend-paying stocks are a favorite for
some investors.
3 How much to pay shareholders

These decisions are made by a company's management team. It must also decide what, if any, other factors may have to be put in place that would influence dividend payments. An
additional factor to consider includes providing shareholders with the option to take their dividends in cash or allowing them to reinvest them by purchasing additional shares through
a dividend reinvestment program (DRIP).

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Types of Dividend Policies:

Stable Dividend Policy

Residual Dividend Policy
A stable dividend policy is the easiest and most commonly used. The
The residual dividend policy is also highly volatile, but some investors
goal of this policy is to provide shareholders with a steady and
see it as the only acceptable dividend policy. With a residual dividend
predictable dividend payout each year, which is what most investors
policy, the company pays out what dividends remain after the company
seek. Investors receive a dividend regardless of whether earnings are
has paid for capital expenditures (CAPEX) and working capital. This
up or down. The goal is to align the dividend policy with the long-term
approach is volatile, but it makes the most sense in terms of business
growth of the company rather than with quarterly earnings volatility. This
operations. Investors do not want to invest in a company that justifies
approach gives the shareholder more certainty concerning the amount
its increased debt with the need to pay dividends.
and timing of the dividend.

Constant Dividend Policy No Dividend Policy

The primary drawback of the stable dividend policy is that investors may Some companies decide not to pay dividends at all, particularly those in
not see a dividend increase in boom years. Under the constant dividend high-growth industries or early-stage startups reinvesting profits to fuel
policy, a company pays a percentage of its earnings as dividends every expansion. These companies prioritize reinvestment of earnings into
year. In this way, investors experience the full volatility of company earnings. research, development, acquisitions, or debt reduction rather than
If earnings are up, investors get a larger dividend and if earnings are down, distributing dividends. By forgoing dividends, the company aims to
investors may not receive a dividend. The primary drawback to the method accelerate growth and enhance shareholder value through a higher future
is the volatility of earnings and dividends. It is difficult to plan financially when stock price rather than income generation. Note that this type of policy
dividend income is highly volatile. may actually still be documented.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Types of Dividend Policies (cont.)

Hybrid Dividend Policy

A hybrid dividend policy combines elements of the different policies above. For example, a manufacturing company might adopt a hybrid policy by offering a
stable base dividend supplemented by additional payouts based on residual earnings from exceptional periods or one-time gains. This approach allows flexibility
so that investors can expect a baseline amount of dividends but also realize they may be awarded higher dividends if operations go well.

Importance of Dividend Policies

A dividend policy is a financial guide that helps management issue dividends. This clarity is essential because it sets expectations among investors about what
potential income they might get from their investments. For income-oriented investors like retirees or those who are risk-averse, a predictable dividend stream
1 provides assurance and helps them plan their finances like they might want or need. It also attracts a certain segment of investors who prefer stable income over
capital appreciation.

A well-defined dividend policy enhances transparency and credibility in the eyes of investors. A company is not required to issue dividends, and it may choose to stop
2 paying a dividend at any time. By committing to a specific dividend policy, companies demonstrate their financial discipline and intention to not only generate
consistent cash flows for the company but to distribute this cash.

A dividend policy can influence the company’s cost of capital and shareholder value. Consistently paying dividends or increasing dividends over time can enhance the
company's attractiveness to investors. In the long run, this can lower its cost of equity and increase the net proceeds of what it’s able to raise for future share
3 issuances. This is because dividends provide tangible returns to shareholders, making the stock more appealing meaning the company can sell new shares in the
future at higher offerings.

A dividend policy helps set a company's overall corporate strategy. For mature companies in stable industries, a dividend policy could reflect the fact that the
company isn’t looking to scale and is probably going to maintain its operations. On the other hand, growth-oriented companies may choose not to pay dividends and
4 reinvest earnings into expanding operations or acquiring new technologies. In both cases, the dividend policy communicates this strategic plan and can be somewhat
of a roadmap for management when thinking about future plans regarding cash.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Key Takeaways
The Bottom Line A dividend policy dictates the structure of a company's
dividend payout.
Dividend-paying stocks can give you a steady stream of income while adding Dividends are often part of a company's strategy.
value to your portfolio. But before you jump in, make sure you review the dividend Stable, constant, and residual are the main types of
policies of certain companies. These policies are set by corporate management dividend policies, though there are alternatives.
and highlight how much to pay, when, and how often. Even though investors know companies are not required to
pay dividends, many consider it a bellwether of that specific
company's financial health.

E. Mergers and Acquisitions

Mergers and acquisitions (M&A) are the different ways companies are combined. Entire All of these ways of combining or consolidating assets are M&A
companies or their major business assets are consolidated through financial transactions activities. The term M&A also is used to describe the divisions of
between two or more companies. A company may: financial institutions that facilitate or manage such activities.

Purchase and absorb another

1 4 Make a tender offer for its stock
company outright
Understanding Mergers vs. Acquisitions

2 Merge with it to create a new company 5 Stage a hostile takeover The terms mergers and acquisitions are often used interchangeably,
however, they have slightly different meaning.

3 Acquire some or all of its major assets

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VII. FUNDAMENTALS OF CORPORATE FINANCE
When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. Unfriendly or hostile takeover deals, in which target
companies do not wish to be purchased, are always regarded as acquisitions. However, an acquisition can also be done with the willing participation of both companies.
On the other hand, a merger describes two firms that join forces to move forward as a single new entity, rather than remain separately owned and operated. In general, the two
firms are of approximately the same size, and this action is known as a merger of equals.
A deal can be classified as a merger or an acquisition based on whether the acquisition is friendly or hostile and how it is announced. In other words, the difference lies in how the
deal is communicated to the target company's board of directors, employees, and shareholders.

Types of Mergers and Acquisitions

Mergers Acquisitions

In a merger, the boards of directors for two companies approve the combination and In a simple acquisition, the acquiring company obtains the majority stake in the
seek shareholders' approval. This type of M&A activity is designed to boost both acquired firm, which does not change its name or alter its organizational structure. In
brands, allowing each to bring their existing strengths to a new company and create a some cases, the target company may require the buyers to promise that the target
bigger piece of the industry pie for the new company that is formed. business remains solvent for a period after acquisition through the use of a whitewash
For example, in 2024, HBC announced that it was acquiring the Neiman Marcus resolution. An acquisition often allows the acquiring company to move into a new or
Group and merging it with another brand that it owned, Saks Fifth Avenue. Both NMG related industry, expanding its offerings by tapping into the acquired company's
(which owns Neiman Marcus and Bergdorf Goodman) and Saks are luxury retailers, existing customer base and services.
but their share of retail sales has declined with the rise of online shopping and the An example of this type of transaction was Amazon's acquisition of Whole Foods in
reduction of brick-and-mortar retail. The merger will consolidate the three existing 2017. The acquisition allowed Amazon to expand into grocery delivery services
brands (Saks, Neiman Marcus, and Bergdorf Goodman) into a single luxury retail (groceries make up a large portion of many people's budgets) as well as tap into the
brand known as Saks Global. This consolidation is intended to make it easier to market for health-conscious customers. Whole Foods, which had been losing market
compete with online retail giants. share to customers who could find similar products at lower prices in other grocery
chains, benefitted from Amazon's broad customer base and ease of connecting with
consumers.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Consolidations Acquisition of Assets

Corporate consolidation happens when two or more companies combine to increase In an acquisition of assets, one company directly acquires the assets of another
their market share and eliminate competition. For example, Facebook consolidated company. The company whose assets are being acquired must obtain approval from
its dominance in the social media industry by acquiring other social media companies its shareholders. The purchase of assets is typical during bankruptcy proceedings,
that had promising business models and could have become competitive with wherein other companies bid for various assets of the bankrupt company, which is
Facebook. liquidated upon the final transfer of assets to the acquiring firms.
An example of this is when it acquired Instagram in 2012 for $1 billion. Instagram
continued to operate as a separate company under the parent Facebook company
(now Meta Platforms). However, other instances of consolidation under Facebook
resulted in acquired social media companies being integrated into the Facebook
platform. For example, the messaging service Beluga was acquired by Facebook, Management Acquisitions
then rebranded as Facebook Messenger.
In a management acquisition, also known as a management-led buyout (MBO), a
company's executives purchase a controlling stake in another company, taking it
Tender Offers private. These former executives often partner with a financier or former corporate
officers in an effort to help fund a transaction.
In a tender offer, one company offers to purchase the outstanding stock of the other This type of M&A transaction is typically financed disproportionately with debt, and
firm at a specific price rather than the market price. The acquiring company the majority of shareholders must approve it. For example, in 2022, Tesla Motors
communicates the offer directly to the other company's shareholders, bypassing the CEO Elon Musk purchased Twitter, Inc. for $44 billion, taking the company private.
management and board of directors. For example, in 2008, Johnson & Johnson The deal included $25.5 billion of margin loan and debt financing.
made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. The
company agreed to the tender offer and the deal was settled by the end of
December 2008.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

How Mergers are Structured

Mergers can be structured in different ways, based on the relationship between the two companies involved in the deal:
Horizontal merger: Two companies that are in direct competition and share the same product lines and markets
Vertical merger: A customer and company or a supplier and company, such as an ice cream maker merging with a cone supplier
Congeneric mergers: Two businesses that serve the same consumer base in different ways, such as a TV manufacturer and a cable company
Market-extension merger: Two companies that sell the same products in different markets
Product-extension merger: Two companies selling different but related products in the same market
Conglomeration: Two companies that have no common business areas

Mergers may also be distinguished by following two financing methods, each with its own ramifications for investors.

Purchase Mergers Consolidation Mergers

As the name suggests, this kind of merger occurs when one company With this merger, a brand new company is formed, and both
purchases another company. The purchase is made with cash or through companies are bought and combined under the new entity. The tax
the issue of some kind of debt instrument. The sale is taxable, which terms are the same as those of a purchase merger.
attracts the acquiring companies, who enjoy the tax benefits. Acquired
assets can be written up to the actual purchase price, and the difference
between the book value and the purchase price of the assets can
depreciate annually, reducing taxes payable by the acquiring company.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Vertical Acquisitions Horizontal Acquisitions

Horizontal integration and vertical integration are competitive strategies that companies use to consolidate their position among competitors. Horizontal
integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level
of the value chain in an industry—for instance when Marriott International, Inc. acquired Starwood Hotels & Resorts Worldwide, Inc.

Vertical integration refers to the process of acquiring business operations within the same production vertical. A company that opts for vertical integration takes
complete control over one or more stages in the production or distribution of a product. Apple, for example, acquired AuthenTec, which makes the touch-ID
fingerprint sensor technology that goes into its iPhones.

How Acquisitions Are Financed

A company can buy another company with cash, stock, assumption of debt, or a combination of some or all of the three. At times, the investment bank involved in the sale
of one company might offer financing to the buying company. This is known as staple financing and is done to produce larger and timely bids.

In smaller deals, it is also common for one company to acquire all of another company's assets. Company X buys all of Company Y's assets for cash, which means that
Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business.

Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time period. Reverse mergers occur when a
private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets.
The private company reverses merges into the public company, and together they become an entirely new public corporation with tradable shares.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
How Mergers and Acquisitions Are Valued

Both companies involved on either side of an M&A deal will value the target company differently. The seller will obviously value the company at the highest price possible, while the
buyer will attempt to buy it for the lowest price possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the
following metrics.

Price-to-Earnings Ratio (P/E Ratio) Replacement Cost

With the use of a price-to-earnings ratio (P/E ratio), an acquiring company makes an offer In a few cases, acquisitions are based on the cost of replacing the target
that is a multiple of the earnings of the target company. Examining the P/E for all the stocks company. For simplicity's sake, suppose the value of a company is simply the
within the same industry group will give the acquiring company good guidance for what the sum of all its equipment and staffing costs. The acquiring company can
target's P/E multiple should be. literally order the target to sell at that price, or it will create a competitor for
the same cost.
Enterprise-Value-to-Sales Ratio (EV/Sales)
Naturally, it takes a long time to assemble good management, acquire
With an enterprise-value-to-sales ratio (EV/sales), the acquiring company makes an offer as property, and purchase the right equipment. This method of establishing a
a multiple of the revenues while being aware of the price-to-sales (P/S ratio) of other price certainly wouldn't make much sense in a service industry wherein the
companies in the industry. key assets (people and ideas) are hard to value and develop.

Discounted Cash Flow (DCF)

A key valuation tool in M&A, a discounted cash flow (DFC) analysis determines a company's
current value, according to its estimated future cash flows. Forecasted free cash flows (net
income + depreciation/amortization (capital expenditures) change in working capital) are
discounted to a present value using the company's weighted average cost of capital
(WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Impact on Shareholders

Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring firm will see a temporary drop in share value. At the same time,
shares in the target firm typically experience a rise in value. This is often because the acquiring firm will need to spend capital to acquire the target firm at a
premium to the pre-takeover share prices.
After a merger or acquisition officially takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the
absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends.
The shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This
phenomenon is prominent in stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-
upon conversion rate. Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may
see a significant erosion of their voting powers in the relatively larger pool of stakeholders.

How Do Mergers Differ From Acquisitions? Why Do Companies Acquire Other Companies?

Two of the key drivers of capitalism are competition and growth. When a
In general, "acquisition" describes a transaction, wherein one firm absorbs company faces competition, it must both cut costs and innovate at the same
another firm via a takeover. The term "merger" is used when the purchasing and time. One solution is to acquire competitors so that they are no longer a threat.
target companies mutually combine to form a completely new entity. Because Companies also grow by acquiring new product lines, intellectual property,
each combination is a unique case with its own peculiarities and reasons for human capital, and customer bases. By combining business activities, overall
undertaking the transaction, the use of these terms tends to overlap. performance efficiency tends to increase, and across-the-board costs tend to
drop as each company leverages the other company's strengths.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

What Is a Hostile Takeover?

Unfriendly acquisitions, commonly known as hostile takeovers, occur
when the target company does not consent to the acquisition. Hostile
Friendly acquisitions are most common and occur when the target firm agrees to
acquisitions don't have the same agreement from the target firm, and so
be acquired; its board of directors and shareholders approve of the acquisition,
the acquiring firm must actively purchase large stakes of the target
and these combinations often work for the mutual benefit of the acquiring and
company to gain a controlling interest, which forces the acquisition.
target companies.

The Bottom Line Key Takeaways:

Mergers and acquisitions (M&A) refers to the ways
Mergers and acquisitions, or M&A, are the different ways that businesses and their businesses, or their assets, are consolidated or combined.
assets can be bought, consolidated, or combined with another business. An In an acquisition, one company purchases another outright.
acquisition is usually the outright purchase of one company by another; in a merger, A merger is the combination of two firms, which
the two businesses generally combine to form a new company. subsequently form a new legal entity under the banner of
one corporate name.
Both mergers and acquisitions can be financed through a combination of stock, debt, Mergers and acquisitions require the valuation of a
or cash. They may be friendly or unfriendly; an unfriendly acquisition is often known as company or its assets to decide how much to pay for those
a hostile takeover and is not desired by the acquired company. assets.
M&A can be financed through a combination of debt, cash,
and stock.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
F. Corporate Governance
A dividend policy outlines how a company will distribute its dividends to its shareholders. This policy details specifics about payouts including how often, when, and how much is
distributed. There are many types of dividend police including stable, constant, and residual policies.

What Is Corporate Governance?

Understanding Corporate Governance
Corporate governance is the system of rules, practices, and processes by which
a company is directed and controlled. Corporate governance essentially involves Governance refers to the set of rules, controls, policies, and resolutions put in
balancing the interests of a company's many stakeholders, which can include place to direct corporate behavior. A board of directors is pivotal in governance,
shareholders, senior management, customers, suppliers, lenders, the government, while proxy advisors and shareholders are important stakeholders who can affect
and the community. As such, corporate governance encompasses practically governance.
every sphere of management, from action plans and internal controls to
performance measurement and corporate disclosure. Communicating a company's corporate governance is a key component of
community and investor relations. For instance, Apple Inc.'s investor relations site
profiles its corporate leadership (the executive team and board of directors) and
provides information on its committee charters and governance documents, such
as bylaws, stock ownership guidelines, and articles of incorporation.

Most successful companies strive to have exemplary corporate governance. For

many shareholders, it is not enough for a company to be profitable; it also must
demonstrate good corporate citizenship through environmental awareness,
ethical behavior, and other sound corporate governance practices.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Corporate Governance and the Board of Directors

Benefits of Corporate Governance
Good corporate governance creates transparent rules
and controls, guides leadership, and aligns the interests The board of directors is the primary direct stakeholder influencing corporate governance. Directors are
of shareholders, directors, management, and elected by shareholders or appointed by other board members and charged with representing the
employees. interests of the company's shareholders.
It helps build trust with investors, the community, and
public officials. The board is tasked with making important decisions, such as corporate officer appointments, executive
Corporate governance can give investors and compensation, and dividend policy. In some instances, board obligations stretch beyond financial
stakeholders a clear idea of a company's direction and optimization, as when shareholder resolutions call for certain social or environmental concerns to be
business integrity. prioritized.
It promotes long-term financial viability, opportunity, and
returns. Boards are often made up of a mix of insiders and independent members. Insiders are generally major
It can facilitate the raising of capital. shareholders, founders, and executives. Independent directors do not share the ties that insiders have.
Good corporate governance can translate to rising They are typically chosen for their experience managing or directing other large companies.
share prices. Independents are considered helpful for governance because they dilute the concentration of power
It can reduce the potential for financial loss, waste, risks, and help align shareholder interests with those of the insiders.
and corruption.
It is a game plan for resilience and long-term success. The board of directors must ensure that the company's corporate governance policies incorporate
corporate strategy, risk management, accountability, transparency, and ethical business practices.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
The Principles of Corporate Governance

While there can be as many principles as a company believes make sense, some of the most common ones are:

1 Fairness: The board of directors must treat shareholders, employees, vendors, and communities fairly and with equal consideration.

Transparency: The board should provide timely, accurate, and clear information about such things as financial performance, conflicts of interest, and risks to
2 shareholders and other stakeholders.

Risk Management: The board and management must determine risks of all kinds and how best to control them. They must act on those
3 recommendations to manage risks and inform all relevant parties about the existence and status of risks.

Responsibility: The board is responsible for the oversight of corporate matters and management activities. It must be aware of and support the successful,
4 ongoing performance of the company. Part of its responsibility is to recruit and hire a chief executive officer (CEO). It must act in the best interests of a company
and its investors.

Accountability: The board must explain the purpose of a company's activities and the results of its conduct. It and company leadership are accountable
5 for the assessment of a company's capacity, potential, and performance. It must communicate issues of importance to shareholders.

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VII. FUNDAMENTALS OF CORPORATE FINANCE
Corporate Governance Models
There are many types of corporate governance that a company might follow. Some use a traditional hierarchical leadership structure, and others are more flexible. Different
corporate governance models may be found throughout the world. Here are a few of them.

The Anglo-American Model

This model can take various forms, such as the Shareholder, Stewardship, and Political Models. The Shareholder Model is the principal model at present.
The Shareholder Model is designed so that the board of directors and shareholders are in control. Stakeholders such as vendors and employees, though
acknowledged, lack control.

Management is tasked with running the company in a way that maximizes shareholder interest. Importantly, proper incentives should be made available to align
management behavior with the goals of shareholders/owners.

The model accounts for the fact that shareholders provide the company with funds and may withdraw that support if dissatisfied. This is supposed to keep
management working effectively.

The board will usually consist of both insiders and independent members. Although traditionally, the board chairperson and the CEO can be the same, this model
seeks to have two different people hold those roles.

The success of this corporate governance model depends on ongoing communications among the board, company management, and the shareholders.
Important issues are brought to shareholders' attention. Important decisions that need to be made are put to shareholders for a vote.

U.S. regulatory authorities tend to support shareholders over boards and executive management.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

The Continental Model The Japanese Model

Two groups represent the controlling authority under the Continental The key players in the Japanese Model of corporate governance are
Model. They are the supervisory board and the management board. banks, affiliated entities, major shareholders called Keiretsu (who
may be invested in common companies or have trading
In this two-tiered system, the management board is composed of relationships), management, and the government. Smaller,
company insiders, such as its executives. The supervisory board is independent, individual shareholders have no role or voice. Together,
made up of outsiders, such as shareholders and union these key players establish and control corporate governance.
representatives. Banks with stakes in a company also could have
representatives on the supervisory board. The board of directors is usually made up of insiders, including
company executives. Keiretsu may remove directors from the board
The two boards remain entirely separate. The size of the supervisory if profits wane.
board is determined by a country's laws and can't be changed by
shareholders. The government affects the activities of corporate management via
its regulations and policies.
National interests have a strong influence on corporations with this
model of corporate governance. Companies can be expected to In this model, corporate transparency is less likely because of the
align with government objectives. concentration of power and the focus on the interests of those with
that power.
This model also greatly values the engagement of stakeholders, as
they can support and strengthen a company's continued operations.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

How to Assess Corporate Governance?

As an investor, you want to select companies that practice good corporate governance in the hope that
you can thereby avoid losses and other negative consequences such as bankruptcy.

You can research certain areas of a company to determine whether or not it's practicing good
corporate governance. These areas include:
Disclosure practices
Executive compensation structure (whether it's tied only to performance or also to other metrics)
Risk management (the checks and balances on decision-making)
Policies and procedures for reconciling conflicts of interest (how the company approaches
business decisions that might conflict with its mission statement)
The members of the board of directors (their stake in profits or conflicting interests)
Contractual and social obligations (how a company approaches issues such as climate change)
Relationships with vendors
Complaints received from shareholders and how they were addressed
Audits (the frequency of internal and external audits and how any issues that those audits raised
have been handled)

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VII. FUNDAMENTALS OF CORPORATE FINANCE

Types of bad governance practices include: Why Is Corporate Governance Important?

Companies that do not cooperate sufficiently with Corporate governance is important because it creates a
auditors or do not select auditors with the appropriate system of rules and practices that determines how a
scale, resulting in the publication of spurious or company operates and how it aligns with the interest of all
noncompliant financial documents its stakeholders. Good corporate governance fosters
Executive compensation packages that fail to create ethical business practices, which lead to financial viability.
an optimal incentive for corporate officers In turn, that can attract investors.
Poorly structured boards that make it too difficult for
shareholders to oust ineffective incumbents.

What Are the 4 Ps of Corporate What Are the Basic Principles of

Governance? Corporate Governance?

The four P's of corporate governance are people, The basic principles of corporate governance are
process, performance, and purpose. accountability, transparency, fairness, responsibility, and risk
management.

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VII. FUNDAMENTALS OF CORPORATE FINANCE

The Bottom Line

Key Takeaways:
Corporate governance consists of the guiding principles that a company puts in Corporate governance is the structure of rules, practices,
place to direct all of its operations, from compensation, risk management, and and processes used to direct and manage a company.
employee treatment to reporting unfair practices, dealing with the impact on the A company's board of directors is the primary force
climate, and more. influencing corporate governance.
Bad corporate governance can destroy a company's
Corporate governance that calls for upstanding, transparent behavior can lead a operations and ultimate profitability.
company to make ethical decisions that will benefit all of its stakeholders, including The basic principles of corporate governance are
investors. Bad corporate governance can lead to the breakdown of a company, accountability, transparency, fairness, responsibility, and
often resulting in scandal and bankruptcy. risk management.

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Bonds and
Their Valuation
VIII. BONDS AND THEIR VALUATION
A. Bond Basics
A bond is a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates to the holders of the bond. Bonds are issued by
corporation and government agencies that are looking for long-term debt capital.

Treasury bonds Corporate bonds

Treasury bonds, generally called Treasuries and sometimes referred Corporate bonds are issued by business firms. Unlike Treasuries,
to as government bonds, are issued by the federal government. corporates are exposed to default risk—if the issuing company gets
into trouble, it may be unable to make the promised interest and
principal payments and bondholders may suffer losses. Corporate
bonds have different levels of default risk depending on the issuing
company’s characteristics and the terms of the specific bond. Default
risk is often referred to as “credit risk”.

Municipal bonds Foreign bonds

Municipal bonds, or munis, is the term given to bonds issued by state Foreign bonds are issued by a foreign government or a foreign
and local governments. Like corporates, munis are exposed to some corporation. All foreign corporate bonds are exposed to default risk, as
default risk, but they have one major advantage over all other bonds: are some foreign government bonds. Indeed, recently, concerns have
the interest earned on most munis is exempt from federal taxes and risen about possible defaults in many countries including Greece,
from state taxes if the holder is a resident of the issuing state. Ireland, Portugal, and Spain. An additional risk exists when the bonds
Consequently, the market interest rate on a muni is considerably lower are denominated in a currency other than that of the investor’s home
than on a corporate bond of equivalent risk. currency.

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VIII. BONDS AND THEIR VALUATION
A. Bond Basics
Key Characteristics of Bonds

Although all bonds have some common characteristics, different types of bonds can have different contractual features. For example, most corporate bonds have provisions that
allow the issuer to pay them off early (“call” features), but the specific call provisions vary widely among different bonds. Similarly, some bonds are backed by specific assets that must
be turned over to the bondholders if the issuer defaults, while other bonds have no such collateral backup. Differences in contractual provisions (and in the fundamental underlying
financial strength of the companies backing the bonds) lead to difference in bonds’ risks, prices, and expected returns. To understand bonds, it is essential that you understand the
following terms.

Par Value – is the stated face value of the bond; for illustrative purposes, we generally assume a par value of $1,000, although any multiple of $1,000 (e.g.,
$10,000 or $10 million) can be used. The par value generally represents the amount of money the firm borrows and promises to repay on the maturity date.
Coupon Payment – The specified number of dollars of interest paid each year.
Coupon Interest Rate – the stated annual interest rate on a bond.
Fixed-Rate Bonds – bonds whose interest rate is fixed for their entire life.
Floating-Rate Bonds – bonds whose interest rate fluctuates with shifts in the general level of interest rates.
Zero Coupon Bonds – bonds that pay no annual interest but are sold at a discount below par, this compensating investors in the form of capital appreciation.
Original Issue Discount (OID) Bond – any bond originally offered at a price below its par value.
Maturity Date – a specified date on which the par value of a bond must be repaid.
Original Maturity – the number of years to maturity at the time a bond is issued.
Call Provisions – a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date.

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VIII. BONDS AND THEIR VALUATION

Sinking Fund Provision – a provision in a bond contract that requires the issue to retire a portion of the bond issue each year.
Convertible Bonds – bonds that are exchangeable at the option of the holder for the issuing firm’s common stock.
Warrants – long-term options to buy a stated number of shares of common stock at a specified price.
Putable Bonds – bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price.
Income Bond – a bond that pays interest only if it is earned.
Indexed (Purchasing Power) Bond – a bond that has interest payments based on an inflation index to protect the holder from inflation.

B. Bond Valuation

The value of any financial asset—a stock, a bond, a lease, or even a physical asset such as an apartment building or a
piece of machinery—is the present value of the cash flows the asset is expected to produce. The cash flows for a
standard coupon-bearing bond, like those of Allied Food, consist of interest payments furring the bond’s 15-year life plus
the amount borrowed (generally the par value) when the bond matures. In the case of a floating-rate bond, the interest
payments vary over time. For zero coupon bonds, there are no interest payments, so the only cash flow is the face amount
when the bond matures. For a “regular” bond with a fixed coupon, like Allied’s.

Discount Bond – a bond that sells below its par value; occurs whenever the going rate of interest is above the
coupon rate.

Premium Bond – a bond that sells above its par value; occurs whenever the going rate of interest is below the
coupon rate.

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VIII. BONDS AND THEIR VALUATION

D. Bond Risks
Assessing a Bond’s Riskiness
In this section, we identify and explain the two key factors that impact a bond’s
riskiness. Once those factors are identified, we differentiate between them and
discuss how you can minimize the risks.

Price Risk

C. Bond Yields and Prices Interest rates fluctuate over time, and when they rise, the value of outstanding bonds
decline. This risk of a decline in bond values due to an increase in interest rates is
Unlike the coupon interest rate, which is fixed, the bond’s yield varies from day to day, called price risk (or interest rate risk).
depending on current market conditions. To be most useful, the bond’s yield should
give us an estimate of the rate of return we would earn if we purchased the bond Price rick is higher on bonds that have long maturities than on bonds that will mature
today and held it over its remaining life. If the bond is not callable, its remaining life is its in the near future. This follows because the longer the maturity, the longer before the
years to maturity. If it is callable, its remaining life is the years to maturity if it is not bond will be paid off and the bondholder can replace it with another bond with a
called or the years to the call if it is called. higher coupon. This point can be demonstrated by showing how the value of a 1-year
bond with a 10% annual coupon fluctuates with the changes in rd and the comparing
Yield to Maturity (YTM) – the rate of return earned on a bond if it is held to maturity. those changes on a 15-year bond.
Yield to Call (YTC) – the rate of return earned on a bond when it is called before its
maturity date.

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VIII. BONDS AND THEIR VALUATION

Reinvestment Risk Default Risk

An increase in interest rates hurt bond-holders because it leads to a decline in the Potential default is another important risk that bondholders face. If the issuer defaults,
current value of a bond portfolio. But can a decrease in interest rates also hurt investors will receive less than the promised return. The quoted interest rate includes
bondholders? The answer is yes because if interest rates fall, long-term investors will a default risk premium—the higher the probability of default, the higher the premium
suffer a reduction in income. For example, consider a retiree who has a bond portfolio and thus the yield to maturity. Default risk on Treasuries is zero, but the risk is
and lives off the income it produces. The bonds in the portfolio, on average, have substantial for lower-grade corporate and municipal bonds.
coupon rates of 10%. Now suppose interest rates decline to 5%. Many of the bonds
will mature or be called; as this occurs, the bondholder will have to replace 10% bonds
with 5% bonds. Thus, the retiree will suffer a reduction of income.

The risk of an income decline due to a drop in interest rates is called reinvestment
risk, and its importance has been demonstrated to all bondholders in recent year as a
result of the sharp drop in rates since the mid-1980s. reinvestment risk is obviously
high on callable bonds. It is also high on short-term bonds because the shorter the
bond’s maturity, the fewer the years before the relatively high old- coupon bonds will
be replaced with the new low-coupon issues. Thus, retirees whose primary holdings
are short-term bonds or other debt securities will be hurt badly by a decline in rates,
but holders of noncallable long-term bonds will continue to enjoy the old high rates.

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VIII. BONDS AND THEIR VALUATION
E. Fixed Income Portfolio Management
What is Fixed Income Portfolio Management?
Fixed-income portfolio management is the process of building and managing portfolios containing bonds, also known as fixed-income securities. Bondholders receive regular coupon
payments at a specified interest rate until the bond matures, at which point the principal is repaid. Bonds are considered to carry lower risk compared to equities and therefore
typically offer a lower expected return. Nevertheless, there are different types of fixed-income securities with a range of risk- return profiles. Investors often choose bonds to generate
stable and regular income. Since bonds are highly sensitive to interest rates and inflation, fixed-income portfolio managers don’t focus on the same factors as equity portfolio
managers do.

Key Learning Points

Fixed income assets provide predictable returns through regular coupon payments and offer portfolio diversification benefits.

Although considered to bear lower risk than equities, bond returns are vulnerable to interest rate fluctuations, default risk, and inflation, which can erode purchasing power.

The asset class is diverse with offerings ranging from virtually risk-free government bonds to speculative high-yield corporate bonds.

A higher allocation to fixed income typically lowers overall portfolio risk.

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VIII. BONDS AND THEIR VALUATION
What is a Fixed Income Security and What Are the Different Types of Fixed Income?
Fixed-income securities are debt-based instruments that offer regular coupon payments to bondholders, who receive the bond’s par (face) value at maturity. This par value is also
referred to as the principal. Unlike equities, fixed-income assets do not offer the opportunity to benefit from share price appreciation. Rather, they offer lower risk through a more
predictable outcome. Both governments and corporations raise money to cover their needs (such as financing projects) by issuing debt securities. Bonds are generally liquid (they
can be purchased and sold relatively quickly) and play a critical role in the global financial markets. Companies tap the bond market to raise more than $1tn in financing each year in
the U.S. alone.
Fixed-income instruments include a wide range of publicly traded instruments (such as commercial paper, notes, and bonds traded either through an exchange or over the counter)
and non-publicly traded ones (for example, loans and private placements). Below are some of the most popular types of fixed-income securities:

Government Bonds Municipal Bonds

Government bonds are issued by sovereign Municipal bonds are issued by local governments and are considered very low risk, although slightly riskier
governments (for example, US Treasury bonds, than sovereign bonds. Examples include:
also known simply as Treasuries) and are General Obligation Bonds (GO Bonds), which are typically used for financing infrastructure and other
considered to be very low- risk due to their public projects like schools and hospitals.
government backing. Governments raise Revenue bonds are backed by revenue generated from a specific project or source, such as toll
revenue through taxation, ensuring their ability to roads, airports or public utilities (the revenue from the project supports the repayment of the bond’s
meet their interest obligations and repay their principal and interest).
bondholders. Some other examples of sovereign Housing Authority Bonds are issued to finance affordable housing initiatives. The proceeds are
bonds include UK Gilts, German Bunds and typically used for the construction, improvement, or maintenance of public housing developments.
Japanese Government Bonds (JGBs). They are backed by rental income and/or state subsidies.

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VIII. BONDS AND THEIR VALUATION
Corporate Bonds Convertible Bonds

Corporate bonds are securities issued by companies and typically pay a higher Convertible bonds can be converted into company stock, typically during pre-
rate of interest than do government bonds. In terms of risk, they are categorized as determined periods. This allows bondholders to exchange their bonds for a
either investment grade or high yield (also known as junk bonds). This specific number of the issuer’s shares. A convertible bond offers investors an
categorization is determined by the bond’s credit rating; BBB and above is option to benefit from potential share price appreciation should they choose to
considered investment grade while anything below is speculative. convert. Because of this option, convertibles offer the potential for higher returns
An investment grade example is Apple’s bond, which pays a fixed interest rate of but also carry a higher level of risk. Typical issuers of convertible bonds are
3.25% and matures in 2030. It has a credit rating of AA+. companies that may have high growth expectations but a less-than-stellar credit
On the other hand, an example of a high yield bond is a J.C. Penney issue that pays rating. By issuing a convertible, the company can access capital at a lower cost
7.4% and matures in 2037. According to Standard & Poor’s, a leading credit rating than through a traditional bond.
agency, the company currently has a credit rating of D.

Asset-Backed Securities (ABS) Collateralized Debt Obligations (CDOs)

Asset-Backed Securities are instruments that are backed by various pools of Collateralized Debt Obligations are complex debt securities, backed by pools of
assets, such as mortgages. When investors buy these securities, their overall return bonds or loans, with levels of risk varying based on the quality of the underlying
depends on the interest and principal payments accruing to the underlying loans. assets. They are structured by bundling various types of debt, such as mortgages
This diversifies risk and provides liquidity to lenders. or corporate loans, into a single security. These are then divided into tranches with
However, the level of risk for each ABS varies depending on the underlying varying risk profiles (lower tranches carry more risk but usually ofer higher
assets. potential returns). Payments from the underlying assets flow through the tranches,
providing returns based on their priority in the payment structure (typically starting
from the senior tranches, which are considered less risky and take priority in
receiving interest and principal payments from the underlying assets).

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VIII. BONDS AND THEIR VALUATION
The Role of Fixed Income in a Portfolio and Why Is It Important?

Fixed income is considered a defensive asset class as bonds are less volatile than stocks. They offer a source of diversification that can help reduce volatility and overall portfolio risk.
Through coupon or interest payments, bonds can provide a stable stream of income, cushion against losses in a portfolio, and enhance total returns.

Laddered Portfolio
Laddered Portfolio is a strategy, commonly referred to as “bond
Fixed Income Portfolio Management Strategies
ladder investing,” that involves buying fixed-income securities with
There are various fixed income strategies that allow investors to achieve
various maturities (from low to high) to achieve a high level of
specific objectives such as generating income or managing risk. Below
diversification. This helps reduce risk. Moreover, as bonds mature at
are three popular approaches.
the shorter end of the ladder, the proceeds can be re-invested into
bonds with longer maturities. This may also enhance potential return.

However, there are also risks associated with laddering, including:

Reinvestment risk – interest rates could decline, and maturing bonds would be reinvested at lower rates.

Liquidity risk – bonds with lower credit ratings or smaller issuances may be less liquid, making them
difficult to buy or sell in the open market.

Credit risk – laddered portfolios can be exposed to credit risk if an issuer defaults.

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VIII. BONDS AND THEIR VALUATION

Bullet Portfolio
This strategy entails buying fixed-income securities that have the same maturity date on different dates. The approach is suitable for investors who may
need a lump sum payment in the future (for example to finance a life event such as university education), as all the bonds in the portfolio will mature on the
same date. Bullet portfolios are exposed to liquidity, reinvestment, and credit risks and are more sensitive to interest rate changes. If interest rates
increase, the bonds become less attractive while new issues will bear higher interest rates.

This portfolio includes bonds with short-term and long-term maturities but eschews intermediate bonds. The idea behind this strategy is to pay close
attention to the short-term issues (typically those with maturities of less than five years) and continue rolling them into new issues on the maturity date. The
objective is to achieve the optimal risk-reward outcome, but the portfolio is nevertheless still vulnerable to interest rate, inflation, reinvestment, and credit
risks.

Yield curve analysis is widely used by central banks, policymakers, and investors. The yield curve is an indicator of market sentiment
and a powerful predictor of economic output and growth that shapes monetary policy and economic forecasts. In addition, it is used as
a benchmark lending rates and other debt instruments such as mortgages.

The yield curve plots the interest rates of bonds with equivalent credit ratings but different maturities. The most popular comparison is
between 3-month, 2-year, 5-year, 10-year, and 30-year (i.e., the short, intermediate, and long-term rates) U.S. Treasury securities.
Nevertheless, a yield curve can be created for municipal bonds or a particular corporate issuer.

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VIII. BONDS AND THEIR VALUATION

Building a Fixed Income Portfolio

Knowing where to start when constructing a fixed-income portfolio can be

challenging as the asset class is large and complex. A conservative “core-satellite”
approach could be a solid starting point. Investors typically focus on the “core” by
adding high-quality bonds such as U.S. Treasuries and investment-grade corporate
bonds, which bear low to moderate credit risk and ofer diversification benefits when
combined with equities. The “core” should represent a greater proportion of the
overall portfolio, while the “satellite” holdings (which are more aggressive in terms of
Generally, there are four types of yield curve: risk, with lower credit ratings and higher default rates, but higher coupons) such as
high yield or convertible bonds, should be a smaller proportion. The exact allocation
Normal – this is when longer-term bonds have higher yields than shorter- will be determined by the investor’s risk tolerance.
1 term bonds, creating an upward-sloping yield curve. This indicates a healthy
economy.

Steep – shows a significant diference between short-term and long-term

2
yields, and signals anticipated economic growth.

Inverted – short-term yields are higher than long-term yields, suggesting

3
an economic downturn or recession.

Flat – short-term and long-term yields are similar, suggesting uncertain

4 future economic conditions. Sometimes the curve can appear elevated, or
“humped” in the middle.

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Investment and
Portfolio Management
IX. INVESTMENT AND PORTFOLIO MANAGEMENT
A. Portfolio Theory
What is the Modern Portfolio Theory (MPT)?
The Modern Portfolio Theory (MPT) refers to an investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. The
theory assumes that investors are risk-averse; for a given level of expected return, investors will always prefer the less risky portfolio.
Hence, according to the Modern Portfolio Theory, an investor must be compensated for a higher level of risk through higher expected returns. MPT employs the core idea of
diversification—owning a portfolio of assets from different classes is less risky than holding a portfolio of similar assets.

Diversification

Diversification is a portfolio allocation strategy that aims to minimize idiosyncratic risk by holding assets that are not
perfectly positively correlated. Correlation is simply the relationship that two variables share, and it is measured using
the correlation coefficient, which lies between -1≤ρ≤1.

A correlation coefficient of -1 demonstrates a perfect negative correlation between two assets. It means that a
positive movement in one is associated with a negative movement in the other.
A correlation coefficient of 1 demonstrates a perfect positive correlation. Both assets move in the same direction in
response to market movements.

A perfect positive correlation between assets within a portfolio increases the standard deviation/risk of the portfolio.
Diversification reduces idiosyncratic risk by holding a portfolio of assets that are not perfectly positively correlated.
For example, suppose a portfolio consists of assets A and B. The correlation coefficient for A and B is -0.9. The figure
shows a strong negative correlation – a loss in A is likely to be offset by a gain in B. It is the advantage of owning a
diversified portfolio.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT

Does Diversification Eliminate Risk?

The idiosyncratic risk associated with the portfolio is lower or negligible if it’s diversified. It is because any loss in one asset is likely to be offset by a gain in another
asset (which is negatively correlated).
Systematic risk refers to the risk that is common to the entire market, unlike idiosyncratic risk, which is specific to each asset. Diversification cannot lower systematic
risk because all assets carry this risk.

Portfolio Frontier Expected Return

According to the Modern Portfolio Theory, a portfolio frontier, also known as an The expected return of a portfolio is the expected value of the probability distribution
efficient frontier, is a set of portfolios that maximizes expected returns for each level of the possible returns it can provide to investors.
of standard deviation (risk).
Consider an investor holds a portfolio with $4,000 invested in Asset Z and $1,000
Standard Deviation invested in Asset Y. The expected return on Z is 10% ,and the expected return on Y is
3%. The expected return of the portfolio is:
Standard deviation measures the level of risk or volatility of an asset. It is used to
determine how widely spread out the asset movements are over time (in terms of
value). Assets with a wider range of movements carry higher risk.
The standard deviation of a portfolio depends on:
Expected Return = [($4,000/$5,000) * 10%] + [($1,000/$5,000) * 3%]
The standard deviation of each asset in the portfolio.
= [0.8 * 10%] + [0.2 * 3%] = 8.6%
The weights of each asset
The correlation between each asset.
Further information on how to calculate portfolio standard deviation can be found in
CFI’s Portfolio Variance article.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT

Risk-Free Rate Capital Allocation Line (CAL)

The risk-free rate refers to the rate of return an investor expects to earn on an asset The Capital Allocation Line (CAL) is a line that depicts the risk-reward trade off of
with zero risk. All assets carry some degree of risk; therefore, assets that generally assets that carry idiosyncratic risk. The slope of the CAL is called the Sharpe ratio,
have low default risks and fixed returns are considered risk-free. An example of a which is the increase in expected return per additional unit of standard deviation
risk- free asset is a 3-month government Treasury bill. (reward-to-risk ratio).

In the chart above, at point “B,” the reward-to-risk ratio (the slope of the CAL) is the
highest, and it is the combination that creates the optimal portfolio according to the
Efficient Frontier
MPT.

The upper portion of the curve (point A onwards) is the “efficient frontier” – it is the
Further information on how to calculate the eficient frontier and capital allocation line
combination of risky assets that maximizes expected return for a given level of
can be found in CFI’s Capital Allocation Line (CAL) and Optimal Portfolio article.
standard deviation. Therefore, any portfolio on this portion of the curve offers the best
possible expected returns for a given level of risk.
According to the MPT, rational risk-averse investors should hold portfolios that fall on
the efficient frontier (since they provide the highest possible expected returns for a
Point “A” on the efficient frontier is the minimum variance portfolio – the
given level of standard deviation). The optimal portfolio (also called the “market
combination of risky assets that minimize standard deviation/risk.
portfolio”) is the combination of assets at point “B,” which combines one risk-free
asset with one risky asset.
Point “B” is the optimal market portfolio, which consists of at least one risk-
free asset. It is depicted by the line that is tangent to the efficient frontier, which is
also called the Capital Allocation Line (CAL).

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT
Key Learning Points

The Modern Portfolio Theory focuses on the relationship between assets in a portfolio in addition to the individual risk that each asset carries. It exploits the fact that a
negatively correlated asset offsets losses that are incurred on another asset. For example, crude oil prices and airline stock prices are negatively correlated.

A portfolio with a 50% weight in crude oil and 50% weight in an airline stock is safe from the idiosyncratic risk carried by each of the individual assets. When oil prices
decline, airline stock prices are likely to increase, offsetting the losses incurred from the oil stock.

B. Asset Allocation
Asset allocation is how investors divide their portfolios among different assets that might include equities, fixed-income assets, and cash and its equivalents. Investors
ordinarily aim to balance risks and rewards based on financial goals, risk tolerance, and the investment horizon.

Why Is Asset Allocation Important?

There's no formula for the right asset allocation for everyone, but the consensus among most financial professionals is that asset allocation is one of the most important
decisions investors make. Selecting individual securities within an asset class is done only after you decide how to divide your investments among stocks, bonds, and cash
and cash equivalents. This will largely determine your investment results.
Investors use different asset allocations for distinct goals. Someone saving to buy a new car in the next year might invest those savings in a conservative mix of cash,
certificates of deposit, and short-term bonds. However, individuals saving for retirement decades away typically invest most of their retirement accounts in stocks because
they have a lot of time to ride out the market's short-term fluctuations.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT
Age-Based Asset Allocation Asset Allocation Through Life-Cycle Funds

Financial advisors generally recommend holding stocks for five years or longer. Some asset-allocation mutual funds are known as life-cycle or target-date
Cash and money market accounts are appropriate for goals less than a year funds. They set out to provide investors with portfolios that address their age,
away. Bonds fall somewhere in between. risk appetite, and investment goals with the correlated parts of different asset
classes. Critics of this approach point out that a standardized solution for
Financial advisors once recommended subtracting an investor's age from 100 to allocating portfolio assets is wrongheaded because individual investors
determine what percentage should be invested in stocks. A 40-year-old would, require individual solutions.
therefore, be 60% invested in stocks. Variations of this rule recommend
subtracting age from 110 or 120, given that average life expectancy continues to These funds gradually reduce the risk in their portfolios as they near the target
grow. Portfolios should generally move to a more conservative asset allocation to date, cutting riskier stocks and adding safer bonds to preserve the nest egg.
help lower risk as individuals approach retirement. The Vanguard Target Retirement 2030 is an example of a target-date fund.

The Vanguard 2030 fund is for people expecting to retire just before or after
2030. As of Aug. 31, 2023, its portfolio comprises 63% stocks, 36% bonds, and
1% short-term reserves. This asset allocation was achieved by investing in the
following four funds:
Vanguard Total Stock Market Index Fund Institutional Plus Shares
Vanguard Total Bond Market II Index Fund
Vanguard Total International Stock Index Fund Investor Shares
Vanguard Total International Bond II Index Fund

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How Do Economic Changes Affect Asset Allocation Strategies? What Is a Good Asset Allocation?

What works for one person might not work for another. There is no such
Economic cycles of growth and contraction greatly afect how you should thing as a perfect asset allocation model. A good asset allocation varies
allocate your assets. During bull markets, investors ordinarily prefer by individual and can depend on various factors, including age, financial
growth-oriented assets like stocks to profit from better market conditions. targets, and appetite for risk. Historically, an asset allocation of 60%
Alternatively, during downturns or recessions, investors tend to shift stocks and 40% bonds was considered optimal. However, some
toward more conservative investments like bonds or cash equivalents, professionals say this idea needs to be revised, particularly given the
which can help preserve capital. poorer performance of bonds in recent years, and say other asset classes
should also be introduced to portfolios.

What Is an Asset Allocation Fund? What Is the Best Asset Allocation Strategy for My Age?

Generally, the younger and further you are from needing to access the
An asset allocation fund provides investors with a diversified portfolio of capital invested, the more you should invest in stocks. One common
investments across various asset classes. The asset allocation of the fund guideline that’s ordinarily quoted is that you should hold a percentage of
can be fixed or variable among a mix of asset classes. It may be held to stocks that is equal to 100 minus your age. So, if you are 30, 70% of your
fixed percentages of asset classes or allowed to lean further on some, portfolio should supposedly consist of stocks. The rest would then be
depending on market conditions. allocated to safer assets, such as bonds. But a lot of these rules don't
work for everyone. For advice that reflects your personal circumstances,
reach out to a financial advisor.

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How Does Behavioral Finance View Asset Allocation?

Behavioral finance explores how common cognitive errors might influence our financial choices. For our asset allocation, we might be swayed too much by recent
market trends, overconfidence, sunk-cost reasoning, or loss aversion, which can lead to less beneficial allocation choices. Awareness of these cognitive biases can
help you keep a disciplined, long-term approach aligned with your goals.

Key Takeaways:

Asset allocation is how investors split up their portfolios among

different kinds of assets.
The Bottom Line
The three main asset classes are equities, fixed income, and cash
Most financial professionals will tell you that asset allocation is one of and cash equivalents.
the most important decisions investors can make. The selection of Each asset class has different risks and return potential, so each
individual securities is secondary to how assets are allocated in will behave differently over time.
stocks, bonds, and cash and cash equivalents, which will play more of No simple formula can find the right asset allocation for every
a role in your investment results. individual investor.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT
C. Security Analysis
Security analysis and portfolio management is a process that allows investors to identify and analyze securities and create an investment portfolio based on those findings. Security
analysis is the process of examining a security in order to estimate its future value. Portfolio management is the process of combining diferent securities to create an investment
portfolio. An investment portfolio is a collection of various types of securities, such as stocks, bonds, and cash. Investors use security analysis and portfolio management to determine
which securities to buy, sell, or hold. It’s important to understand that security analysis and portfolio management are not investment strategies. Because of this, an investor can use
security analysis and portfolio management to create any type of investment portfolio. The process of security analysis and portfolio management is not a quick task, but it is essential
for any investor who wants to maximize their investment potential.

Different Types of Investment Securities

Assets that are traded on the stock market are considered securities, so every stock that is listed on the New York Stock Exchange or other exchanges is a type of security.
However, there are a number of other types of securities that are used by investors, such as government bonds, corporate bonds, mutual funds, commodities, and real estate.
Each of these investment securities has their own unique characteristics and risk-and-reward profile, which will be discussed in more detail later in this guide. There are three
main types of investment securities: equity securities, debt securities, and hybrid securities. Equity securities are any type of security that owns a share in a company, such as
stocks and real estate investment trusts (REITs). Debt securities are any type of security that pays interest and has a set maturity date, such as government bonds and
corporate bonds. Hybrid securities are any type of security that has a mixture of equity and debt characteristics.

Security Analysis Tools and Techniques

Security analysis is a methodical and thorough process, so it’s essential to use the right tools and techniques to get the most out of the process. There are many different
tools and techniques that investors can use during the security analysis process, but a few of the most important include financial statements, financial statement analysis,
and fundamental analysis. Financial statements are reports that provide an overall snapshot of a company’s financial health, including the company’s assets, liabilities, and
equity. Financial statement analysis involves studying a company’s financial statements to identify any potential red flags, such as declining profit over time or increasing
debt. Fundamental analysis is the process of examining a company’s financial statements to predict future performance and estimate the value of a company.

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Advantages and Disadvantages of Security Analysis and Portfolio Management

The benefits of security analysis and portfolio management are that it can help investors to make better investment decisions, diversify their portfolios, and create a
financial plan that is tailored to their unique needs and goals. The disadvantages of security analysis and portfolio management are that it is a time-intensive process,
requires a significant amount of research, and requires investors to take on risk. If you decide to invest in securities, you will be responsible for managing your own
investments and may incur losses, especially during times of financial uncertainty. You will also need to take the time to research potential investments and create an
investment portfolio that is tailored to your needs, will be able to withstand financial fluctuations, and can help you meet your financial goals.

D. Investment Strategies
What Is an Investment Strategy?
The term investment strategy refers to a set of principles designed to help an individual investor achieve their financial and investment goals. This plan is what guides an investor's
decisions based on goals, risk tolerance, and future needs for capital. They can vary from conservative (where they follow a low-risk strategy where the focus is on wealth
protection) while others are highly aggressive (seeking rapid growth by focusing on capital appreciation).
Investors can use their strategies to formulate their own portfolios or do so through a financial professional. Strategies aren't static, which means they need to be reviewed
periodically as circumstances change.

Understanding Investment Strategies

Investment strategies are styles of investing that help individuals meet their short- and long-term goals. Strategies depend on a variety of
factors, including:
Age Available capital
Goals Personal situations (family, living situation)
Lifestyles Expected returns
Financial situations

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Investment strategies vary greatly. There isn't a one-size-fits-all approach to

investing, which means there isn't one particular plan that works for
everyone. This also means that people need to reevaluate and realign their
This, of course, isn't an exhaustive list, and may include other details about strategies as they get older in order to adapt their portfolios to their situation.
the individual. These factors help an investor determine the kind of Investors can choose from value investing to growth investing and
investments they choose to purchase, including stocks, bonds, money conservative to more risky approaches.
market funds, real estate, asset allocation, and how much risk they can
tolerate.

As mentioned above, people can choose to make their investment decisions on their own or by using a
financial professional. More experienced investors are able to make decisions and investment choices on
their own. Keep in mind that there is no right way to manage a portfolio, but investors should behave rationally
by doing their own research using facts and data to back up decisions by attempting to reduce risk and
maintain sufficient liquidity.

Because investment strategies depend so heavily on your personal situation and goals, it's important for you
to do your research before you commit your capital to any investment.

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Special Consideration

Risk is a huge component of an investment strategy. Some individuals have a high tolerance for risk while other investors are risk-averse.5 Here are a few common risk-
related rules:
Investors should only risk what they can afford to lose
Riskier investments carry the potential for higher returns
Investments that guarantee the preservation of capital also guarantee a minimal return

For example, U.S. Treasury bonds, bills, and certificates of deposit (CDs) are considered safe because they are backed by the credit of the United States. However, these investments
provide a low return on investment. Once the cost of inflation and taxes have been included in the return on income equation, there may be little growth in the investment.
Along with risk, investors should also consider changing their investment strategies over time.6 For instance, a young investor saving for retirement may want to alter their investment
strategy when they get older, shifting their choices from riskier investments to safer options.

Types of Investment Strategies

Investment strategies range from conservative plans to highly aggressive ones. A review of some of the top investors will show that there are a wide variety of strategies to
consider. Conservative investment plans employ safe investments that come with low risks and provide stable returns. Highly aggressive ones are those that involve risky
investments, such as stocks, options, and junk bonds, with the goal of generating maximum returns.

People who have a greater investment horizon tend to employ aggressive plans because they have a longer timeline, while those who want to preserve capital are more likely
to take a conservative approach.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT

Types of Investment Strategies (cont.)

Many investors buy low-cost, diversified index funds, use dollar-cost averaging, and reinvest dividends. Dollar-cost averaging is an investment strategy where a fixed dollar
amount of stocks or a particular investment are acquired on a regular schedule regardless of the cost or share price. Some experienced investors, though, select individual
stocks and build a portfolio based on individual firm analysis with predictions on share price movements.

Value Investing Growth Investing

Some investors may choose strategies such as value and growth

investing. With value investing, an investor chooses stocks that look as
they though trade for less than their intrinsic value. This means that
these stocks that the market is underestimating. Growth investing, on
the other hand, involves investing capital in the stocks of junior
companies that have the potential for earnings growth.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT
E. Risk Management
What is risk management? Why is risk management important?

Risk management is the process of identifying, If an unforeseen event catches your organization unaware, the impact could be minor, such as a small impact on
assessing and controlling financial, legal, strategic your overhead costs. In a worst-case scenario, though, it could be catastrophic and have serious ramifications, such
and security risks to an organization’s capital and as a significant financial burden or even the closure of your business.
earnings. These threats, or risks, could stem from a To reduce risk, an organization needs to apply resources to minimize, monitor and control the impact of negative
wide variety of sources, including financial events while maximizing positive events. A consistent, systemic and integrated approach to risk management can
uncertainty, legal liabilities, strategic management help determine how best to identify, manage and mitigate significant risks.
errors, accidents and natural disasters.

F. Performance Evaluation
Investment planning doesn’t stop once you make an investment. Evaluating the performance of your investments is a critical part of managing—and monitoring— your assets over
time.
Effective performance evaluation is a middle ground between “set it and forget it” and incessant monitoring. A yearly evaluation of your investments, at roughly the same time each
year, is often enough. An annual review can keep you engaged in your holdings while tracking the progress of your investment goals. It can also help you know when your asset
allocation has shifted and it's time to rebalance your holdings.
If you have all of your investments in accounts with a single financial services firm, you might get consolidated statements containing information about all your accounts. However, if
you have accounts at several firms, or if you have both tax- deferred and taxable accounts, you might need to look at several different statements to get a complete picture of your
total portfolio performance. In addition to sending regular statements, many firms provide online access to your account information, so you can look up the latest values for your
holdings any time you like. You might also be able to access your account information by phone.

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Generally speaking, progress means that your portfolio value is steadily increasing, even though one or more of your investments may have lost
value. You can generally find the current value of each investment online. The value of your investments is also provided to you by your
brokerage or financial services firm in the form of regular account statements.

Performance Measures
Here are some common ways to measure performance:

Yields on Bonds: When you buy a bond at issue, its yield is the same as its interest
1
Yield rate or coupon rate. See Bond Yield and Return.

Budgets can be prepared as incremental, activity-based, value

Yields on Stocks: For stocks, yield is calculated by dividing the year's dividend by
proposition, or zero-based. While some types like zero-based start a 2
the stock's market price. Of course, if a stock doesn't pay a dividend, it has no yield.
budget from scratch, incremental or activity-based may spin off from a
prior-year budget to have an existing baseline. Capital budgeting may Yields on CDs: If your assets are in conventional CDs, figuring your yield is easy.
be performed using any of the methods above, though zero-based 3
Your bank or other financial services firm will provide not only the interest rate the
budgets are most appropriate for new endeavors. CD pays, but its annual percentage yield (APY). In most cases, that rate remains
fixed for the CD's term.

Rate of Return
Your investment return is all of the money you make or lose on an investment. To find your total return, generally considered the most accurate measure of return, you
add the change in value—up or down—from the time you purchased the investment to all of the income you collected from that investment in interest or dividends.
Learn more in this Smart Investing Course: Worth Holding On To? Rate of Return.

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To find percent return, you divide the change in value plus income by the amount you invested. Here's the formula for that calculation:

(Change in value + Income) / Investment amount = Percent return

For example, suppose you invested $2,000 to buy 100 shares of a stock at $20 a share. Over the three years that you own it, the price increases to $25 a share and the company
pays a total of $120 in dividends. To find your total return, you'd add the $500 increase in value to the $120 in dividends, and to find percent return you divide by $2,000, for a result of
31 percent.

That number by itself doesn't give you the whole picture, though. Since you hold investments for different periods of time, the best way to compare their performance is by looking at
their annualized percent return.

The standard formula for computing annualized return is:

AR = (1 + return)(1 / years) - 1

In this example, your annualized return is 9.42 percent.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT

Remember that you don't have to sell the investment to calculate your return. In
Use FINRA’s Fund Analyzer to find fact, figuring return may be one of the factors in deciding whether to keep a
annual and total return for mutual funds stock in your portfolio or trade it in for one that seems likely to provide a
and ETFs. Search online to find annual stronger performance.
and total return calculators.

Whatever type of securities you hold, here are some tips to help you evaluate and monitor investment performance:

Factor in transaction fees. To be sure your calculation is accurate, it's important to include the transaction fees you pay when
you buy your investments. If you're calculating return on actual gains or losses after selling the investment, you should also
subtract the fees you paid when you sold.
Create a single spreadsheet for your investments. If your investments are spread out among diferent financial firms, it’s a
good idea to create a master spreadsheet that contains each investment and its value at the time you undertake your evaluation.

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IX. INVESTMENT AND PORTFOLIO MANAGEMENT

Contiuation...

Consider the role of taxes on performance. Computing after-tax returns is important, including capital gains and losses. This is
often helpful to do with the help of a tax professional. Learn more about capital gains.
Factor in inflation. With investments you hold for a long time, inflation may play a big role in calculating your return. Inflation means
your money loses value over time. A number of FINRA’s calculators compute inflation’s impact on savings and investments.
Compare your returns over several years. This will help you see when different investments had strong returns and when the
returns were weaker. Among other things, year-by-year returns can help you see how your various investments behaved in different
market environments.
Rebalance as needed. Be prepared to make adjustments when the situation calls for it. In investing parlance, this is referred to
as rebalancing.

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Cash and Working
Capital Management
X. CASH AND WORKING CAPITAL MANAGEMENT
A. Cash Flow Management
Cash flow is the lifeblood of your business. The more clogged channels, the more it can affect financial health. There are a million ways to manage cash flow, but only a few strategies
that lead to successful cash flow management.
What is Cash Flow Management?
Cash flow management is tracking and controlling how much money comes in and out of a business in order to accurately forecast cash flow needs. It’s the day-to-day process
of monitoring, analyzing, and optimizing the net amount of cash receipts— minus the expenses. It’s all about managing your business finances responsibly, so there’s enough
cash to grow.
Effective cash management strategies help to predict how much money will be available to cover things like debt, payroll, and vendor invoices.
Cash Flow Categories
Cash can flow from and through several parts of an organization, such as:

Cash Flows from Operations (CFO) Cash Flows from Financing (CFF)

Operating cash flow describes money flows from ordinary operations, like Financing cash flow (CFF) demonstrates the net flows of cash that are used to fund
production and the sale of goods. This is the figure that determines whether or not the business and its working capital. Activities can include transactions that involve
a company has enough funds coming in to pay bills and operating expenses. There issuing debt or equity and paying dividends. CFF provides investors with insight into
must be more operating cash inflows (CFO) than outflows to have long-term an organization’s cash position and how well the capital structure is managed.
viability.

Cash Flows from Investing (CFI)

The Relationship Between AP and Cash Flow Management
Investing cash flow (CFI) is a figure that represents how much cash has been Accounts payable is a central component of managing cash flow because it
generated or spent from investment-related activities in a specific time period. represents money a company owes vendors. Once the payment of a liability is due,
managing the timing of those payments is what helps a business maintain a healthy
cash flow.

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For example, if a company is experiencing a cash flow shortage, they may choose to delay accounts payables in order to conserve cash. However, this move can also damage
supplier relationships and affect credit ratings. It will even result in late fees and interest charges.

On the other hand, paying AP too quickly may have a negative impact on your cash flow. That’s because you’re reducing the amount of cash on hand for business needs. This is why
managing AP is so important for cash flow management.

Effective cash management techniques mean striking a balance between paying on time and delaying transactions to maintain healthy cash reserves. A company can use a variety of
strategies to balance cash flow, like negotiating new payment terms or implementing an electronic invoicing system. You can even use AP automation for cash flow forecasting and
managing payment cycles.

AP Automation as a Tool for Cash Flow Management

Accounts payable automation is a powerful tool for improving cash flow management. It involves the use of technology to
streamline the entire AP process, from invoice to approval. AP automation can benefit your cash flow in the following ways:
Faster Invoice Processing: Invoices move quicker, reducing the time it takes suppliers to get paid. This helps a business
maintain healthy relationships and avoid late fees or penalties.
Improved Control and Visibility: Provide real-time visibility into the status of invoices and payments, allowing companies to
monitor their cash flow and make more informed decisions about paying bills.
Reduced Mistakes and Fraud: AP automation reduces fraud and errors by eliminating manual tasks and providing greater
visibility into the entire AP process. This helps a company avoid costly mistakes and prevents fraud from impacting cash flow.
Cash Savings: Businesses reduce the costs associated with manual processes, like printing, data entry, postage, and
storage. This frees up cash for other business needs to drive growth.
AP automation like Tipalti leads to better cash flow forecasting because companies can use the data and analytics to predict
future cash flow more accurately. This helps to foresee expenses and thus, make better decisions.

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X. CASH AND WORKING CAPITAL MANAGEMENT

Importance of Cash Flow Management Utilization of Funds

Proper cash flow management means no stone is left unturned. A company should
Cash management is critical for a company’s success. If the business constantly
always ensure the sufficiency of cash and make sure there is no underutilization of
spends more than it earns, there are going to be issues with cash flow. Especially
funds. There must be a balance between profitability and liquidity. No amount of
for a small business or startup. It’s your livelihood.
money will replace astute planning.

Investor Trust

At a basic level, a company’s ability to create value for investors is determined by its Additional benefits for strategizing cash
ability to maximize long-term free cash flow (FCF) and generate positive cash flow management:
flows. Free cash flow is the cash a business generates from normal operations after
subtracting money spent on capital expenditures (CapEx). Facilitate investments and keeps
people interested
Help to plan for capital
expenditure and profit margins
Staying in Business Take advantage of more
opportunities with idle cash
For a small business, avoiding extended cash shortages (large gaps between cash Prepare the business for
inflows and cash outflows) is important. The longer you go without positive cash unexpected outflows
flow, the harder it will be to stay in business for an extended period of time. Allow adequate availability of
cash for business purposes

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X. CASH AND WORKING CAPITAL MANAGEMENT
B. Accounts Receivable and Payable Management
What is Accounts Payable Management?
It’s the money that a business has to pay to another business for receiving goods/services from them. To make it more simple, these are the unpaid bills a company has yet to pay. It’s
required to keep track of all the bills and invoices a company has received. Here, comes the Accounts Payable management. The management generally includes controlling all the
aspects of Accounts Payable. Paying your bills on time is important! If you don’t, things can go the wrong way – you might miss payments, break trust with suppliers, and even face
legal obligations. That’s why tracking your bills is key. This makes managing bills easier for any business size.

Importance Of AP Management

Stronger Vendor Relationships:

1 Let’s put yourself in the vendors’ place. You might feel bad when you don’t get paid. Similarly, the vendor might have trust issues with you if you miss a payment. By
keeping your accounts payable in check, you can avoid late payments and build trust with your clients.

Save Money on Late Fees:

2 Late fees and penalties can eat into your profits. Eficient accounts payable ensures your invoices are processed on time, so you can avoid those extra charges.

Ensure Peace of Mind With Better Finances:

3 Accounts payable management practices give you a clear picture of your finances, thus, making it easier for you to plan for upcoming expenses and avoid any
unforeseen shortfalls.

Identify Errors and Prevent Fraud:

4 Mistakes happen, but they can be costly. A well-organized accounts payable system helps you easily identify errors before they become problems. It can also make
it harder for fraudsters to sneak in fake invoices and steal your money.

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X. CASH AND WORKING CAPITAL MANAGEMENT
Accounts Receivable Management Importance

Accounts receivable management is defined as the practice of managing Improved cash flow: An efficient accounts receivable
customer payments that are owed to a business. It entails monitoring unpaid management system helps businesses receive payments faster,
invoices, following up with clients for payments, and account reconciliation. reducing the time between invoice generation and payment receipt.

It can be a hassle to keep track of accounts receivable, but an accounts

receivable software like Invoicera can help. Businesses can get paid faster and Reduction in bad debt: Poor accounts receivable management can
avoid debt by: lead to unpaid debts and bad debts. An adequate system ensures
timely payment collection and reduces the risk of non-payment.
1 Setting clear rules on how and when customers can pay
Increased customer satisfaction: An organized and streamlined
2 Sending accurate invoices quickly invoicing process helps maintain a positive relationship with
customers by providing precise and accurate payment information.

3 Following up on late payments

Better financial planning: Effective accounts receivable
management helps businesses track their payment collections and
4 Keeping good records of everything
forecast their cash flow, enabling better financial planning.

5 Making sure any missed payments are chased up Competitive advantage: An efficient accounts receivable management
system helps businesses gain a competitive advantage by improving their
The above steps can help businesses to have a healthy cash flow. financial stability, allowing them to invest in growth and expansion.

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C. Inventory Management

What is inventory management?

Inventory management is a systematic approach to sourcing, storing, and selling inventory. Effective inventory management involves
optimizing the flow of goods within an organization, from purchase right through to sale, always ensuring that an appropriate quantity is
available in the right place and at the right time to meet customer demand.
Inventory in this context refers to the goods handled by a business with the intention of selling, the raw materials that they use in
production, finished products, or even products they purchase in bulk to break down into parts to sell separately.
The approach a business takes to inventory management determines how these materials, goods, and products are sourced, stored,
and sold. Importantly, an effective approach to inventory management should align with the overall goals of the business.
For example, if a business is looking to minimize their costs, their approach to inventory management might involve reducing the
amount of safety stock they have on hand, and therefore minimizing inventory storage costs.
Many business choose to use a dedicated inventory management system to gain more control over their inventory. These platforms
can provide a company with the ability to get a top-down view of inventory throughout the supply chain, which can be extremely useful
in determining the right inventory replenishment strategy.

How does inventory management work?

It basically works by tracking products, components, and ingredients across suppliers, production, sales and stock on-hand to make sure it is being used effectively and efficiently. It
can be as deep a process as you want or need it to. For example, it can look at the diference between dependent and independent demand, or forecasting your sales to plan ahead.
However, it all goes back to your stock. It will track and control your inventory as it moves from your suppliers to your warehouse, then on to your customers.

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X. CASH AND WORKING CAPITAL MANAGEMENT

Why is inventory management important?

Inventory management is important because it outlines how you can run your business, grow your sales, and serve your customers. Managing inventory is crucial for businesses that
are based on the sale of products. Putting a system in place that does not require manual stocktaking, which can be a time consuming and disruptive process, can allow for more
accurate figures that are instantly available.
Inventory management also allows you to build good relationships with customers, because it will tell you exactly how quickly you can fulfil orders. This promotes consistency, and
customers are more likely to return to a business when they know they can deliver orders on time. This is particularly true when it comes to business- to-business transactions.
Additionally, it can help your company to grow. When organisations begin to grow, they become more complex and may add more products. Therefore, managing inventory early on
in the company will help to retain control as the company begins to scale up.

Benefits of inventory management

Greater cost savings

By streamlining any inventory management processes, you can eliminate any inventory costs associated with human error. Automation means that a business can reduce
excess and obsolete stock, and then reduce any costs incurred by that stock in space consumption or warehouse fees.

Better business negotiations

Because products will be more traceable, negotiations with suppliers and buyers will be considerably easier. Companies could also gain a better understanding of which
suppliers are more beneficial to the business, and which could be improved on.

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X. CASH AND WORKING CAPITAL MANAGEMENT

Benefits of inventory management (cont.) Inventory financing

Strong inventory management practices can also include unlocking the potential
Reduces the risk of overselling benefits of inventory financing. Inventory financing is a form of working capital
that allows businesses to purchase inventory on credit, using the purchased
Overselling is a major challenge for online sellers, which can result in loss of stock itself as collateral for the loan.
control and being suspended from marketplaces like Amazon or eBay. Inventory
management can allow businesses to synchronise orders and inventory across It’s often used by medium-sized companies looking to boost their stock reserves
each eCommerce platform, ensuring that stock levels are adjusted when a sale in preparation for demand, without drastically affecting their cash flow. By
comes through. boosting stock levels without the usual up-front cost to working capital –
businesses using inventory financing methods can ride out seasonal cash flow
fluctuations and fulfil higher demand during busy periods.

Profitable business decisions

Inventory finance techniques include reducing
Using the data provided by an inventory management system can allow for more long lead times by owning goods in transit,
data-driven business decisions, with a better-informed understanding of supply ensuring access to nearby safety stocks, and
and demand. Many inventory management systems will equip companies with embracing a vendor-managed inventory (VMI)
the tools needed to make strategic decisions, such as forecasting sales trends. approach. All forms of inventory finance help
to optimize available inventory, ensure the
continuity of production, and strengthen
working capital management.

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X. CASH AND WORKING CAPITAL MANAGEMENT
D. Short-term Financing
Short-term financing means business financing from short-term sources, which are for less than one year. The same helps the company generate cash for working of the business
and for operating expenses, which is usually for a smaller amount. It involves developing money by online loans, lines of credit, and invoice financing.

It is also referred to as working capital financing and is used for inventory, receivables, etc. In most cases, this type of financing is required in the business process because of their
uneven cash flow into the business or due to their seasonal business cycle.

Types of Short Term Financing

Trade Credit - This is the floating time that allows the business to pay for the goods or services they have purchased or received. The general floating time
allowed to pay is 28 days. This helps the businesses manage their cash flows more efficiently and help deal with their finances. Trade credit is a good way of
1 financing the inventories, which means how many days the vendor will be allowed before its payment is due. The vendor offers the trade credit as an inducement in
a continuing business, which is why it costs nothing.

Working Capital Loans - Banks or other financial institutions extend loans for a shorter period after studying the business’s nature, working capital cycle, records,
2 etc. Once the loan is sanctioned and disbursed by the bank or other financial institutions, it can be repaid in small installments or paid in full at the end of loan tenure,
depending on the agreed terms of loans between both parties. It is often advised to finance the permanent working capital needs through these loans

Invoice Discounting - It refers to arranging the funds against submitting invoices whose payments will be received shortly. The receivables invoices are
3 discounted with the banks, financial institutions, or any third party. On submission of bills, they will pay the discounted value of bills, and on the due date, they will
collect the payment on the business’s behalf.

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X. CASH AND WORKING CAPITAL MANAGEMENT
Factoring - It is a similar arrangement of finance like invoice discounting. It is debtor finance in which businesses sell their accounts receivable to a third party
4 whom we call factor at a lower rate than the net realizable value. It can be of any type with recourse or without recourse, unlike invoice discounting, which can
only be with recourse.

Business Line of Credit - It is the best way of financing working capital needs. The business can approach the bank for approval of a certain amount based on
their credit line structure judged through a credit score, a business model, and projected inflows. Then, the business can withdraw the amount as and when
5 needed, subject to the maximum approved amount. Then, they can again deposit the amount as and when it gets available. Moreover, the best thing is that
interest is charged on the utilized amount on the daily reducing balance method. In this manner, it becomes a very cost-efficient mode of financing.

Advantages of Short Term Loans

Less interest Disbursed Quickly Less Documentation

As these are to be paid of in a very short period The risk involved in defaulting the loan payment is As it is less risky, the documents required for the
within about a year, the total amount of interest cost lesser than that of the long-term loan as they have a same will also be not too much, making it an option
under it will be least as compared to long term loans long maturity date. Because of this, it takes less time for all to approach short-term loans.
that take many years to be paid of. The long term to get sanctioned the short-term loan as their
loan total interest cost might be more than the maturity date will be shorter. Thus one can get the
principal amount. loan sanctioned and the fund disbursed very
quickly.

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X. CASH AND WORKING CAPITAL MANAGEMENT

Disadvantages of Short Term Loans

The main disadvantage of short-term finance is that one can get a smaller loan and a shorter maturity date so that the borrower won’t get burdened with bigger installments.
However, it is fixed that the loan period will be less than one year. Therefore, if a high amount of loan is sanctioned, the monthly installment will come very high, increasing the
chance of default in repayment of the loan, which will affect the credit score adversely.

It can leave the borrower with no other option than to come into the trap of the cycle of borrowing in which one continues borrowing to repay the previous unpaid loan. In this
cycle, the interest rate increases, affecting the business and its liquidity.

Important Things to Note: Conclusion

Short term loans are very helpful not only for
businesses but also for individuals. For business, this
resolves the problem of sudden cash flow and in the
The main agenda of short-term finance for a business is to get funds
same line, it resolves the problem of an emergency
1 for working capital so that the cycle runs efficiently and the fund
fund for the individual. However, the consequences
does not become a hurdle in the day-to-day business.
of nonpayment of the installment of short-term loans
can be very dangerous. It will affect the credit score
and increase the financial burden and hurdle in day-
2 If the person is unable to repay the loan, it will afect their credit score.
to-day business operations. Therefore, it is advisable
to properly go through the projected business and
cash flow before opting for finance.

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X. CASH AND WORKING CAPITAL MANAGEMENT

E. Working Capital Optimization

Working capital originated with the old Yankee peddler who would load up his wagon and go of to peddle his wares. The
merchandise was called “working capital” because it was what he actually sold, or “turned over,” to produce his profits. The wagon
and horse were his fixed assets. He generally owned the horse and wagon (so they were financed with “equity” capital), but he
bought his merchandise on credit (that is, by borrowing from his supplier) or with money borrowed from a bank. Those loans were
called working capital loans, and they had to be repaid after each trip to demonstrate that the peddler was solvent and worthy of a
new loan. Banks that followed this procedure were said to be employing "sound banking practices." The more trips the peddler
took per year, the faster his working capital turned over and the greater his profits.

F. Liquidity Management
Liquidity management is the proactive process of ensuring a company has the cash on hand to meet its financial obligations as they come due. It is a critical component of financial
performance as it directly impacts a company’s working capital.

Working capital can be defined as the difference between a company’s current assets and liabilities. If a company has a positive working capital, it has more assets than liabilities and
is in good financial health. On the other hand, a negative working capital shows that a company has more liabilities than assets and is at risk of defaulting on its financial obligations.

Cash forecasting: When businesses can anticipate their future cash needs, they can take steps to ensure they will have the necessary funds on hand
when those needs arise. This might involve taking out a loan or line of credit or increasing sales to generate more revenue.

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X. CASH AND WORKING CAPITAL MANAGEMENT
F. Liquidity Management

Managing short-term debt obligations and investments: For a company to maintain a healthy cash flow, it is crucial to manage both its short-term
debt and investments. This includes making timely payments on debts and monitoring investments closely to ensure they are performing as expected.

Assessing lines of credit: A line of credit is a source of funding that can be used in case of an emergency, such as unexpected expenses or short-
term cash flow gaps.

Optimizing accounts receivable and accounts payable processes: An effective liquidity management strategy involves streamlining the invoicing
and collections process to ensure that payments are received on time, as well as taking advantage of early payment discounts when possible.

While liquidity management is a critical part of financial management, it is not an exact science. There will always
be some degree of uncertainty when forecasting and making business decisions about how to best manage a
company’s liquidity.

By taking a proactive approach and having a plan in place, businesses can minimize the risk of defaulting on
their other obligations and ensure they have the cash on hand to meet their short-term and long-term needs.

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X. CASH AND WORKING CAPITAL MANAGEMENT
What Are the Types of Liquidity?
When a business is planning its liquidity management strategy, understanding the diferent types of liquidity is important to ensure that all the company’s needs are being met.

Asset Liquidity Market Liquidity Accounting Liquidity

An asset is liquid if it can be converted into When a market has high liquidity, it means Accounting liquidity refers to the company’s
cash quickly and easily, without incurring a that there are a lot of buyers and sellers and ability to meet
significant loss. Cash on hand and the prices of assets are relatively stable. its day-to-day operational expenses, such as
investments in short- term debt instruments Market liquidity is an important consideration payroll and inventory costs. This is
are considered to be liquid assets. when making investment decisions as it will the most important type of liquidity as it
impact how easy it will be to buy or sell an directly impacts a company’s solvency.
asset.

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X. CASH AND WORKING CAPITAL MANAGEMENT

Why Is Liquidity Risk Management Important?

In supply chain management

Supply chain management is the process of coordinating the flow of goods and resources from suppliers to customers. It is a complex process that involves managing
multiple moving parts, including raw materials, inventory, finished products, transportation, and logistics.

Disruptions in the supply chain can lead to increased costs, decreased sales, and lower profits. For this reason, companies need to have a liquidity management plan in
place to manage any potential disruptions. This could include having an emergency fund to cover unexpected expenses and maintaining lines of credit.

In cash flow management

For most businesses, cash flow is the lifeblood of their operations and it is critical to ensure that there is always enough cash on hand to meet financial obligations.
However, even the most well-managed businesses can run into cash flow problems from time to time because of unforeseen circumstances.

By proactively managing liquidity risk, businesses can minimize the impact of cash inflows and outflows disruptions and ensure they have the funds necessary to pay for
day-to-day expenses.

Some liquidity management practices include closely monitoring accounts receivable and accounts payable processes and increasing sales to generate more revenue.

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X. CASH AND WORKING CAPITAL MANAGEMENT
How to Assess Liquidity?
Financial analysts often use liquidity ratios to assess a company’s liquidity. These ratios compare a company’s current assets to its current liabilities.

Current ratio:
This ratio measures a company’s ability to pay its short-term obligations with its current assets. It is the simplest and most common way of calculating a
company’s liquidity, which is dividing a company’s current assets by its current liabilities.

Quick Ratio:
This ratio is similar to the current ratio, but it excludes inventory from the calculation of current assets because inventory can take time to convert into cash and
may not be readily available to meet short-term obligations. The quick ratio is calculated by dividing a company’s current assets (cash + securities + accounts
receivable) by its current liabilities.

Cash Ratio:
This ratio measures a company’s ability to pay its short-term obligations with its most liquid assets, which are cash and cash equivalents. The cash ratio is
calculated by dividing a company’s cash and cash equivalents by its current liabilities.

In all cases, a higher ratio is better as it shows that a company has a greater ability to meet its financial obligations.

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X. CASH AND WORKING CAPITAL MANAGEMENT
What Are the Factors That Impact Liquidity Risk?
Most businesses need some level of working capital to maintain operations. However, there are a number of factors that can impact a company’s working capital and, as a result, its
liquidity.
Some of the most common factors that affect liquidity risks include:

Inventory: Too much inventory can tie up working capital that could be used more effectively elsewhere. On the other hand, too little inventory can lead to
production delays and lost sales.

Uncollected receivables: This is the money owed to a company by its customers for goods or services that have been delivered. If you have a lot of open invoices,
it can put a strain on your company’s cash positions and impact its liquidity.

Outstanding payables: This is the opposite of accounts receivable and refers to the money that a company owes to its suppliers. To manage this liquidity risk,
businesses often take advantage of early payment discounts or extended payment terms on current and future debts.

Reduced credit limits: This is one of the most common problems that businesses can face during an economic downturn. Companies are often forced to pay
cash for inventory and other supplies, which can put a strain on working capital.

Seasonality: Most businesses experience fluctuations in demand throughout the year. For example, retailers typically see a significant increase in sales during the
holiday season. However, this spike in demand can also lead to an increase in accounts receivable and a decrease in inventory levels, which can impact liquidity risk.

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Practice Questions
 A financial intermediary is an entity that collects funds from investors and lends them to individuals or organizations in need of capital. An example of
this would be a bank that accepts deposits and uses those funds to provide long-term mortgage loans.
a. True
b. False

Today’s financial institutions are much more diverse compared to the past, when federal laws strictly separated investment banks, commercial
banks, insurance companies, and similar entities. Modern financial services corporations now offer a broad spectrum of products, from basic
checking accounts and insurance to underwriting securities and providing stock brokerage services.
a. True
b. False

You recently sold 200 shares of Tesla stock through a broker. This would be classified as:
a. A money market transaction
b. A primary market transaction
c. A secondary market transaction
d. A futures market transaction
e. An over-the-counter market transaction

If investors expect inflation to be zero, the nominal return on a short-term U.S. Treasury bond will be equivalent to the real risk-free rate, r*.
a. True
b. False

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 Which of the following statements is CORRECT?
a. The New York Stock Exchange operates as an auction market and has a physical location
b. Home mortgage loans are traded in the money market
c. Selling shares of stock through a broker qualifies as a primary market transaction
d. Capital markets are focused solely on common stocks and other equity securities
e. Although the lines are becoming less clear, investment banks typically focus on lending money, while commercial banks primarily assist companies in raising
capital from external sources

The risk associated with interest rates rising, leading to a decrease in the value of existing bonds, is referred to as "interest rate risk" or "price risk
a. True
b. False

Which of the following factors is most likely to cause an increase in nominal interest rates?
a. Households cut back on spending and boost their savings
b. A new technology, such as the Internet, is introduced, leading to greater investment opportunities
c. Expected inflation decreases
d. The economy enters a recession
e. The Federal Reserve takes actions to stimulate economic growth

Assuming the current corporate bond yield curve is upward sloping, we can confidently infer that:
a. Inflation is not expected to decrease in the future
b. The economy is likely not experiencing a recession
c. Long-term bonds are not necessarily a better investment than short-term bonds
d. The upward slope of the yield curve may be influenced by maturity risk premiums
e. Long-term interest rates are generally more volatile compared to short-term rates

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 Which of the following statements is most accurate?
a. Retained earnings, as shown on the balance sheet, indicate the cash available for a company to distribute as dividends to shareholders
b. 70% of the interest income earned by corporations is exempt from taxable income
c. 70% of the dividends received by corporations are excluded from taxable income
d. Investors must pay the highest individual tax rate on long-term capital gains because taxes are due only when the gain is realized
e. The corporate tax system encourages equity financing, as dividend payments are tax-deductible for corporations

Last year, Tulip Industries reported (1) negative cash flow from operations, (2) negative free cash flow, and (3) an increase in cash on its balance sheet.
Which of the following factors might account for this scenario?
a. The company experienced a significant rise in its inventory levels
b. The company saw a notable increase in its accrued liabilities
c. The company issued new common stock
d. The company made a substantial capital investment early in the year
e. The company had a large increase in depreciation expenses

MikeRow Software's balance sheet indicates total common equity of $5,125,000. The company has 530,000 shares of stock in circulation, with each
share priced at $27.50. What is the difference between the firm's market value and book value per share?
a. $17.83
b. $18.72
c. $19.66
d. $20.64
e. $21.67

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 Which of the following, when considered independently, would raise a company's current ratio?
a. An increase in net fixed assets
b. An increase in accrued liabilities
c. An increase in notes payable
d. An increase in accounts receivable
e. An increase in accounts payable

A company aims to improve its financial position. Which of the following actions would lead to an increase in its current ratio?
a. Reduce the company’s days’ sales outstanding to the industry average, then use the cash savings to buy plant and equipment
b. Use cash to buy back some of the company’s own shares
c. Take on short-term debt and use the funds to pay off long-term debt
d. Issue new stock, then allocate some of the proceeds to purchase more inventory and keep the rest in cash
e. Use cash to increase the company’s inventory

Companies E and P both reported identical earnings per share (EPS), yet Company E's stock is priced higher. Which of the following statements is
CORRECT?
a. Company E likely has fewer growth opportunities
b. Company E is probably judged by investors to be riskier
c. Company E must have a higher market-to-book ratio
d. Company E is likely to pay a lower dividend
e. Company E has a higher price-to-earnings (P/E) ratio

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 PetroGas Company has a current ratio of 2.0. Which of the following actions, if taken alone, would decrease the current ratio?
a. Borrow using short-term notes payable and use the funds to decrease accruals
b. Borrow using short-term notes payable and use the funds to pay down long-term debt
c. Use cash to reduce accruals
d. Use cash to pay off short-term notes payable
e. Use cash to settle accounts payable

Which of the following bonds would see the largest percentage increase in value if the yield to maturity were to decrease by 1%?
a. A 1-year zero-coupon bond
b. A 1-year bond with an 8% coupon rate
c. A 10-year bond with an 8% coupon rate
d. A 10-year bond with a 12% coupon rate
e. A 10-year zero-coupon bond

Corporations typically generate returns for their shareholders by acquiring and managing both tangible and intangible assets. The risk associated
with each asset should be assessed based on how it impacts the overall risk faced by the company's shareholders.
a. True
b. False

Which of the following statements best describes the outcome of randomly selecting and adding stocks to your portfolio?
a. Adding more stocks will decrease the portfolio's unsystematic (or diversifiable) risk
b. Adding more stocks will raise the portfolio's expected return
c. Adding more stocks will lower the portfolio's beta and, in turn, reduce its systematic risk
d. Adding more stocks will not impact the portfolio's overall risk
e. Adding more stocks will decrease the portfolio's market risk but not its unsystematic risk

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 Taylor Furnishings aims to shorten its cash conversion cycle. Which of the following actions would be most effective?
a. Increase average inventory without boosting sales
b. Take measures to reduce the days sales outstanding (DSO)
c. Start paying bills more quickly, which would lower average accounts payable without impacting sales
d. Issue common stock to pay off long-term bonds
e. Issue long-term bonds and use the proceeds to repurchase some of its common stock

The firm's objective should be:

a. Maximizing profits
b. Maximizing shareholder value
c. Maximizing customer satisfaction
d. Maximizing sales

Buying a security from a company that is offering its stock to the public for the first time would be classified as:
a. a secondary market transaction
b. an initial public offering (IPO)
c. a seasoned new issue
d. Both A and B

The existence of a corporation is not influenced by the condition of its investors.

a. True
b. False

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 The average duration that a peso is invested in current assets is referred to as the:
a. net working capital
b. inventory conversion period
c. receivable conversion period
d. cash conversion period

In a sole proprietorship, the owner has unlimited personal liability for the debts and obligations incurred.
a. True
b. False

The implementation of safety stock by a company will:

a. decrease inventory costs
b. increase inventory costs
c. have no impact on inventory costs
d. none of the above

General partners can transfer ownership freely, while limited partners need approval from all other partners to transfer their ownership.
a. True
b. False

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 Swift Fashions Inc.'s balance sheet on December 31, 2014, reported total common equity of $4,050,000, with 200,000 shares outstanding. The
company earned $450,000 in net income during 2014 and distributed $100,000 in dividends. What was the book value per share on December 31,
2014, assuming no changes in the number of shares issued or repurchased during the year?
a. $20.90
b. $22.00
c. $23.10
d. $24.26
e. $25.47

Which of the following would suggest an enhancement in a company's financial health, assuming all other factors remain unchanged?
a. Both the inventory and total assets turnover ratios decrease
b. The total debt to total capital ratio rises
c. The profit margin decreases
d. The times-interest-earned ratio decreases
e. Both the current and quick ratios increase

The Midnights Corporation has recently acquired a costly piece of equipment. Originally, the company planned to depreciate the equipment over 5
years using the straight-line method. However, following a new provision passed by Congress, Nantell is now required to depreciate the equipment
over 7 years using the same method. Assuming other factors remain unchanged, which of the following outcomes will result from this change? It is
assumed that the company applies the same depreciation method for both tax reporting and financial reporting purposes.
a. Nantell’s taxable income will decrease
b. Nantell’s operating income (EBIT) will increase
c. Nantell’s cash position will improve
d. Nantell’s reported net income for the year will decrease
e. Nantell’s tax liability for the year will decrease

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 Which of the following would typically suggest an improvement in a company's financial position, assuming all other factors remain unchanged?
a. The TIE (Times Interest Earned) ratio decreases
b. The DSO (Days Sales Outstanding) increases
c. The quick ratio increases
d. The current ratio decreases
e. The total asset turnover decreases

If a bank loan officer is reviewing a company's loan application, which of the following statements would be considered CORRECT?
a. Other factors being equal, a lower inventory turnover ratio would result in a higher interest rate charged by the bank
b. All else being equal, a higher Days Sales Outstanding (DSO) ratio would lead to a higher interest rate from the bank
c. Other things remaining the same, a lower debt-to-capital ratio would likely result in a lower interest rate from the bank
d. If the company’s Times Interest Earned (TIE) ratio is lower, and other factors remain unchanged, the bank would charge a higher interest rate
e. All else being equal, a lower current ratio would typically lead to a higher interest rate on the loan

Assume that the interest rates for 20-year Treasury bonds and corporate bonds with varying ratings, all of which are noncallable, are as follows:

T-bond = 7.72% A = 9.64%

AAA = 8.72% BBB = 10.18%

The variations in these rates are most likely due to:

a. Differences in the real risk-free rate
b. Tax-related effects
c. Default and liquidity risk differences
d. Differences in maturity risk
e. Inflation differences

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 A 10-year corporate bond with a 9% annual coupon is currently priced at par ($1,000). Which of the following statements is CORRECT?
a. The bond's expected capital gains yield is zero
b. The bond's yield to maturity is greater than 9%
c. The bond's current yield is greater than 9%
d. If the bond's yield to maturity decreases, the bond will trade at a discount
e. The bond's current yield is lower than its expected capital gains yield

Net working capital is the result of dividing current assets by current liabilities.
a. True
b. False

For a portfolio consisting of 40 randomly selected stocks, which of the following is most likely true?
a. The portfolio’s risk is higher than the risk of each stock when held alone
b. The portfolio’s risk is the same as the risk of each stock when held alone
c. The portfolio’s beta is lower than the weighted average of the individual stock betas
d. The portfolio’s beta is equal to the weighted average of the individual stock betas
e. The portfolio’s beta is higher than the weighted average of the individual stock beta

Which of the following statements most accurately describes the focus of finance?
a. The impact of political, social, and economic factors on corporations
b. Maximizing profitability
c. The creation and preservation of economic wealth
d. Mitigating risk
e. Gaining access to capital markets

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 The challenge in identifying profitable projects is primarily due to:
a. Social responsibility
b. Competitive markets
c. Ethical concerns
d. Opportunity costs
e. Rising costs

A sole proprietorship is often considered the preferred business structure in most situations.
a. True
b. False

Since the market return represents the expected return on an average stock, it incorporates a certain level of risk. Consequently, there is a market
risk premium, which represents the additional return above the risk-free rate needed to compensate investors for taking on this average risk.
a. True
b. False

Fearless Company adopts an aggressive financing policy for working capital management, whereas Red Corporation follows a conservative financing
policy. Which of the following statements is correct?
a. Fearless has a lower proportion of short-term debt to total debt, while Red has a higher proportion of short-term debt to total debt
b. Fearless has a lower current ratio, while Red has a higher current ratio
c. Fearless faces less liquidity risk, while Red faces more liquidity risk
d. Fearless uses long-term debt to finance short-term assets, while Red uses short-term debt to finance short-term assets

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