Chapter 6. Determination of Interest Rates in Financial Markets

. Interest rates
. The determinants of interest rates
. Term structure of interest rates and yield curves
. What determines the shape of yield curves
. Other factors






. Interest rates


Cost of borrowing money



Factors that affect cost of money:

Production opportunities

Time preference for consumption

Risk

Inflation









. The determinants of interest rates


 The quoted (nominal) interest rate on a debt security is composed of a real risk-free rate, r*, plus several risk premiums



 Risk premium: additional return to compensate for additional risk







 Quoted nominal return = r = r* + IP + DRP + MRP + LP

 where, r = the quoted, or nominal rate on a given security

r* = real risk-free rate

IP = inflation premium (the average expected rate of inflation over the life
time of the security)

 DRP = default risk premium

 MRP = maturity risk premium

 LP = liquidity premium



 and r* + IP = rRF = nominal risk-free rate (T-bill rate)





. Term structure of interest rates and yield curves


Term structure of interest rates: the relationship between yields and maturities



 Yield curve: a graph showing the relationship between yields and maturities



 Normal yield curve (upward sloping)

 Abnormal yield curve (downward sloping)

 Humped yield curve (interest rates on medium-term maturities are higher than
both short-term and long-term maturities)



 Term to maturity   -    Interest rate Interest rate (%)

 1 year 0.4%

 5 years 2.4%

 10 years 3.7%

 30 years 4.6%



. What determines the shape of yield curves?


Term structure theories

(1) Expectation theory: the shape of the yield curve depends on investor’s expectations about future interest rates (inflation rates)



 Forward rate: a future interest rate implied in the current interest rates



 For example, a one-year T-bond yields 5% and a two-year T-bond yields 5.5%, then the investors expect to yield 6% for the T-bond in the second year.



(1+5.5%)2 = (1+5%)(1+X), solve for X(forward rate) = 6.00238%



Approximation: (5.5%)*2 - 5% = 6%






 (2) Liquidity preference theory: other things constant, investors prefer to make short-term loans, therefore, they would like to lend short-term funds at lower rates



 Implication: keeping other things constant, we should observe normal yield curves





. Other factors


Fed policy: money supply and interest rates

Increase in money supply lowers short-term interest rates and stimulates the economy but may lead to inflation in the future



Government budget deficit or surpluses: if government runs a huge deficit and the debt must be covered by additional borrowing, which increases the demand for funds and thus pushes up interest rates


International perspective: trade deficit, country risk, exchange rate risk



Business activity: during recession, demand for funds decreases; during expansion, demand for funds rises



http://www.csun.edu/~zz1802/index.htm





.

Chapter 5. Time Value of Money

 Time line
 Future value (FV) and present value (PV)
 Future value annuity (FVA) and present value annuity (PVA)
 Perpetuity
 Uneven cash flows
 Semiannual and other compounding periods
 Amortization
 Applications


Now everyone knows that people can deposit money in banks and banks pay interest on the deposits. Hence if one invests $1000 in a deposit and goes after 90 days he gets a higher amount. Thus value of deposit appreciates with time. This phenomenon of appreciation in the value of principal with passage of time due to payment of interest is known as time value of money. Hence, the amount deposited and amount received back reflect the time value of money.


 Time line
Time line: an important tool used to show timing of cash flows
  Cash outflows vs. cash inflows: cash outflows are negative and cash inflows are
positive

 Future value (FV) and present value (PV)

FV: the amount to which a cash flow will grow over a given number of periods

Compounding: an arithmetic process of determining the final value of a cash flow or a series of cash flows when compound interest is applied


The relationship among future value, interest rate, and time


PV: the value today of a future cash flow
Discounting: a process of finding the present value of a cash flow or a series of  cash flows from the future


The relationship among present value, interest rate, and time


 Future value annuity (FVA) and present value annuity (PVA)
Annuity: a series of equal payments for a number of specified periods
Ordinary annuity: an annuity with payments made at the end of each period
FVA: the future value of an annuity for a number of specified periods


Annuity due: an annuity with payments made at the beginning of each period

Each payment in annuity due earns one period of additional interest



PVA: the present value of an annuity over a number of periods


Rule of 72: Number of years  to double your money(N)   Interest per year * N = 72 (approximation)

 Perpetuity
Annuity that lasts forever
Present value of a perpetuity = payment / interest rate = PMT / (I/YR)
 Uneven cash flows
A series of cash flows that varies in amount from one period to the other
(1) Annuity plus additional final payment
(2) Irregular cash flows
Looking for patents or treat each cash flow separately
Naïve way to deal with uneven cash flows: deal with one cash flow at a time

 Semiannual and other compounding periods
Annual compounding: interest payment is calculated once a year
Semiannual compounding: interest payment is calculated twice a year
Other compounding periods: quarterly, monthly, daily, and continuously, etc.
Effective rate = (1 + i / m)m
- 1, where i is the nominal annual rate and m is the
number of compounding (for example, for quarterly compounding, m = 4)



 Amortization
Amortized loan: a loan that is repaid in equal payments over its duration.


 Applications of Time Value of Money

Bond and stock valuations use time value of money mathematics.
Project appraisal or investment proposal appraisal uses time value of money ideas.

Chapter 4. Financial Statement Analysis for Financial Decision Making

 Financial ratio analysis
 Du Pont equations
 Trend analysis
 Limitations in ratio analysis
 Looking beyond the numbers
 Financial ratio analysis


Evaluating a firm’s financial statement to predict the firm’s future performance
(1) Liquidity ratios: show a firm’s ability to pay off short-term debt (the relationship of a firm’s cash and other current assets to its current liabilities)
Current ratio = current assets / current liabilities
Quick ratio (acid test ratio) = (current assets - inventory) / current liabilities


The traditional recommended value for current ratio is 2:1 and quick ratio is 1:1.


(2) Asset management ratios: measure how effectively a firm manages its assets
Inventory turnover = sales / inventory
Days Sales Outstanding (DSO) = account receivables / average daily sales
Fixed asset turnover = sales / net fixed assets
Total asset turnover = sales / total assets
Firms want to increase turnover ratios and keep DSO as low as possible

(3) Debt management ratios: show how the firm has financed its assets as well as the firm’s ability to pay off its long-term debt (how effectively a firm manages its debt)

Using debt has tax benefit (interests on debt are tax deductible). On the other hand, too much debt increases the firm’s risk of being bankruptcy.

Effect of Financial Leverage (effect of using debt)
Debt ratio = total debt / total assets
Times interest earned (TIE) = operating income (EBIT) / interest expenses
The higher the TIE, the better

(4) Profitability ratios: show how profitable a firm is operating and utilizing its
assets (shows the combined effects)
Operating profit margin = EBIT / sales
Profit margin = net income / sales
Return on assets (ROA) = net income / total assets
Basic earnings power (BEP) = EBIT / total assets
Return on equity (ROE) = net income / common equity
The higher the returns, the better the performance

(5) Market value ratios: relate stock price to earnings and book value and show
what investors think about the firm and its future prospects
Price / earnings ratio (P/E ratio) = price per share / earnings per share
Market / book ratio = market price per share / book value per share


 Du Pont equations
ROA = net income / total assets = (net income / sales) * (sales / total assets)
 = profit margin* total assets turnover
In order to increase ROA, firms can try to improve profit margin and/or total asset  turnover

ROE = net income / common equity
 = (net income / sales)* (sales / total assets) * (total assets / common equity)
 = profit margin * total assets turnover * equity multiplier
In order to increase ROE, firms can try to improve profit margin and/or total asset
turnover and/or equity multiplier




 Trend analysis
Analyzing a firm’s financial ratios over time to estimate the likelihood of improvement or deterioration in its financial conditions.


 Limitations in ratio analysis

Different divisions in different industries
Industry average
Accounting methods
Inflation
Window dressing
Seasonality

 Beyond the numbers  - Problem issues
Tied to one customer?
Tied to one product?
Rely on one supplier?
Having operations overseas?
Having more competition?
Developing future products?
Having legal issues?

Chapter 3. Financial Statements and Taxes

 Financial statements and reports
 Basic financial statements
 Free cash flow
 MVA and EVA
 Income taxes

Finance managers have to prepare or arrange to prepare financial statements of their company and they have to analyze the financial statements of their customers, suppliers and companies in which they may make short term or long term equity or debt  investments.



 Financial statements and reports
Annual report
A report issued annually to shareholders that contains:
(1) Verbal statements: explain what happened and why; offer future prospects
(2) Financial statements:
Balance sheet
Income statement
Cash flow statement
Shareholder’s equity statement


Importance of financial statements and reports
To investors: provide valuable information regarding the firm
To managers: for internal control and financial planning

 Basic financial statements


(1) Balance sheet: a statement of a firms’ financial position at a point in time
Cash & marketable securities Accounts payable (A/P)
Accounts receivable (A/R) Accrued wages and taxes (Accruals)
Inventory Notes payable
------------------------------------ -------------------------------------
Current assets Current liabilities
+ + Total liabilities
Net fixed assets Long-term debt
+ +
Other assets Shareholders’ equity (c/s and R/E)
------------------------------------ --------------------------------------
Total assets = Total liabilities and equity
Note: Current liabilities + long-term debt = total liabilities
 Shareholder’s equity (Common equity) = total assets - total liabilities
Shareholders’ equity = common stock (c/s) + retained earnings (R/E)
 = paid-in capital + retained earnings
Paid-in capital = market value of stock - par value of stock
Retained earnings are cumulative, assuming no preferred stocks

Working capital: refers to current assets
Net working capital = current assets - current liabilities
Net operating working capital = current assets - (current liabilities - notes
payable)

Market value vs. book value
Market value = the actual market price
Book value = (common equity) / (# of shares outstanding)



(2) Income statement: a report summarizing a firm’s revenues, expenses, and
profits during a reporting period
Sales
- Operating cost except depreciation and amortization
-------------------------------------------------------------------
EBITDA
- Depreciation and amortization
----------------------------------------------------
Earnings before interest and taxes (EBIT)
- Interest expenses
----------------------------------
Earnings before Tax (EBT)
- Income tax
----------------------------------
Net income (NI)
NI can be used for cash dividend and/or retained earnings


Commonly used terms:
Earnings per share (EPS) = NI / number of shares outstanding
Dividend per share (DPS) = cash dividend / number of shares outstanding
Dividend payout ratio = cash dividend / NI
Retention ratio = retained earnings / NI


(3) Cash flow statement: a report showing how things affect the balance sheet and
income statement will affect the firm’s cash flows
Cash flow statement has four sections: operating, long-term investing, financing
activities, and summary on cash flows over an accounting period


(4) Shareholder’s equity statement
Last year’s end balance
Add this year’s R/E = NI - Common stock cash dividend
This year’s end balance


 Free cash flow
Accounting profit vs. cash flow
Accounting profit is a firm’s net income reported on its income statement.
Net cash flow is the actual net cash that a firm generates during a specified period.
Net cash flow = NI + depreciation and amortization
Free cash flow: a mount of cash available for payments to all investors, including
stockholders and debt-holders after investments to sustain ongoing operations
FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +

in
net operating working capital)
 MVA and EVA
MVA stands for market value added, which is the excess of the market value of
equity over its book value - focus
EVA stands for economic value added, which is the excess of net operating profit
after tax (NOPAT) over capital costs
NOPAT = EBIT*(1-T)
Capital costs = total investor-supplied operating capital*after-tax cost of capital



 Income taxes
Progressive tax rate system: the tax rate is higher on higher income
Taxable income: gross income minus exceptions and allowable deductions as set
forth in the Tax Code or the income that is subject to taxes
Marginal tax rate: the tax rate applicable to the last dollar made
Average tax rate: taxes paid divided by total taxable income
Personal income tax:
Interest income: taxed as ordinary income (up to 39.6% for federal taxes +
additional state taxes)
Dividend income: used to be taxed as ordinary income (currently is taxed at 15%
for most investors and the maximum 20% for wealthy investors)
Capital gains (short-term, less than a year): taxed as ordinary income
Capital gains (long-term, more than a year): taxed at 15% for most investors and
the maximum of 20% for wealthy investors
Capital losses are tax deductible up to $3,000 or to offset capital gains
Alternative Minimum TAX (AMT): created by Congress to make it more difficult
for wealthy individuals to avoid taxes through the use of various deductions
Equivalent pre-tax yield vs. after tax return
Equivalent pre-tax yield = tax-free return / (1 – T)
After tax return = before tax return (1 – T)
Example: suppose your marginal tax rate is 28%. Would you prefer to earn a 6%
taxable return or 4% tax-free return? What is the equivalent taxable yield of the
4% tax-free yield?
Answer: 6%*(1-28%) = 4.32% or 4% / (1-28%) = 5.56%
You should prefer 6% taxable return because you get a higher return after tax,
ignoring the risk


Corporate income tax:


Interest income is taxed as ordinary income
Interest expenses are tax deductible
Dividend income is 70% tax-exempt (70% dividend exclusion)
Dividend paid is not tax deductible
Capital gains are taxed as ordinary income
Capital losses can only offset capital gains (carry back for 3 years or carry
forward for 5 years)
Operating losses can offset taxable income (carry back for 2 years or carry
forward for 20 years)
Deprecation: plays an important role in income tax calculation - the larger the
depreciation, the lower the taxable income, the lower the tax bill
Depreciation methods:
Straight-line method depreciates cost evenly throughout the useful life of the fixed
asset
Double-declining balance method is an accelerated depreciation method that
counts twice as much of the asset’s book value each year as an expense compared
to straight-line depreciation.
Modified accelerated cost recovery system (MACRS) is the current tax
depreciation system in the United States. Under this system, the capitalized cost
(basis) of tangible property is recovered over a specified life by annual deductions
for depreciation. The lives are specified broadly in the Internal Revenue Code.
The Internal Revenue Service (IRS) publishes detailed tables of lives by classes of
assets.

Chapter 2. Financial Markets and Institutions

 Capital allocation process
 Financial markets
 Financial institutions
 The stock market and stock returns
 Stock market efficiency
 Capital allocation process


The process of capital flows from those with surplus capital to those who need it.

Three types of transfer
(1) Direct transfer: a business sells its security directly to investors
(2) Indirect transfer through an investment banker: a business sells its security to
an investment banker, which in turn sells the same security to individual investors
(3) Indirect transfer through a financial intermediary: a financial intermediary obtains funds from investors by offering its own securities and uses funds to buy other business securities

Capital formation process

 Financial markets
Physical asset market vs. financial asset markets
Physical asset markets are markets for real (or tangible) assets
Financial asset markets are markets for financial assets - focus of this class
Money markets vs. capital markets
Money markets are markets for short-term and highly liquid debt securities (less
than one year)
Capital markets are markets for intermediate and long-term debts and stocks (one
year or longer)
Primary markets vs. secondary markets
Primary markets are markets for issuing new securities
Secondary markets are markets for trading existing securities
Spot markets vs. futures markets
Spot markets are markets for immediate delivery
Futures markets are markets for future delivery even though the deal is made
today
Private markets vs. public markets
In private markets: transactions are negotiated directly between two parties
Public markets: standardized contracts are traded on organized exchanges
Derivative markets: for derivative securities
A derivative security is a security whose value is derived from the value of an
underlying asset. For example, futures contracts and option contracts
Why do we need financial markets?
Bring borrowers and lenders together to exchange needs


 Financial institutions
Investment banks (investment banking houses): specialized in underwriting and distributing new securities, such as Merrill Lynch (now acquired by Bank of America) and Goldman Sachs.

The role of investment bankers: underwriters

Design securities with features that are attractive to investors
Buy these securities from the issuing firm
Resell these securities to individual investors
Public offering vs. private placement
Public offering: a security offering to all investors
Private placement: a security offering to a small number of potential investors


Commercial banks: provide basic banking and checking services, such as BOA

Financial service corporations: large conglomerates that combine different
financial institutions into a single corporation, such as Citigroup
S&Ls, credit unions
Life insurance companies
Mutual funds: sell themselves to investors and use funds to invest in securities
Exchange traded funds (ETFs): mutual funds but traded like stocks
Hedge funds: similar to mutual funds with few restrictions


 The stock market and stock returns
Organized markets vs. over-the-counter (OTC) markets
Organized markets (exchanges) have physical locations, such as NYES
OTC markets are connected by computer network with many dealers and brokers,
such as NASDAQ 10
Auction markets vs. dealer markets
Organized markets are auction markets
OTC markets are dealer markets
IPO markets: markets for initial public offerings


Stock market transactions (three types)
(1) Trading outstanding (existing) shares takes place in a secondary market
(2) Selling additional shares by a publicly owned firm takes place in a primary market (seasoned offerings)
(3) Selling shares to the public for the first time by a privately owned firm takes place in a primary market (IPOs)


Bid: someone wants to buy 4,000 shares at 29.03
Ask: someone is offering to sell 4,500 shares at 29.04


Stock market returns

Expected return: return expected to be realized, which is always positive
Realized return: actual return received, which can be either positive or negative

There is a positive relation between expected return and risk


Stock market efficiency
Efficient market: prices of securities in the market should fully and quickly reflect all available information, which means that market prices should be close to intrinsic values (market in equilibrium)


Levels of market efficiency
Weak-form efficiency - stock prices already reflect all information contained in the history of past price movements (only past prices, volumes, and returns)
Semistrong-form efficiency - stock prices already reflect all publicly available information in the market (only past publicly available information)
Strong-form efficiency - stock prices already reflect all available information in the market, including inside information (all public and private information)

Chapter 1. An Overview of Financial Management - Introduction to Financial Management of Companies

 What is finance: cash flows between capital markets and firm’s operations
 The goal of a firm
 Forms of business organization
 Intrinsic value and market price of a stock
 Agency problem
 Business ethics
 Career opportunities in finance



 What is finance: cash flows between capital markets and firm’s operations


(1) Cash raised by selling financial assets in financial markets
(2) Cash invested in firm’s operations and used to purchase real assets
(3) Cash generated from firm’s operations
(4a) Cash reinvested in firms’ operations
(4b) Cash returned to investors


Financing decisions vs. investment decisions: raising money vs. allocating money

Activity (1) is a financing decision
Activity (2) is an investment decision
Activities (4a) and (4b) are financing decisions


The role of a financial manager:

Forecasting and planning of firms’ financial needs
Planning of firm's financial needs involves investment decision - approving the investment proposals made by various operating managers (all departments including marketing and HR are classified under operating managers)
Making financing decisions
Coordinating with other departments/divisions
Dealing with financial markets
Managing risks



Finance within an organization: importance of finance

Finance includes three areas.

(1) Financial management: corporate finance, which deals with decisions related to how many and what types of assets a firm needs to acquire (investment decisions), how a firm should raise capital to purchase assets (financing decisions), and how a firm should do to maximize its shareholders wealth (goal of a firm) - the focus of this class

(2) Capital markets: study of financial markets and institutions, which deals with interest rates, stocks, bonds, government securities, and other marketable securities. It also covers Federal Reserve System and its policies.  The knowledge of capital markets is required to know likely conditions in the markets as well as documentation required, procedure to be followed and regulatory requirements of financial markets to raise finance in the form of equity, debt or risk management products.
(3) Investments: study of security analysis, portfolio theory, market analysis, and behavioral finance. This knowledge is required to understand how markets value financial assets and how demand is created for the financial assets of a company through decisions of large number of individual and institutional investors.

 The goal of a firm
To maximize shareholder’s wealth (or firm’s long-run value)
Why not profit or EPS maximization?
Profit maximization usually ignores timing and risk of cash flows
EPS  is also a profit measure only.

Why not focusing on short-term?
Top executives receive huge bonuses for engaging in risky transactions that could generate short-term profits and those transactions collapse later on, subprime mortgage, for example



Corporation: legal entity created by a state.

Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital

Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting
 Intrinsic value and market price of a stock
Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should
be worth)
Market price is the actual price of a stock, which is determined by the demand and supply of the stock in the market


Determinants of intrinsic value and stock price
Intrinsic value is supposed to be estimated using the “true” or accurate risk and
return data. However, since sometimes the “true” or accurate data is not directly
observable, the intrinsic value cannot be measured precisely.
Market value is based on perceived risk and return data. Since the perceived risk and return may not be equal to the “true” risk and return, the market value can be mispriced as well.

Stock in equilibrium: when a stock’s market price is equal to its intrinsic value the stock is in equilibrium.
Stock market in equilibrium: when all the stocks in the market are in equilibrium (i.e. for each stock in the market, the market price is equal to its intrinsic value) then the market is in equilibrium

Actual prices vs. intrinsic values
When the intrinsic value of a stock is higher than the market price of the stock, we
say that the stock in the market is under-valued (under-priced)
For example, if the intrinsic value for a stock is $26 and the market price is $25,
then the stock is under-valued.
When the intrinsic value of a stock is lower than the market price of the stock, we
say that the stock in the market is over-valued (over-priced)
For example, if the intrinsic value for a stock is $30 and the market price is $32,
then the stock is over-valued.
When the intrinsic value of a stock is equal to the market price of the stock, we
say that the stock in the market is fairly priced (the stock is in equilibrium)

 Agency problem
A potential conflict of interest between two groups of people
Stockholders vs. managers
Instead of shareholders’ wealth maximization, managers may be interested in
their own wealth maximization
Useful motivational tools
Performance shares, executive stock options (positive)
Threat of firing (negative)
Hostile takeover (negative)
Stockholders vs. bondholders
Stockholders prefer high-risk projects for higher returns
Bondholders receive fixed payment and therefore prefer lower risk projects


 Business ethics
Standards of conduct or moral behavior toward its employees, customers,
community, and stockholders - all its stakeholders
Measurements: tendency of its employees, adhere to laws and regulations, moral
standards to product safety and quality, fair employment practice, fair marketing
and selling practice, proper use of confidential information, community
involvement, and no illegal payments or practice to obtain business.

Financial markets demand ethical practices and finance managers have to know the ethical codes of various markets and have to put in place an ethical code in their organizations to match them.


Power Point Slides - Brigham and Young  10th Edition

From  http://www.swlearning.com/finance/brigham/ffm10e/powerpoint.html


http://www.csun.edu/~zz1802/index.htm

Manufacturing Management Subject Update 2014

Journal of Manufacturing Technology Management


October 2014
Scope and Definition of Manufacturing - Production Management

September 2014


18 Sep
Creaky Machinery: How to Get the Most Out of Your Aging Factory
Sep 18, 2014 John Mills

Identify the cost of operating the old machine.
Estimate your savings with minor repairs. Figure out whether the repair would pay enough to justify the effort required. Do an engineering economic study for a new machine or challenger. Would you be better off buying the new machinery.
Remember if economics is compelling finance will come.
http://www.industryweek.com/workforce/creaky-machinery-how-get-most-out-your-aging-factory?


June 2014


A Simple Guide for Manufacturers on When to Choose a Robot
BY RACHEL GREENBERG ON JUNE 3, 2014
http://nistmep.blogs.govdelivery.com/simple-guide-manufacturers-choose-robot/