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Chapter 1: The Role and Environment of Managerial Finance

- What is Finance: Finance can be defined as the art and science of managing money.
- Legal forms of Business Organization:
Sole Proprietorship: The vast majority of small businesses start out as sole proprietorships. These firms
are owned by one person, usually the individual who has day-to-day responsibility for running the
business. Sole proprietorships own all the assets of the business and the profits generated by it
Advantages of a Sole Proprietorship
Easiest and least expensive form of ownership to organize.
Sole proprietors are in complete control, and within the parameters of the law, may make decisions as
they see fit.
Profits from the business flow-through directly to the owners personal tax return.
The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship
Sole proprietors have unlimited liability and are legally responsible for all debts against the
business. Their business and personal assets are at risk.
May be at a disadvantage in raising funds and are often limited to using funds from personal savings or
consumer loans.
May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity
to own a part of the business.
Some employee benefits such as owners medical insurance premiums are not directly deductible from
business income (only partially as an adjustment to income).
Partnerships: In a Partnership, two or more people share ownership of a single business
Advantages of a Partnership
Partnerships are relatively easy to establish; however time should be invested in developing the
partnership agreement.
With more than one owner, the ability to raise funds may be increased.
The profits from the business flow directly through to the partners personal tax return.
Prospective employees may be attracted to the business if given the incentive to become a partner.
The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership
Partners are jointly and individually liable for the actions of the other partners.
Profits must be shared with others.
Since decisions are shared, disagreements can occur.
Some employee benefits are not deductible from business income on tax returns.
The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
Types of Partnerships that should be considered:
1. General Partnership
Partners divide responsibility for management and liability, as well as the shares of profit or loss
according to their internal agreement. Equal shares are assumed unless there is a written agreement
that states differently.
2. Limited Partnership and Partnership with limited liability
Limited means that most of the partners have limited liability (to the extent of their investment) as well as
limited input regarding management decision, which generally encourages investors for short term
projects, or for investing in capital assets. This form of ownership is not often used for operating retail or
service businesses. Forming a limited partnership is more complex and formal than that of a general
3. Joint Venture
Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners
in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file
as such, and distribute accumulated partnership assets upon dissolution of the entity.

Corporations:A Corporation, chartered by the state in which it is headquartered, is considered by law to
be a unique entity, separate and apart from those who own it. A Corporation can be taxed; it can be
sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The
shareholders elect a board of directors to oversee the major policies and decisions. The corporation has
a life of its own and does not dissolve when ownership changes.
Advantages of a Corporation
Shareholders have limited liability for the corporations debts or judgments against the corporation.
Generally, shareholders can only be held accountable for their investment in stock of the
company. (Note however, that officers can be held personally liable for their actions, such as the failure
to withhold and pay employment taxes.
Corporations can raise additional funds through the sale of stock.
A Corporation may deduct the cost of benefits it provides to officers and employees.
Can elect S Corporation status if certain requirements are met. This election enables company to be
taxed similar to a partnership.
Disadvantages of a Corporation
The process of incorporation requires more time and money than other forms of organization.
Corporations are monitored by federal, state and some local agencies, and as a result may have more
paperwork to comply with regulations.
Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from
business income; thus this income can be taxed twice.

Limited Liability Company (LLC): The LLC is a relatively new type of hybrid business structure that is
now permissible in most states. It is designed to provide limited liability features of a corporation and the
tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than
that of a general partnership.
1. Provision of capital: To establish and execute programmes for the provision of capital required by
the business.
2. Investor relations: to establish and maintain an adequate market for the company securities and
to maintain adequate liaison with investment bankers, financial analysis and share holders.
3. Short term financing: To maintain adequate sources for companys current borrowing from
commercial banks and other lending institutions.
4. Banking and Custody: To maintain banking arrangement, to receive, has custody of accounts.
5. Credit and collections: to direct the granting of credit and the collection of accounts due to the
company including the supervision of required arrangements for financing sales such as time
payment and leasing plans.
6. Investments: to achieve the companys funds as required and to establish and co-ordinate
policies for investment in pension and other similar trusts.
7. Insurance: to provide insurance coverage as required.
8. Planning for control: To establish, co-ordinate and administer an adequate plan for the control of
9. Reporting and interpreting: To compare information with operating plans and standards and to
report and interpret the results of operations to all levels of management and to the owners of the
10. Evaluating and consulting: To consult with all the segments of management
responsible for policy or action concerning any phase of the operation of the business as it relates
to the attainment of objectives and the effectiveness of policies, organization structure and
11. Tax administration: to establish and administer tax policies and procedures.
12. Government reporting: To supervise or co-ordinate the preparation of reports to government
13. Protection of assets: To ensure protection of assets for the business through internal control,
internal auditing and proper insurance coverage.

What is the basic goal of a business?
The primary financial goal of the business firm is to maximize the wealth of the firm's owners. Wealth, in
turn, refers to value. If a group of people owns a business firm, the contribution that firm makes to that
group's wealth is determined by the market value of that firm.

Important definitions
Stakeholders: A person, group or organization that has interest or concern in an organization.
Stakeholders can affect or be affected by the organization's actions, objectives and policies.
Some examples of key stakeholders are creditors, directors, employees, government (and
its agencies), owners (shareholders), suppliers, unions, and the community from which
the business draws its resources.

Corporate Governance: The framework of rules and practices by which a board of
directors ensures accountability, fairness, and transparency in a company's relationship with its
all stakeholders (financiers, customers, management, employees, government, and the community)

Individual investors: An individual who purchases small amounts of securities for him/herself, as
opposed to an institutional investor. also called retail investor or small investor.

Institutional investors: Entity with large amounts to invest, such as investment companies,
mutual funds, brokerages, insurance companies, pension funds, investment banks
and endowment funds. Institutional investors are covered by fewer protective regulations because it is
assumed that they are more knowledgeable and better able to protect themselves. They account for
a majority of overall volume.
Agency Problem: A conflict arising when people (the agents) entrusted to look after the interests of
others (the principals) use the authority or power for their own benefit instead.
Financial Markets: Markets for sale and purchase of stocks (shares), bonds, bills of
exchange, commodities, futures and options, foreign currency, etc.,
which work as exchanges for capital and credit. See also capital market and money market.

Private Placement: Sale of an entire issue of a security to a small group of investors who undertake not
to resell it within a specified period. In the US, if the sale is made to less than 35 investors, it
is exempt from Securities and Exchange Commission (SEC) registration requirements.

Public Offering: Offer of sale of an issue of securities to general public by the issuer,
after meeting all requirements of the securities inspectorate. Public offerings are commonly handled
by underwriters who guaranty the placement (sale) of the entire issue.
Primary Market: Financial market in which newly issued securities are offered to the public.
Secondary Market: Financial market where previously issued securities (such bonds, notes, shares)
and financial instruments (such as bills of exchange and certificates of deposit) are bought and sold.

Money Market: Network of banks, discount houses, institutional investors, and money dealers who
borrow and lend among themselves for the short-term (typically 90 days)
Capital Market: A financial market that works as a conduit for demand and supply of debt and equity
capital. It channels the money provided by savers and depository institutions (banks, credit
unions, insurance companies, etc.) to borrowers and investees through a variety of financial
instruments (bonds, notes, shares) called securities.

Chapter 3: Time Value of Money

What is the time value of money?

The time value of money means that money you hold in your hand today is worth more than
money you expect to receive in the future. Similarly, money you must pay out today is a greater
burden than the same amount paid in the future.

2. Why does money have time value?

Positive interest rates indicate that money has time value. When one person lets another borrow
money, the first person requires compensation in exchange for reducing current consumption.
The person who borrows the money is willing to pay to increase current consumption. The
required rate of return on an investment reflects the pure time value of money, an adjustment for
expected inflation, and any risk premiums present.

3. What is compound interest? Compare compound interest to discounting.

Compound interest occurs when interest is earned on interest and on the original principal of an
investment. Discounting is the inverse of compounding. Compound interest causes the value of
a beginning amount to increase at an increasing rate. Discounting causes the present value of a
future amount to decrease at an increasing rate.

4. How is present value affected by a change in the discount rate?

Present value is inversely related to the discount rate. In other words, present value moves in the
opposite direction of the discount rate. If the discount rate increases, present value decreases. If
the discount rate decreases, present value increases.

5. What is an annuity?
A stream of equal periodic cash flows over a specified time period.
There are two types of annuity that you need to understand. An Ordinary Annuity is where those cash
flows appear at the end of each period. An Annuity Due is where those cash flows appear at the
beginning of the period.
For example, if you were to pay $2,000 per year at the end of every year spanning four years, subject to
five per cent interest, you would be paying an Ordinary Annuity. This is an Ordinary Annuity because the
same cash flows occur at the end of each equal period.
If those cash flows occurred at the beginning of each period $2,000 per year on 1 January they would
be regarded as an Annuity Due.
It is important to note that all things being equal an Annuity Due will hold greater value than an Ordinary
Annuity because the payments accrue an extra period of interest (due to immediate investment rather
than deferred investment).


Value of

Annual Compounding Compounded (m) Times per Year
Value of a
Sum. (
) + 1 ( V P = V F

+ 1 PV = FV
Value of a
Sum. (
) + 1 ( FV = PV

+ 1 FV = PV

Value of
Annuity. (

1 - ) + 1 (

( )

m i
m i
1 ) / ( 1
Value of
Annuity. (

) + 1 ( - 1

( )

m i
m i
) / ( + 1 - 1

Value of a
= perpetuity PV
] 1 ) 1 [(
/ 1

Rate given
the APR.
APR = EAR 1 - + 1 = EAR |



The length
of time
for a PV to
grow to a

) + (1 ln
(FV/PV) ln
( )
+ 1 ln *
FV/PV) ( ln

for a PV to
grow to a

1 -
/ 1



1 -
* =
) /( 1 nm
m i

i = the nominal or Annual Percentage Rate n = the number of periods
m = the number of compounding periods per
EAR = the Effective Annual Rate
ln = the natural logarithm, the logarithm to the
base e
e = the base of the natural logarithm 2.71828
PMT = the periodic payment or cash flow Perpetuity = an infinite annuity

Amortization Schedule
An amortization schedule is a list of balances, payments, and interest charges from loan inception until
For example, we have a one-year $1,000 loan at 5% compounded monthly. How do we construct a
schedule that shows the allocation of payments to principal and interest over the life of the loan?
The first step is to determine the payment amount that will amortize the loan. This can be accomplished
either with the TVOM equation or with the Excel PMT function.
We'll start with PV of an annuity equation....

) + 1 ( - 1

$6000 loan paid back over 4years at 10% APR involving a fixed annual repayment of $1892.74 per year.
of the year

Principal (2-3)
End of year
1 $ 6000 $1892.74 $ 600 $1292.74 $4707.26
2 4707.26 $1892.74 470.73 1422.01 3285.25
3 3285.25 $1892.74 328.53 1564.21
4 1721.04 $1892.74 172.10 1720.64

EAR: An investment's annual rate of interest when compounding occurs more often than once a year
Single Amount: A lump-sum amount either currently held or expected at some future date. Examples
include Php 1,000 today and Php 650 to be received at the end of 10 years.
Mixed Stream: A stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that
reflect no particular pattern. Examples include the following two cash flow streams A and B.
The Concept of Future Value
We speak of compound interest to indicate that the amount of interest earned on a given deposit has
become part of the principal at the end of a specified period. The term principal refers to the amount of
money on which the interest is paid. Annual compounding is the most common type.
The future value of a present amount is found by applying compound interest over a specified period of
time. Savings institutions advertise compound interest returns at a rate of x percent, or x percent interest,
compounded annually, quarterly, monthly, weekly, daily, or even continuously. The concept of future
value with annual compounding can be illustrated by a simple example.
The Concept of Present Value
The process of finding present values is often referred to as discounting cash flows. It is concerned in
answering the following question: If i can earn i percent on my money, what is the most I would be willing
to pay now for an opportunity to receive FV
dollars n periods from today?
This process is actually the inverse of compounding interest. Instead of finding the future value of present
dollars invested at a given interest, discounting determines the present value of a future amount,
assuming an opportunity to earn a certain return on the money. This annual rate of return is variously
referred to as the discount rate, required return, cost of capital, and opportunity cost.
Finding the Present Value of an Perpetuity
A perpetuity is an annuity wiht an infinite life - in other words, an annuity that never stops providing its
holder with a cash flow at the end of each year (for example,the right to receive P500 at the end of each
year forever).
It is sometimes necessary to find the present value of a perpetuity. The present value interest factor for a
perpetuity discounted at the rate i is
= 1/i
Future Value of a Mixed Stream
Determining the future value of a mixed stream of cash flows is straightforward. We determine the future
value of each cash flow at the specified future date and then add all the individual future values to find the
total future value.
Present Value of a Mixed Stream
Finding the present value of a mixed stream of cash flows is similar to finding the future value of a mixed
stream. We determine the present value of each future amount and then add all the individual present
values together to find the total present value.

Interest is often compounded more frequently than once a year. Savings institutions compound interest
semiannually, quarterly, monthly, weekly, daily, or even continously. This section discusses various
issues and techniques related to these more frequent compounding intervals.
Semiannual Compounding
Semiannual compounding of interest involves two compounding periods within the year. Instead of the
stated interest rate being paid once a year, one-half of the stated interest rate is paid twice a year.
Quarterly Compounding
Quarterly compounding of interest involves four compounding periods within the year. One fourth of the
stated interest rate is paid four times a year.
Continuous Compounding
In the extreme case, interest can be compounded continously. Continuous compounding involves
compounding over every microsecond - the smallest time period imaginable. Through the use of calculus,
we know that as m approaches infinity, the interest-factor equation becomes
(continuous compounding) = e
i x n

where e is the exponential function,
which has a value of 2.7183. The future value for continuous
compounding is therefore
(continuous compounding) = PV x (e
i x n
2. Monthly Compounding. In this case there are 12 compounding periods. Interest earned each month
is added to the balance and is itself available to earn interest in each succeeding month. Thus, the future
value is greater than the amount calculated using annual compounding.

3. Weekly Compounding. As should be expected, increasing the frequency of the compounding period
increases the impact of the interest rate. That it does so should be intuitive: more interest is available
sooner to earn more interest. Whereas before we had to wait until the end of the month before the
interest was 'added back to the pot', now it is being credited each week.

4. Daily Compounding. Now instead of earning interest weekly, we earn it daily. As expected the, the
impact of the interest rate is magnified. However, this time the impact is not as dramatic as might be

Risk and Return
5-1 Risk is defined as the chance of financial loss, as measured by the variability of expected returns
associated with a given asset. A decision maker should evaluate an investment by measuring
the chance of loss, or risk, and comparing the expected risk to the expected return. Some assets
are considered risk-free; the most common examples are U. S. Treasury issues.

5-2 The return on an investment (total gain or loss) is the change in value plus any cash distributions
over a defined time period. It is expressed as a percent of the beginning-of-the-period
investment. The formula is:

| |
Return =
(ending value - initial value) + cash distribution
initial value

Types of Risks:
Risk can be referred as the chances of having an unexpected or negative outcome. Any action or activity
that leads to loss of any type can be termed as risk. There are different types of risks that a firm might
face and needs to overcome. Widely, risks can be classified into three types: Business Risk, Non-
Business Risk and Financial Risk.
1. Business Risk: These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits. As for example: Companies undertake high cost risks in
marketing to launch new product in order to gain higher sales.
2. Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of
political and economic imbalances can be termed as non-business risk.
3. Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to firms.
Financial risk generally arises due to instability and losses in the financial market caused by
movements in stock prices, currencies, interest rates and more.
Types of Financial Risks:
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to
market movements and market movements can include host of factors. Based on this, financial risk can
be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and
Legal Risk.
- Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that
currency exchange rates can change the price of the asset as well. Foreign-exchange riskapplies
to all financial instruments that are in a currency other than your domestic currency. As an
example, if you are a resident of America and invest in some Canadian stock in Canadian dollars,
even if the share value appreciates, you may lose money if the Canadian dollar depreciates in
relation to the American dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result
of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To
learn more, read How Interest Rates Affect The Stock Market.)
- Political Risk - Political risk represents the financial risk that a country's government will
suddenly change its policies. This is a major reason why developing countries lack foreign
- Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the
the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As
a whole, stocks tend to perform well during a bull market and poorly during a bear market -
volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of
risk because it refers to the behavior, or "temperament", of your investment rather than the
reason for this behavior. Because market movement is the reason why people can make money
from stocks, volatility is essential for returns, and the more unstable the investment the more
chance there is that it will experience a dramatic change in either direction.
Legal Risk:
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to
face financial loses out of legal proceedings, it is legal risk.

Realized return requires the asset to be purchased and sold during the time periods the return is
measured. Unrealized return is the return that could have been realized if the asset had been
purchased and sold during the time period the return was measured.
-6 The standard deviation of a distribution of asset returns is an absolute measure of dispersion of
risk about the mean or expected value. A higher standard deviation indicates a greater project
risk. With a larger standard deviation, the distribution is more dispersed and the outcomes have
a higher variability, resulting in higher risk.

5-7 The coefficient of variation is another indicator of asset risk, measuring relative dispersion. It is
calculated by dividing the standard deviation by the expected value. The coefficient of variation
may be a better basis than the standard deviation for comparing risk of assets with differing
expected returns.

5-8 An efficient portfolio is one that maximizes return for a given risk level or minimizes risk for a
given level of return. Return of a portfolio is the weighted average of returns on the individual
component assets:

1 j
j j p k

w k

where n = number of assets, w
= weight of individual assets, and j k

= expected

The standard deviation of a portfolio is not the weighted average of component standard
deviations; the risk of the portfolio as measured by the standard deviation will be smaller. It is
calculated by applying the standard deviation formula to the portfolio assets:

k k

( )
( )

5-9 The correlation between asset returns is important when evaluating the effect of a new asset on
the portfolio's overall risk. Returns on different assets moving in the same direction are positively
correlated, while those moving in opposite directions are negatively correlated. Assets with high
positive correlation increase the variability of portfolio returns; assets with high negative
correlation reduce the variability of portfolio returns. When negatively correlated assets are
brought together through diversification, the variability of the expected return from the resulting
combination can be less than the variability or risk of the individual assets. When one asset has
high returns, the other's returns are low and vice versa. Therefore, the result of diversification is
to reduce risk by providing a pattern of stable returns.

Diversification of risk in the asset selection process allows the investor to reduce overall risk by
combining negatively correlated assets so that the risk of the portfolio is less than the risk of the
individual assets in it. Even if assets are not negatively correlated, the lower the positive
correlation between them, the lower the resulting risk.
The Capital Asset Pricing Model
- The Capital Asset Pricing Model (CAPM) is a model that describes the relation
between risk and expected return: E(R
) = R
) R
The CAPM demonstrates that the expected return for a given asset is a function of the
- the pure time value of money, R

- the reward for bearing systematic risk, [E(R
) R
- the amount of systematic risk,



0.1 0.25
0.2 0.5
0.25 0.25

Calculate return, standard deviation, cv and range.

Chapter 6: Bond

A bond is a long-term contract under which a borrower (the issuer) agrees to make payments of interest
and principal, on specific dates, to the holders (creditors) of the bond.

Par value - Also called the maturity value or face value; the amount that an issuer agrees to pay at the
maturity date.

Coupon interest rate - With bonds, notes, or other fixed income securities, the stated percentage rate of
interest, usually paid twice a year (semiannually). Coupon payments - A bond's dollar interest

Maturity date - Date on which the principal amount of a bond or other debt instrument becomes due and

Call provision - An embedded option granting a bond issuer the right to buy back all or part of an issue
prior to maturity.

Bond indenture - Contract that sets forth the promises of a corporate bond issuer and the rights of

Sinking fund - A fund to which money is added on a regular basis that is used to ensure investor
confidence that promised payments will be made and that is used to redeem debt securities or preferred
stock issues.

Sinking fund provision - A condition included in some corporate bond indentures that requires the
issuer to retire a specified portion of debt each year.

Warrant - A security entitling the holder to buy a proportionate amount of stock at some specified future
date at a specified price, usually one higher than current market price. Warrants are traded as securities
whose price reflects the value of the
underlying stock. Corporations often bundle warrants with another class of security to enhance the
marketability of the
other class. Warrants are like call options, but with much longer time spans-sometimes years. And,
warrants are offered by
corporations, while exchange-traded call options are not issued by firms.


Bond Valuation: Important Relationships

- A decrease in interest rates (required rates of return) will cause the value of a bond to increase;
an interest rate increase will cause a decrease in value. The change in value caused by
changing interest rates is called interest rate risk. A bondholder owning a long-term bond is
exposed to greater interest rate risk than when owning a short-term bonds.
- The market value of the bond will always approach its par value as its maturity date approaches,
provided the firm does not go bankrupt.
- If the bondholder's required rate of return (current interest rate) equals the coupon interest rate,
the bond will sell at "par," or maturity value.
- If the current interest rate exceeds the bond's coupon rate, the bond will sell below par value or at
a "discount."
- If the current interest rate is less than the bond's coupon rate, the bond will sell above par value
or at a "premium."

Bond Yields

Yield to maturity - The percentage rate of return paid on a bond, note, or other fixed income security if
the investor buys and holds it to its maturity date.

Types of bonds

- Treasury bonds - Debt obligations of the US Treasury that have maturities of 10 years or more.
- Municipal bond - State or local governments offer muni bonds or municipals, as they are called, to
pay for special projects such as highways or sewers. The interest that investors receive is exempt
from some income taxes.
- Foreign bond - A bond issued on the domestic capital market of another country.
- Mortgage bond - A bond in which the issuer has granted the owner a lien against the pledged
- Debenture - Any debt obligation backed strictly by the borrower's integrity, e.g. an unsecured
bond. A debenture is documented in an indenture.
- Subordinated debenture bond - An unsecured bond that ranks after secured debt, after debenture
bonds, and often after some general creditors in its claim on assets and earnings.
- Junk bond - A bond with a speculative credit rating of BB (S&P) or Ba (Moody's) or lower. Junk
or high-yield bonds offer investors higher yields than bonds of financially sound companies.
- Zero Coupon Bonds

Zero coupon bonds result from the separation of coupons from the body of a security. Zeros sell at deep
discounts from face value.The difference between the purchase price of the zero and its face value when
redeemed is the investor's return.
Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any
government agency.

- Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility
as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-
term corporate bond has a maturity of less than five years, intermediate is five to 12 years and
long term is more than 12 years.
- Convertible Bonds
A convertible bond may be redeemed for a predetermined amount of the company's equity at
certain times during its life, usually at the discretion of the bondholder. Convertibles are
sometimes called "CVs."
- Callable Bonds
Callable bonds, also known as "redeemable bonds," can be redeemed by the issuer prior to
maturity. Usually a premium is paid to the bond owner when the bond is called
- Term Bonds
Term bonds are bonds from the same issue that share the same maturity dates. Term bonds
that have a call feature can be redeemed at an earlier date than the other issued bonds. A call
feature, or call provision, is an agreement that bond issuers make with buyers. This agreement is
called an "indenture," which is the schedule and the price of redemptions, plus the maturity dates.
- Amortized Bonds
An amortized bond is a financial certificate that has been reduced in value for records on
accounting statements. An amortized bond is treated as an asset, with the discount amount being
amortized to interest expense over the life of the bond.
- Adjustment Bonds
Issued by a corporation during a restructuring phase, an adjustment bond is given to the
bondholders of an outstanding bond issue prior to the restructuring. The debt obligation is
consolidated and transferred from the outstanding bond issue to the adjustment bond.
- Junk Bonds
A junk bond, also known as a "high-yield bond" or "speculative bond," is a bond rated "BB" or
lower because of its high default risk. Junk bonds typically offer interest rates three to four
percentage points higher than safer government issues.
- Angel Bonds
Angel bonds are investment-grade bonds that pay a lower interest rate because of the issuing
company's high credit rating. Angel bonds are the opposite of fallen angels, which are bonds that
have been given a "junk" rating and are therefore much more risky.
What is the difference between bonds and debentures?
A debenture is a debt security issued by a corporation that is not secured by specific assets, but rather by
the general credit of the corporation. Stated assets secure a corporate bond, unlike a debenture, but in
India these are used interchangeably.

Bonds are lOUs between a borrower and a lender. The borrowers include public financial institutions and
corporations. The lender is the bond fund, or an investor when an individual buys a bond. In return for the
loan, the issuer of the bond agrees to pay a specified rate of interest over a specified period of time.

Typically bonds are issued by PSUs, public financial institutions and corporates. Another distinction is
SLR (Statutory liquidity ratio) and non-SLR bonds. SLR bonds are those bonds which are approved
securities by RBI which fall under the SLR limits of banks.

What affects bond prices?
Bond prices are primarily affected by 2 factors:

The current interest rate- The price of a bond, and therefore the value of your investment fluctuates with
changes in interest rates. For example, you buy a bond for Rs.1,000 that pays 5% interest. If you hold the
bond until maturity, you get your Rs.1,000 back plus the 5% interest payments you've received from the
issuer. However, between the time you bought the bond and the date it matures, the bond won't always
be worth Rs.1,000. If interest rates rise, your bond is worth less than Rs.1 000. If interest rates fall, your
bond is worth more than Rs.1,000.

The credit quality of the issuer- If the rating agencies change the credit rating of the issuer while you hold
the bond, the value of your bond will be affected. If the credit rating declines, the value of your bond will
also decline. However, if you hold the bond to maturity and the issuer doesn't default, you will get your
entire Rs.1,000 back.

When the bonds are initially priced, the maturity also helps determine the price. Longer maturities tend to
pay higher interest rates than shorter maturities. That's because your investment is exposed to interest-
rate risk for a longer period of time.
What are LIBOR & MIBOR?
LIBOR- Stands for the London Inter Bank Offered Rate. This is a very popular benchmark and is issued
for US Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese Yen. The British
Bankers Association (BBA) asks 16 banks to contribute the LIBOR for each maturity and for each
currency. The BBA weeds out the best four and the worst 4, calculates the average of the remaining 8
and the value is published as LIBOR.

MIBOR- Stands for Mumbai Inter Bank Offered Rate and is closely modeled on the LIBOR. Currently
there are 2 calculating agents for the benchmark-Reuters and the National Stock Exchange (NSE). The
NSE MIBOR benchmark is the more popular of the two and is based on rates polled by NSE from a
representative panel of 31 banks/institutions/primary dealers.
What are debt market instruments?
Debt instruments typically have maturities of more than one year. The main types are government
securities called G-secs or Gilts. Like T-bills, Gilts are issued by RBI on behalf of the Government. These
instruments form a part of the borrowing program approved by Parliament in the Finance Bill each year
(Union Budget). Typically, they have a maturity ranging from 1 year to 20 years.

Like T-Bills, Gilts are issued through auctions but RBI can sell/buy securities in its Open Market
Operations (OMO). OMOs cover repos as well and are used by RBI to manipulate short-term liquidity and
thereby the interest rates to desired levels. The other types of government securities include Inflation-
linked bonds, Zero-coupon bonds, State government securities (state loans).
What is a credit rating?
Rating organisations evaluate the credit worthiness of an issuer with respect to debt instruments or its
general ability to pay back debt over the specified period of time. The rating is given as an alphanumeric
code that represents a graded structure or creditworthiness. Typically the highest credit rating is AAA and
the lowest is D (for default). Within the same alphabet class, the rating agency might have different
grades like A, AA, and AAA and within the same grade AA+, AA- where the "+" denotes better than AA
and "-" indicates the opposite. For short-term instruments of less than one year, the rating symbol would
be typically "P" (varies depending on the rating agency).

Legal aspects of corporate bonds:


1) The bonds of the Nordy Company have a coupon interest rate of 9%. The interest on the bonds is
paid semiannually, the bonds mature in 8 years, and their par value is $1,000. If the required rate of
return, k
= 8%, what is the value of each bond? What is the value of each bond if the interest is paid

2) You own a bond that pays $100 in interest annually, has a par value of $1000, and matures in 15
years. What is the value of the bond if your required rate of return is 12%? What is the value of the bond
if your required rate of return (a) increases to 15% or (b) decreases to 8%? Now, recompute all three
answers assuming that the bond matures in 5 years instead of 15 years.

3) Dullco Company bonds are selling in the market for $1,045 (104.50). These bonds will mature in 15
years and pay $70 in interest annually. If the bonds are purchased at the market price, what is the (a)
coupon rate, (b) current yield,
(c) approximate yield to maturity and (d) capital gains yield?

4) Apex Company is planning to issue zero coupon bonds that will mature at $1,000 in 20 years. If your
required rate of return on these bonds is 9.35%, what are you willing to pay for the bonds? If these bonds
are currently selling for $213.50, what is their yield to maturity (YTM)?


1) $1,058.26; $1,057.47

2) $863.78; (a)$707.63; (b)$1,171.19
$927.90; (a)$832.39; (b)$1,079.85

3) (a)7%; (b)6.70%; (c)6.50%; Exact YTM = 6.5208%;
(d)-0.20%; Exact CGY = -0.1792%

4) $167.35; 8.03%

Chapter 7: Stock Valuation

Debt capital: Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a
company that is normally repaid at some future date. Debt capital differs
from equity or share
capitalbecause subscribers to debt capital do not become part owners of the business, but are
merely creditors, and the suppliers of debt capital usually receive a contractually fixed annual percentage
return on their loan, and this is known as the coupon rate.
Equity capital: Invested money that, in contrast to debt capital, is not repaid to the investors in the
normal course of business. It represents the risk capital staked by the owners through purchase of
a company's common stock (ordinary shares).

Differences between debt capital and equity capital:
Debt and equity financing provide a means for companies to carry out plans that require large amounts of
money, such as developing new product lines, acquiring another company or starting a business. The two
methods differ in terms of whether a company borrows the money or raises the money. Debt financing
involves borrowing money from investors or lenders, while equity financing requires a company to sell a
percentage of its interests to investors.
When considering debt vs. equity financing, a key difference between the two has to do with who gets or
maintains ownership of the company. With debt financing, companies take out loans, either from banks or
by offering bonds. With equity financing, companies sell shares on the stock market or through a private
offering. Debt financing allows companies to retain full ownership of the business. Equity financing
distributes ownership or equity among stockholders. Companies that opt for debt financing have only to
repay the monies due on loans or bonds issued without compromising any equity earned or built up in the
company. With equity financing, companies may distribute a portion of any profits made to stockholders.
Key differences between debt and equity financing have to do with the types of risks involved. As debt
financing uses loans and bonds as sources for capital, companies must comply with repayment
schedules during periods of high and low cash flow. Ultimately, any interest costs attached to the debt
increases the amount of money a company needs in order to break-even in terms of covering operations
costs. With equity financing, companies have no repayment obligation, so the risks fall on the investors or
shareholders. On the other hand, the more shareholders a company has the less decision-making power
owners and management have over a business' operations.
Debt and equity financing differ in how they affect the ongoing profits made through a business.
Companies that use debt financing maintain their equity holdings throughout, so any profits made remain
with the company. Companies that use the equity financing approach must distribute their profits to
shareholders since shareholders have ownership in the company. The use of loans for debt financing
also allows businesses to list interest costs as a tax write-off, which reduces the overall cost of the loan
amount. Since equity financing generates the capital needed to make profits, companies can use equity
financing as a way to strengthen their ability to use debt financing in the future.
Differences between common stock and preferred stock:
Preferred stock is the term for a hybrid investment vehicle. This is part stock and part debt instrument.
Preferred stock can also be called preferred shares. This type of investment is ranked higher than
common stock but lower than bonds.
Owners of preferred stock are not allowed to vote like common stock holders but will usually be paid a
dividend. They also carry first rights to liquidation proceedings and bankruptcy. Often, preferred stock will
have a convertibility feature, allowing the owner to convert into common shares. To find out out preferred
shares, read the Certificate of Designation to company puts out. Preferred stocks are similar to bonds as
they are rated by a major credit rating agency.
Preferred stocks are generally acceptable to a wider range of investor and are thought to be a safer
vehicle than common stocks.

Understanding Common Stocks
Common stock is a way for individuals to own a portion of a publicly traded company. It is referred to as
common to differentiate it from preferred stock. This is significant in case of a bankruptcy, as common
stock is paid out last, after preferred stock holders, bondholders and creditors. Common stockholders
have voting rights unlike preferred stockholders. There is no set schedule for dividend payment to
common stockholders. Common stock can move up and down sharply over time and returns vary greatly.
Generally, common stock carries much more risk than preferred stock but returns can be greater if market
conditions and the companies performance excel.

Chapter 8:Capital Budgeting Techniques