Chapter 16: Managing Finances

Time Value of Money Recognizes the basic fact that, while it’s invested, money grows by earning interest or yielding some other form of return.
Compound Growth The compounding of interest paid to the investor over given time periods.
The Rule of 72 Allows your o find the number of years needed to double your money by dividing the annual interest rate (in percent) into 72.
Stock A portion of the ownership of a corporation.
Common Stock The most basic form of ownership in a company.
Stock Values are Expressed in 2 Different Ways -Market Value-Book Value
Market Value The current price of a share in the stock market.• Reflects the amount that buyers are willing to pay for a share of the company’s stock.
Book Value Determined as the firm’s owners’ equity (from the balance sheet) divided by the number of common shares owned by all shareholders.• Used as a comparison indicator because the market value for successful companies is usually greater than its book value.
Investment Traits of Common Stock • Common stocks are among the riskiest of all investments.• Uncertainties about the stock market itself can quickly change a given stock’s value.• Common stocks offer high growth potential.
Dividend A payment to shareholders, on a per-share basis, from the company’s earnings.
Mutual Funds Created by companies such as T. Rowe Price and Vanguard that pool cash investments from individuals and organizations to purchase a portfolio of stocks, bonds and other securities.
Reasons For Investing -Stability and Safety-Conservative Capital Growth-Aggressive Growth-Exchange-Traded Fund (ETF)
Stability and Safety • Funds stressing safety seek only modest growth with little fluctuation in principal value regardless of economic conditions.• They include money market and mutual funds and other funds that preserve the fund holders’ capital and reliably pay current income.• Typical assets of these funds include lower-risk US corporate bonds, US government bonds, and other safe short0term securities that provide stable income from interest and dividends.
Conservative Capital Growth • Mutual funds that stress preservation of capital and current income, but also seek some capital appreciation are called balanced funds.• These funds hold long-term municipal bonds, corporate bonds, and common stocks with good dividend-paying records and potential for market appreciation (higher market value), though there is always the risk of price declines if the general stock market fails.
Aggressive Growth • Seek maximum long-term capital growth.• They sacrifice current income and safety by investing in stocks of new (and even troubled) companies, firms developing new products and technologies, and other high-risk securities.• They are designed for investors who can accept the risk of loss inherent in common stock investing with severe price fluctuations, but also the potential for superior returns over time.
Exchange-Traded Fund (ETF) A bunds of stocks (or bonds) that are in an index that tracks the overall movement of a market; unlike a mutual fund, however, an ETF can be traded like a stock.
Advantages of ETFs -They can be traded throughout the day like a stock.-They have low operating expenses.-They do not require high initial investments.-ETFs can be bought and sold – priced continuously at any time throughout the day.-Intraday Trading-ETFs require no minimum investment, meaning they offer ease of entry for investors getting started without such money.-Lower-Annual Operating Expenses
Intraday Trading You can time your transaction during the day to buy or sell when (or if) the market reaches a desired price.
Lower-Annual Operating Expenses Annual fees for ETFs are low compared to fees for mutual funds.
Securities Stocks, bonds and mutual funds represent secured, or financially valuable claims on the part of investors.
Securities Markets The markets in which stocks and bonds are sold.
Primary Securities market New stocks and bonds are bought and sold by firms and governments.
Securities and Exchange Commission (SEC) The government agency that regulates US securities markets.
Investment Bank A financial institution such as Merrill Lynch or Goldman Sachs that specializes in issuing and reselling new securities.
Investment Banks Provide 3 Important Services • They advise companies on the timing and financial terms of new issues.• They underwrite – that is, assume liability for – new securities, thus providing the issuing firms with 100% of the money (less commission). The inability to resell the securities is a risk that the banks must bear.• They create distribution networks for moving new securities through groups of other banks and brokers into the hands of individual investors.
Secondary Securities Market Handled by such familiar bodies as the New York Stock Exchange and more recently, by online trading with electronic communication networks.
Stock Exchange An organization of individuals coordinated to provide an institutional auction setting in which stocks can be bought and sold.
The Trading Floor Brokers at an exchange trade face to face on the trading floor (outcry market).
The Major Stock Exchanges -New York Stock Exchange is the largest.-Global Stock Exchanges-The NASDAQ Market
New York Stock Exchange o Only firms meeting certain minimum requirements – earning power, total value of outstanding stock, and number of shareholders – are eligible for listing on the NYSE.o Today’s NYSE is a hybrid market that utilizes both floor and electronic trading.
National Association of Securities Dealers Automated Quotation (NASDAQ) System The world’s oldest electronic stock market was established in 1971.o NASDAQ orders are gathered and executed on a computer network connecting 350,000 terminals world-wide.
Electronic Communication Networks (ECNs) Electronic trading systems that bring buyers and sellers together outside of traditional stock exchanges by automatically matching buy and sell orders at specified prices.
Advantages of ECNs • Lower transaction costs per share to mere pennies due to fast and efficient trading procedures.• Allow after-hours trading and protect traders’ anonymity.
Individual Investor Trading Includes -Stock Brokers-Online Investing
Stock Brokers Earn commissions by executing buy and sell orders for outside customers.-Brokers do not own the securities; they earn commissions from the individuals and organizations for whom they place orders.
Types of Stock Brokers -Discount Brokers-Full-Service Brokers
Discount Brokers o Discount brokers offer well-informed individual investors who know what they want to buy or sell a fast, low-cost way to participate in the market.o Sales personnel receive fees or salaries, not commissions. o They do not offer in depth investment advice or person-to-person sales consultations.o They offer automated online services, such as stock research, industry analysis, and screening for specific types of stocks.
Full-Service Brokers o Full-service firms such as Merrill Lynch offer clients consulting advice in personal financial planning, estate planning, and tax strategies, along with a wider range of investment products.o In addition to delivering and interpreting information, financial advisors can point clients toward investments that might otherwise be lost in an avalanche of online financial data.
Book-Entry Ownership Procedure that holds investors’ shares in book-entry form, rather than issuing a physical paper certificate of ownership.
Market Indexes Provide useful summaries of overall price trends, both in specific industries and in the stock market as a whole.-Reveal bull and bear market trends.
Bull Markets Periods of rising stock prices, generally lasting 12 months or longer; investors are motivated to buy, confident that they will realize capital gains.
Bear Markets Periods of falling stock prices, usually 20% off peak prices; investors are motivated to sell, anticipating further falling prices.
Dow Jones Industrial Average (DJIA) The oldest and most widely cited US market index.• The DOW is an average of the stock prices for these 30 large firms, and traders and investors use it as a traditional barometer of the market’s overall movement.
DJIA Function o It measures the performance of the industrial sector of the US stock markets by focusing on just 30 blue chip, large cap companies as reflectors of the economic health of the many similar US firms.
Types of Market Indexes -The Dow Jones Industrial Average (DJIA)-The S&P 500-NASDAQ Composite Index-Russell 2000 Index-Index-Matching ETFs
The S&P 500 A broader report, considered by many to be the best single indicator of the US equities market.• It consists of 500 large-cap stocks, including companies from various sectors – such as information technology, energy, industrials, financials, health care, consumer staples, and telecommunications – for a balanced representation of the overall large-cap equities market.
NASDAQ Composite Index Market index that includes all NASDAQ-listed companies, both domestic and foreign, with a high proportion of technology companies and small-cap stocks.
Russell 2000 Index A specialty index that measures the performance of the smallest US companies based on market capitalization.• As the most quoted index focusing on the small-cap portion of the US economy, its stocks represent a range of sectors such as financials, consumer discretionary, healthcare, technology, materials, and utilities.
Index-Matching ETFs • Many ETFs are available to investors for duplicating (or nearly duplicating) the market performance of popular stock-market indexes.
Risk-Return (Risk-Reward) Relationship Whereas safer investments tend to offer lower returns, riskier investments tend to offer higher returns (rewards)
Current Dividend Yield (Interest Dividend Yield) The returns from stock dividends, and are figured by dividing the yearly dollar amount of dividend income by the investment’s current market value.
Price Appreciation An increase in the dollar value of an investment
Capital Gain The profit, realized from the increased value of an investment.
Total Return The sum of an investment’s current dividend (interest) yield and capital gain.
Total Return Equation (Current dividend payment + Capital gain)/ Original investment x100 = Total return (%)
2 Ways to Determine the Desired Risk-Return Balance -Diversification-Allocation
Diversification Buying several different kinds of investments rather than just one.
Example of Diversification Diversification as applied to common stocks means that you invest in stocks of several different companies.• The risk of loss is reduced by spreading the total investment across different stocks because although any one stock may tumble, the changes are less that all of them will fall at the same time.
Asset Allocation The proportion – the relative amounts – of fund invested in (or allocated to) each of the investment alternatives.
Example of Asset Allocation You may decide to allocate 50% of your funds to common stocks, 25% to a money market mutual fund, and 25% to a US Treasury bond mutual fund.
Portfolio The combined holdings of all the financial investments – stocks, bonds, mutual funds, real estate – of any company or individual.
Secured Loan The borrower guarantees repayment of the loan by pledging the asset as collateral to the lender.
Collateral An asset pledged for the fulfillment of repaying a loan.o If the borrower defaults, or fails to repay the loan, the bank can take possession of his or her assets and sell them to recover the outstanding debt.
Loan Principal The amount of money that is loaned and must be repaid.
Interest Fee paid to a lender for the use of borrowed funds; like a rental fee.
Annual Percentage Rate (APR) One-year rate that is charged for borrowing, expressed as a percentage of the borrowed principal.
Working Capital Equation Working Capital = Current assets – Current liabilities
Positive Working Capital The firm’s current assets are large enough to pay off current liabilities.
Negative Working Capital The firm’s current liabilities are greater than current assets, so it may need to borrow money from a commercial bank.
Unsecured Loan The borrower does not have to put up collateral.-Firms with bad credit scores typically cannot get unsecured loans.
Angel Investors Outside individuals who provide new capital for firms in return for a share of equity ownership.-Provide venture capital
Venture Capital Private funds from wealthy individuals or companies that seek investment opportunities in new growth companies.
Corporate Bond A formal pledge (an IOU) obligating the issuer to pay interest periodically and repay the principal at maturity (a preset future date) to the lender.
Characteristics of Corporate Bonds • The bondholder (the lender) has no claim to ownership of the company and does not receive dividends.• Interest payments and repayment of principal are financial obligations; payments to bondholders have priority over dividend payments to stockholders in cases of financial distress.- Bond Indenture• Corporate bonds have been traditionally issued to fund outstanding debts and major projects for various lengths of time.• Longer-term corporate bonds are somewhat riskier than short-term bonds because they are exposed to greater unforeseen economic conditions that may lead to default.
Bond Indenture A legal document identifying the borrower’s obligations and the financial returns to lenders.
Maturity Date (Due Date) When the firm must repay the bond’s face value to the lender.
Face Value (Par Value) Amount of money that the bond buyer (lender) lent the issuer, and that the lender will receive upon repayment.
Default The borrower fails to make payment when due to lenders.-Bankholders may then file a bondholder’s claim.
Bondholder’s Claim A request for court enforcement of the bond’s term of payment.
Bankruptcy The court-granted permission not to pay some or all debts.
Initial PUblic Offerings (IPOs) The first sale of a company’s stock to the general public.o They are a major source of funds that fuel continued growth for many firms, as well as introduce numerous considerations and complexities inherent in running a public company.
Corporate Raider An investor conducting a type of hostile (unwanted) takeover.• They buy shares on the open market, attempting to seize control of the company and its assets.• The raider then sells off those assets at a profit, resulting in the company’s disappearance.
Stock Valuation o Because of the uncertainties involved in stock prices, investment professionals believe day-to-day prices to be a generally poor indicator of any stock’s real value.o A long-run perspective considers the company’s financial health, past history of results and future forecasts, its record for managerial performance, and overall prospects for competing successfully in the coming years.
Why Shares Are Different Prices Shares Are Different Prices• One reason is supply and demand for each company’s shares; another is because some corporations want the shares to sell within a particular price range, say between $20 and $80, believing it will attract a larger pool of investors.• If the price gets too high, the company can restore it to the desired range by a stock split.
Stock Split A stock dividend paid in additional shares to shareholders.
Market Capitalization (Market Cap) The total dollar value of all the company’s outstanding shares, calculated as the current stock price multiplied by the number of shares outstanding.o The investment industry categorizes firms according to size of capitalization. o Investors typically regard larger market caps as less risky, and firms with small market caps (small-cap firms) as being particularly risky investments.
Firms can meet their capital needs through 2 sources -Debt Financing-Equity Financing
Debt Financing Long-term borrowing from sources outside the company.
Advantages of Debt Financing • Because the number of parties involved is limited, loans can often be arranged very quickly.• The firm need not make public disclosure of its business plans or the purpose for which it is acquiring the loan.
Disadvantages of Debt Financing • Borrowers may have trouble finding lenders to supply large sums.• Borrowers may also face restrictions as conditions of the loan.• Borrowers may have to pledge long-term assets as collateral or agree to take on no more debt until the loan is paid.
Advantages of Corporate Bonds • Bonds are attractive when firms need large amounts for long periods of time.• The issuing company gains access to large numbers of lenders through nationwide bond markets.• Bonds entail high administrative and selling costs.
Disadvantages of Corporate Bonds • Bonds also impose binding obligations on the firm, in many cases for up to 30 years, to pay bondholders a stipulated sum of annual or semiannual interest, even in times of financial distress.
Equity Financing Looking inside the company for long-term funding.
The Expense of Common Stock • It can be expensive because paying dividends is more expensive than paying bond interest.• Interest paid to bondholders is a business expense and therefore a tax deduction for the firm.• Payments of cash dividends to shareholders are not tax deductible.
Retained Earnings as a Source of Capital • Retained earnings are net profits retained for the firm’s use rather than paid out in dividends to stockholders.• If a company uses retained earnings as capital, it will not have to borrow money and pay interest.• Retained earnings mean smaller dividends for shareholders.• This practice may decrease the demand for – and the price of – the company’s stock.

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