Notes on Corporate Finance

Corporate repurchase
A corporation's repurchase of stock or bonds it has issued. In the case of stocks, this
reduces the number of shares outstanding, giving each remaining shareholder a larger
percentage ownership of the company. This is usually considered a sign that the company's
management is optimistic about the future and believes that the current share price is
undervalued. Reasons for buybacks include putting unused cash to use, raising earnings per
share, increasing internal control of the company, and obtaining stock for employee stock
option plans or pension plans. hen a company's shareholders vote to authori!e a buyback,
they aren't obliged to actually undertake the buyback. also called corporate repurchase.
Read more" http"##www.investorwords.com#$%&#buyback.html'i(!!%)*+,k-nT
Definition of 'Sinking Fund'
A means of repaying funds that were borrowed through a bond issue. The
issuer makes periodic payments to a trustee who retires part of the issue by
purchasing the bonds in the open market.
Investopedia
expains
'Sinking
Fund'
!ather than the
issuer repaying
the entire
principa of a
bond issue on the
maturity date"
another company
buys back a
portion of the
issue annuay
and usuay at a
fixed par vaue or
at the current
market vaue of
the bonds"
whichever is ess.
Shoud interest
rates decine
foowing a bond
issue" sinking#
fund provisions
aow a firm to
essen the interest
rate risk of its
bonds as it
essentiay
repaces a portion
of existing debt
with ower#
yieding bonds.
From the
investor's point of
view" a sinking
fund adds safety
to a corporate
.ooks like Company profits both ways/
01 Interest rates rise 2 bonds less e(pensive. Company buys back the low price bonds.
)1 Interest rates fall 2 bonds more e(pensive. Company pays slightly more than face
value
Definition of '$referred Stock'
A class of ownership in a corporation that has a higher claim on the assets and earnings
than common stock. 3referred stock generally has a dividend that must be paid out
before dividends to common stockholders and the shares usually do not have voting
rights.
The precise details as to the structure of preferred stock is specific to each corporation.
4owever, the best way to think of preferred stock is as a financial instrument that has
characteristics of both debt 5fi(ed dividends1 and e6uity 5potential appreciation1. Also
known as 7preferred shares7.
Definition of 'Treasury Stock %Treasury Shares&'
The portion of shares that a company keeps in their own treasury. Treasury stock may have come
from a repurchase or buyback from sharehoders' or it may have never been issued to the pubic
in the first pace. These shares don't pay dividends" have no voting rights" and shoud not be
incuded in shares outstanding cacuations.
Treasury stock is often created when shares of a company are initially issued. In this
case, not all shares are issued to the public, as some are kept in the company's treasury
to be used to create e(tra cash should it be needed. Another reason may be to keep a
controlling interest within the treasury to help ward off hostile takeovers.
Alternatively, treasury stock can be created when a company does a share buyback and
purchases its shares on the open market. This can be advantageous to shareholders
because it lowers the number of shares outstanding. 4owever, not all buybacks are a
good thing. 8or e(ample, if a company merely buys stock to improve financial ratios
such as 93: or 3#9, then the buyback is detrimental to the shareholders, and it is done
without the shareholders' best interests in mind.
-ortgage backed security
A type of asset/backed security that is secured by a mortgage or collection of
mortgages. These securities must also be grouped in one of the top two ratings as
determined by a accredited credit rating agency, and usually pay periodic payments that
are similar to coupon payments. 8urthermore, the mortgage must have originated from a
regulated and authori!ed financial institution.
hen you invest in a mortgage/backed security you are essentially lending money to a
home buyer or business. An -;: is a way for a smaller regional bank to lend mortgages
to its customers without having to worry about whether the customers have the assets to
cover the loan. Instead, the bank acts as a middleman between the home buyer and the
investment markets.
This type of security is also commonly used to redirect the interest and principal
payments from the pool of mortgages to shareholders. These payments can be further
broken down into different classes of securities, depending on the riskiness of different
mortgages as they are classified under the -;:.
Conversion 3rice
The price per share at which a convertible security, such as corporate bonds or
preferred shares, can be converted into common stock.
6uotient of the principal value of the convertible security divided by the conversion price
The conversion price is determined when the convertible security is issued and can be
found in the bond indenture 5in the case of convertible bonds1 or in the security
prospectus 5in the case of convertible preferred shares1. The conversion price is
essential in determining the number of shares to be received, by computing the 6uotient
of the principal value of the convertible security divided by the conversion price. <sually,
the conversion price is set at a significant amount higher than the current price of the
common stock, so as to make conversion desirable only if a company's common shares
e(perience a significant increase in value.
Convertible ;onds" 3ros And Cons 8or
Companies And Investors
There are pros and cons to the use of convertible bonds as a means of financing by
corporations. =ne of several advantages of this delayed method of e6uity financing is a
delayed dilution of common stock and earnings per share 593:1. Another is that the
company is able to offer the bond at a lower coupon rate / less than it would have to pay
on a straight bond. The rule usually is that the more valuable the conversion feature, the
lower the yield that must be offered to sell the issue> the conversion feature is a
sweetener.
Companies with poor credit ratings often issue convertibles in order to lower the yield
necessary to sell their debt securities. The investor should be aware that some
financially weak companies will issue convertibles ?ust to reduce their costs of financing,
with no intention of the issue ever being converted. As a general rule, the stronger the
company, the lower the preferred yield relative to its bond yield.
3ros
There are also corporations with weak credit ratings that also have great potential for
growth. :uch companies will be able to sell convertible debt issues at a near/normal
cost, not because of the 6uality of the bond but because of the attractiveness of the
conversion feature for this 7growth7 stock. hen money is tight and stock prices are
growing, even very credit/worthy companies will issue convertible securities in an effort
to reduce their cost of obtaining scarce capital. -ost issuers hope that if the price of their
stocks rise, the bonds will be converted to common stock at a price that is higher than
the current common stock price. ;y this logic, the convertible bond allows the issuer to
sell common stock indirectly at a price higher than the current price. 8rom the buyer's
perspective, the convertible bond is attractive because it offers the opportunity to obtain
the potentially large return associated with stocks, but with the safety of a bond
0. Reduce cost of borrowing money
). Reduce the dilution of 93:
%. Reduce the high coupon payments on the straight bonds. Reduce the financial
burden on the payment of big interests 5reducing the burden of debt service1
@. .ess negative signal than issuing the straight e6uity
A. +elayed action 2 delayed e6uity. 4ence less native reaction.
+isadvantages
There are some disadvantages for convertible bond issuers, too. =ne is that financing
with convertible securities runs the risk of diluting not only the 93: of the company's
common stock, but also the control of the company.
93: can go down because of dilution/ conversion increases the ' of outstanding shares
4edging
.et's see how this works with an e(ample. :ay you own shares of Cory's Te6uila
Corporation 5Ticker" CTC1. Although you believe in this company for the long run, you
are a little worried about some short/term losses in the te6uila industry. To protect
yourself from a fall in CTC you can buy a put option 5a derivative1 on the company,
which gives you the right to sell CTC at a specific price 5strike price1. This strategy is
known as a married put. If your stock price tumbles below the strike price, these losses
will be offset by gains in the put option. 58or more information, see this article on married
puts or this options basics tutorial.1
8utures Contract
The futures market is a centrali!ed marketplace for buyers and sellers from around the
world who meet and enter into futures contracts. s3ricing can be based on an open cry
system, or bids and offers can be matched electronically. The futures contract will state
the price that will be paid and the date of delivery
The profits and losses of a futures contract depend on the daily movements of the
market for that contract and are calculated on a daily basis. 8or e(ample, say the futures
contracts for wheat increases to BA per bushel the day after the above farmer and bread
maker enter into their futures contract of B@ per bushel. The farmer, as the holder of the
short position, has lost B0 per bushel because the selling price ?ust increased from the
future price at which he is obliged to sell his wheat. The bread maker, as the long
position, has profited by B0 per bushel because the price he is obliged to pay is less than
what the rest of the market is obliged to pay in the future for wheat.
=n the day the change occurs, the farmer's account is debited BA,CCC 5B0 per bushel D
A,CCC bushels1 and the bread maker's account is credited by BA,CCC 5B0 per bushel D
A,CCC bushels1. As the market moves every day, these kinds of ad?ustments are made
accordingly. <nlike the stock market, futures positions are settled on a daily basis, which
means that gains and losses from a day's trading are deducted or credited to a person's
account each day. In the stock market, the capital gains or losses from movements in
price aren't reali!ed until the investor decides to sell the stock or cover his or her short
position.
As the accounts of the parties in futures contracts are ad?usted every day, most
transactions in the futures market are settled in cash, and the actual physical commodity
is bought or sold in the cash market. 3rices in the cash and futures market tend to move
parallel to one another, and when a futures contract e(pires, the prices merge into one
price. :o on the date either party decides to close out their futures position, the contract
will be settled. If the contract was settled at BA per bushel, the farmer would lose BA,CCC
on the futures contract and the bread maker would have made BA,CCC on the contract.
;ut after the settlement of the futures contract, the bread maker still needs wheat to
make bread, so he will in actuality buy his wheat in the cash market 5or from a wheat
pool1 for BA per bushel 5a total of B)A,CCC1 because that's the price of wheat in the cash
market when he closes out his contract. 4owever, technically, the bread maker's futures
profits of BA,CCC go towards his purchase, which means he still pays his locked/in price
of B@ per bushel 5B)A,CCC / BA,CCC E B)C,CCC1. The farmer, after also closing out the
contract, can sell his wheat on the cash market at BA per bushel but because of his
losses from the futures contract with the bread maker, the farmer still actually receives
only B@ per bushel. In other words, the farmer's loss in the futures contract is offset by
the higher selling price in the cash market / this is referred to as hedging.
;asis Risk
The risk that offsetting investments in a hedging strategy will not e(perience price
changes in entirely opposite directions from each other. This imperfect correlation
between the two investments creates the potential for e(cess gains or losses in a
hedging strategy, thus adding risk to the position.
=ffsetting vehicles are generally similar in structure to the investments being hedged,
but they are still different enough to cause concern. 8or e(ample, in the attempt to
hedge against a two/year bond with the purchase of Treasury bill futures, there is a risk
that the Treasury bill and the bond will not fluctuate identically.
-argin Account
A margin account is an account offered by brokerages that allows investors to borrow
money to buy securities. An investor might put down ACF of the value of a purchase and
borrow the rest from the broker. The broker charges the investor interest for the right to
borrow money and uses the securities as collateral.
The specific calculations as to how margin works get a little more complicated, but you
can learn about this in our Margin Trading tutorial.
The important thing to understand about margin is that it has conse6uences. -argin is
leverage, which means that both your gains and losses are amplified. -argin is great
when your investments are going up in value, but the double/edged sword of leverage
really hurts when your portfolio heads south. ;ecause margin e(poses you to e(tra risks,
it's not advisable for beginners to use it. -argin can be a useful tool for e(perienced
investors, but until you get to that point, play it safe.
8loating Rate 3referred :tock
A type of preferred stock where the dividends issued will vary with a benchmark, most
often a T/bill rate. The value of the dividend from the preferred share is set by a
predetermined formula to move with rates, and because of this fle(ibility preferred prices
are often more stable then fi(ed/rate preferred stocks.
The preferred category of stocks are more secure as they will be one of the first of the
e6uity holders to receive dividend payments in the event of the company's li6uidation.
There is often a limit to the amount the rate can change on the dividend, adding further
security to the issue.
Convertible 3referred :tock
3referred stock that includes an option for the holder to convert the preferred shares into
a fi(ed number of common shares, usually anytime after a predetermined date.
-ost convertible preferred stock is e(changed at the re6uest of the shareholder, but
sometimes there is a provision that allows the company 5or issuer1 to force conversion.
The value of convertible common stock is ultimately based on the performance 5or lack
thereof1 of the common stock.
Similarities between preferred stocks and convertible bonds
 The market value of both instruments is affected by changes in interest rates. When
interest rates go up, prices for these investments (both with fixed payments) go down. The
effect is often less marked on preferred stock however.
 oth exist in !callable" versions. #or instance, when a preferred stock$s fixed dividend is
greater than prevailing interest rates, a company may !call" the preferred stock and pay the
investor a pre%defined redemption price.
 &referred stock has priority over common stock for any payments due, and so do bonds.
'owever, bonds also have priority over preferred stock.
 &referred stock can often be converted into common stock, like convertible bonds can be
converted into common stock. (n both cases, investors have a safety net of a minimum
income while the opportunity remains open for investors to profit from an upturn in the
overall worth of the issuing company.
 )redit ratings apply to preferred stocks as to bonds. *atings are lower for preferred
stocks, because they do not have the same guarantees as bonds.
 )urrent yields for preferred stock are calculated as for bonds. +xample, with a fixed
dividend of -../0 and a market price of -10, a preferred stock has a current yield of 23
(-../04-10). 5s stock presents higher risk than bonds, the yield on preferred stock may be
set higher than for convertible bonds issued by the same company.

6ifferences between preferred stocks and convertible bonds
 5t the end of the day, preferred stock is still e7uity, while convertible bonds are still debt.
(n other words, a company is not obligated to pay the preferred stock holders a dividend.
'owever, preferred stock holders must be paid all their dividends before common stock
holder receive a dividend.
 &ayments to investors holding preferred stocks cost the issuing company more per dollar
paid out, but are also sub8ect to board approval by the company. ond interest is paid out
before tax, making it less expensive, and is also an obligation that a company must respect.
 &referred stock may be more accessible to investors than bonds, because they tend to
have lower face values, compared to bonds with face values of around -.,000 and
minimum purchase re7uirements.
 6ebt is tax efficient than &referred Stock
% See more at, http,44www.learnbonds.com4convertible%bonds%vs%preferred%
stocks49sthash.h:)nnb*h.dpuf
hat is a Convertible 3referred :tockG
In most cases, convertible preferred stocks are similar to convertible bonds and respond accordingly in the
market place. However, there are some differences between the two.
In most instances, a preferred stock is a perpetual instrument and, as such, does not mature. Its liquidation value
—the stated value of the preferred stock at redemption—is an option of the issuing company. Preferred stocks
rank ahead of common stocks, but below more senior obligations of the company, that is debt obligations.
Therefore, holders of preferred shares will be paid before common shareholders. Dividends on preferred stocks
are usually paid in quarterly amounts. However, dividends on preferred stocks are not secured and may be
omitted. While corporations are required to pay interest on convertible bonds, they are not required to pay
preferred dividends. Dividend payments are voted at the convenience of the company. But many preferred issues
provide provisions for cumulative payments. That is, the corporation is obliged to make up omitted payments
before it may distribute dividends to common stock holders. Furthermore, missed dividend payments give
preferred shareholders the right to elect directors to the company’s Board of Directors. In general, preferred
dividends are paid regularly.
If a convertible preferred stock trades on an exchange, its notation will be similar to a common stock.
Convertibility is not generally indicated. However, prices shown are actual prices at which the preferred has
traded, and not a percentage of par. Also, dividends shown are actual dollar amounts and not a percentage of
par. For example, the Newell Financial $2.625 preferred pays an annually dividend of $2.625.
Whereas convertible bonds are debt instruments for a corporation, preferreds are considered equity. Convertible
preferreds are generally protected against dilution. In addition, some preferreds may enjoy several added
features. For example, the dividend on the common is increased above a certain level, if the preferred dividend
would also be increased.
What is the difference between forward and futures contracts?
8undamentally, forward and futures contracts have the same function" both types of
contracts allow people to buy or sell a specific type of asset at a specific time at a given
price.
4owever, it is in the specific details that these contracts differ. 8irst of all, futures
contracts are e(change/traded and, therefore, are standardi!ed contracts. 8orward
contracts, on the other hand, are private agreements between two parties and are not as
rigid in their stated terms and conditions. ;ecause forward contracts are private
agreements, there is always a chance that a party may default on its side of the
agreement. 8utures contracts have clearing houses that guarantee the transactions,
which drastically lowers the probability of default to almost never.
:econdly, the specific details concerning settlement and delivery are 6uite distinct. 8or
forward contracts, settlement of the contract occurs at the end of the contract. 8utures
contracts are marked/to/market daily, which means that daily changes are settled day by
day until the end of the contract. 8urthermore, settlement for futures contracts can occur
over a range of dates. 8orward contracts, on the other hand, only possess one
settlement date.
.astly, because futures contracts are 6uite fre6uently employed by speculators, who bet
on the direction in which an asset's price will move, they are usually closed out prior to
maturity and delivery usually never happens. =n the other hand, forward contracts are
mostly used by hedgers that want to eliminate the volatility of an asset's price, and
delivery of the asset or cash settlement will usually take place.
The right of a stockholder to vote on matters of corporate policy and who will make up
the board of directors. *oting often involves decisions on issuing securities, initiating
corporate actions and making substantial changes in the corporation's operations.
:hareholders do not necessarily need to be physically present at the site of the
company's annual meeting in order to e(ercise their right to vote. It is common for
shareholders to voice their vote by pro(y by mailing in their response. <nlike the single
vote right that individuals commonly possess in democratic governments, the number of
votes that a shareholder has corresponds to the numbers of shares that he owns. 8or
e(ample, a shareholder that owns 0CC shares will have a 0CC times more sway than a
shareholder that owns a single share.
8utures and forward contracts are linear 5!ero sum game1. =ptions are not.
Depository share
A <.:. dollar/denominated e6uity share of a foreign/based company available for
purchase on an American stock e(change. American +epositary :hares 5A+:s1 are
issued by depository banks in the <.:. under agreement with the issuing foreign
company> the entire issuance is called an American +epositary Receipt 5A+R1 and the
individual shares are referred to as A+:s.
+epending on the level of compliance with <.:. securities regulations the foreign
company wishes to follow, the company may either list its shares over/the/counter
5=TC1 with low reporting re6uirements or on a ma?or e(change like the HI:9 or
Hasda6. .istings on the latter e(changes generally re6uire the same level of reporting as
domestic companies, and also re6uire adherence to JAA3 accounting rules.
8irstly, do not confuse different classes of common stock with preferred stock. 3referred
shares are an entirely different type of security, affording their owners priority dividend
payments and a higher position on the priority ladder in the event of a company's
li6uidation or bankruptcy. Common stock represents the lower/ranked 5and much more
prevalent1 form of e6uity financing. 4owever, a company can choose to issue different
classes of common stock to certain investors, board members or company founders.
Jenerally, companies that choose to have multiple classes of common stock issue two
classes, usually denoted as Class A and Class ; shares. Common practice is to assign
more voting rights to one class of stock than the other. 8or e(ample, a private company
that decides to go public will usually issue a large number of common shares, but the
occasional company will also provide its founders, e(ecutives or other large
stakeholders with a different class of common stock that carries multiple votes for each
single share of stock. Commonly, the 7super voting7 multiple is about 0C votes per higher
class share, although occasionally companies choose to make them much higher.
<sually, Class A shares are superior to Class ; shares, but there is no standard
nomenclature for multiple share classes / sometimes Class ; shares have more votes
than their Class A counterparts. ;ecause of this, investors should always research the
details of a company's share classes if they are considering investing in a firm with more
than one class.
<sually, the purpose of the super voting shares is to give key company insiders greater
control over the company's voting rights, and thus its board and corporate actions. The
e(istence of super voting shares can also be an effective defense against hostile
takeovers, since key insiders can maintain ma?ority voting control of their company
without actually owning more than half of the outstanding shares.
*oting issues aside, different share classes typically have the same rights to profits and
company ownership. Thus, even though retail investors may be limited to purchasing
only inferior classes of common stock for a given company, they still en?oy a
proportionally e6ual claim to the company's profits. In these cases, investors see their
fair share of a company's returns on e6uity, although they do not en?oy the voting power
their shares would normally provide in the absence of dual classes. 3rovided the large
stakeholders who own the disproportionate voting shares are successful in running the
company, this should be of little concern to investors / especially the typical retail
investor who has a very tiny stake in the company anyway. Hormally, the e(istence of
dual class shares would only be a problem if an investor believed the disproportionate
voting rights were allowing inferior management to remain in place in spite of the best
interests of shareholders.
';id/Ask :pread'
The amount by which the ask price e(ceeds the bid. This is essentially the difference in
price between the highest price that a buyer is willing to pay for an asset and the lowest
price for which a seller is willing to sell it.
8or e(ample, if the bid price is B)C and the ask price is B)0 then the 7bid/ask spread7 is
B0.
The si!e of the spread from one asset to another will differ mainly because of the
difference in li6uidity of each asset. 8or e(ample, currency is considered the most li6uid
asset in the world and the bid/ask spread in the currency market is one of the smallest
5one/hundredth of a percent1. =n the other hand, less li6uid assets such as a small/cap
stock may have spreads that are e6uivalent to a percent or two of the asset's value.
The Two :ides =f +ual/Class :hares
What Are Dual-Class Shares?
hen the Internet company Joogle went public, a lot of investors were upset that it
issued a second class of shares to ensure that the firm's founders and top e(ecutives
maintained control. 9ach of the Class ; shares reserved for Joogle insiders would carry
0C votes, while ordinary Class A shares sold to the public would get ?ust one vote. 5To
learn more, see When Insiders Buy, Should Investors Join Them?1
+esigned to give specific shareholders voting control, une6ual voting shares are
primarily created to satisfy owners who don't want to give up control, but do want the
public e6uity market to provide financing. In most cases, these super/voting shares are
not publicly traded and company founders and their families are most commonly the
controlling groups in dual/class companies.
Who Lists Them?
The Hew Iork :tock 9(change allows <.:. companies to list dual/class voting shares.
=nce shares are listed, however, companies cannot reduce the voting rights of the
e(isting shares or issue a new class of superior voting shares. 58or more information,
see The NYSE And Nasdaq !o" They Wor#$1
-any companies list dual/class shares. 8ord's dual/class stock structure, for instance,
allows the 8ord family to control @CF of shareholder voting power with only about @F of
the total e6uity in the company. ;erkshire 4athaway Inc., which has arren ;uffett as a
ma?ority shareholder, offers a ; share with 0#%Cth the interest of its A/class shares, but
0#)CCth of the voting power. 9chostar Communications demonstrates the e(treme power
that can be had through dual/class shares" founder and C9= Charlie 9rgen has about
AF of the company's stock, but his super/voting class/A shares give him a whopping
&CF of the vote.
Good or Bad?
It's easy to dislike companies with dual/class share structures, but the idea behind it has
its defenders. They say that the practice insulates managers from all :treet's short/
term mindset. 8ounders often have a longer term vision than investors focused on the
most recent 6uarterly figures. :ince stock that provides e(tra voting rights often cannot
be traded, it ensures the company will have a set of loyal investors during rough
patches. In these cases, company performance may benefit from the e(istence of dual/
class shares.
ith that said, there are plenty of reasons to dislike these shares. They can be seen as
downright unfair. They create an inferior class of shareholders and hand over power to a
select few, who are then allowed to pass the financial risk onto others. ith few
constraints placed upon them, managers holding super/class stock can spin out of
control. 8amilies and senior managers can entrench themselves into the operations of
the company, regardless of their abilities and performance. 8inally, dual/class structures
may allow management to make bad decisions with few conse6uences.
4ollinger International presents a good e(ample of the negative effects of dual/class
shares. 8ormer C9= Conrad ;lack controlled all of the company's class/; shares, which
gave him %CF of the e6uity and K%F of the voting power. 4e ran the company as if he
were the sole owner, e(acting huge management fees, consulting payments and
personal dividends. 4ollinger's board of directors was filled with ;lack's friends who
were unlikely to forcefully oppose his authority. 4olders of publicly traded shares of
4ollinger had almost no power to make any decisions in terms of e(ecutive
compensation, mergers and ac6uisitions, board construction poison pills or anything else
for that matter. 4ollinger's financial and share performance suffered under ;lack's
control. 5To learn more, see Mergers And A%quisitions &nderstanding Ta#eovers$1
Academic research offers strong evidence that dual/class share structures hinder
corporate performance. A harton :chool and 4arvard ;usiness :chool study shows
that while large ownership stakes in managers' hands tend to improve corporate
performance, heavy voting control by insiders weakens it. :hareholders with super/
voting rights are reluctant to raise cash by selling additional shares//that could dilute
these shareholders' influence. The study also shows that dual/class companies tend to
be burdened with more debt than single/class companies. 9ven worse, dual/class stocks
tend to under/performs the stock market.
The Bottom Line
Hot every dual/class company is destined to perform poorly//;erkshire 4athaway, for
one, has consistently delivered great fundamentals and shareholder value. Controlling
shareholders normally have an interest in maintaining a good reputation with investors.
Insofar as family members wield voting power, they have an emotional incentive to vote
in a manner that enhances performance. All the same, investors should keep in mind the
effects of dual/class ownership on company fundamentals.
:hort :elling" hat Is :hort :ellingG
8irst, let's describe what short selling means when you purchase shares of stock. In
purchasing stocks, you buy a piece of ownership in the company. The buying and selling
of stocks can occur with a stock broker or directly from the company. ;rokers are most
commonly used. They serve as an intermediary between the investor and the seller and
often charge a fee for their services.
LCMhen using a broker, you will need to set up an account. The account that's set up is
either a cash account or a margin account. A cash account re6uires that you pay for
your stock when you make the purchase, but with a margin account the broker lends you
a portion of the funds at the time of purchase and the security acts as collateral.
hen an investor goes long on an investment, it means that he or she has bought a
stock believing its price will rise in the future. Conversely, when an investor goes short,
he or she is anticipating a decrease in share price.
:hort selling is the selling of a stock that the seller doesn't own. -ore specifically, a
short sale is the sale of a security that isn't owned by the seller, but that is promised to
be delivered. That may sound confusing, but it's actually a simple concept. 5To learn
more, read Bene'it (rom Borro"ed Se%urities.1
:till with usG 4ere's the skinny" when you short sell a stock, your broker will lend it to
you. The stock will come from the brokerage's own inventory, from another one of the
firm's customers, or from another brokerage firm. The shares are sold and the proceeds
are credited to your account. :ooner or later, you must 7close7 the short by buying back
the same number of shares 5called covering1 and returning them to your broker. If the
price drops, you can buy back the stock at the lower price and make a profit on the
difference. If the price of the stock rises, you have to buy it back at the higher price, and
you lose money.
-ost of the time, you can hold a short for as long as you want, although interest is
charged on margin accounts, so keeping a short sale open for a long time will cost more
4owever, you can be forced to cover if the lender wants the stock you borrowed back.
;rokerages can't sell what they don't have, so yours will either have to come up with
new shares to borrow, or you'll have to cover. This is known as being called away. It
doesn't happen often, but is possible if many investors are short selling a particular
security.
;ecause you don't own the stock you're short selling 5you borrowed and then sold it1,
you must pay the lender of the stock any dividends or rights declared during the course
of the loan. If the stock splits during the course of your short, you'll owe twice the
number of shares at half the price. 5To learn more about stock splits, read
&nderstanding Sto%# S)lits$1
:hort selling
Short seing %or (seing short)& is a techni*ue used by peope who try to profit from the
faing price of a stock. Short seing is a very risky techni*ue as it invoves precise timing
and goes contrary to the overa direction of the market. Since the stock market has
historicay tended to rise in vaue over time" short seing re*uires precise market timing"
which is a very difficut feat.
+ere,s how short seing works. Assume you want to se short -.. shares of a company
because you beieve saes are sowing and its earnings wi drop. /our broker wi borrow the
shares from someone who owns them with the promise that you wi return them ater. /ou
immediatey se the borrowed shares at the current market price. 0hen the price of the
shares drops %you hope&" you (cover your short position) by buying back the shares" and your
broker returns them to the ender. /our profit is the difference between the price at which you
sod the stock and your cost to buy it back" minus commissions and expenses for borrowing
the stock. 1ut if you,re wrong" and the price of the shares increase" your potentia osses are
unimited. The company,s shares may go up and up" but at some point you have to repace
the -.. shares you sod. In that case" your osses can mount without imit unti you cover
your short position.
ebate
0. In a short/sale transaction, the portion of interest or dividends earned by
the owner 5lender1 of shares that are paid to the short seller 5borrower1 of
the shares.
). In an options transaction, the amount paid to the holder of the option if
the option e(pires worthless.
Short S!uee"e
A situation in which a heavily shorted stock or commodity moves sharply higher, forcing
more short sellers to close out their short positions and adding to the upward pressure
on the stock. A short s6uee!e implies that short sellers are being s6uee!ed out of their
short positions, usually at a loss. A short s6uee!e is generally triggered by a positive
development that suggests the stock may be embarking on a turnaround. Although the
turnaround in the stockNs fortunes may only prove to be temporary, few short sellers can
afford to risk runaway losses on their short positions and may prefer to close them out
even if it means taking a substantial loss.
-argin Call
A broker's demand on an investor using margin to deposit additional money or securities
so that the margin account is brought up to the minimum maintenance margin. -argin
calls occur when your account value depresses to a value calculated by the broker's
particular formula.
This is sometimes called a 7fed call7 or 7maintenance call.7
;lack :wan event
An event or occurrence that deviates beyond what is normally e(pected of a situation
and that would be e(tremely difficult to predict. This term was populari!ed by Hassim
Hicholas Taleb, a finance professor and former all :treet trader.
8ire :ale
Seing goods or assets at heaviy discounted prices. Fire sae originay referred to the discount
sae of goods that were damaged by fire' it may now refer to any sae where the seer is in
financia distress. In the context of the financia markets" fire sae refers to securities that are
trading we beow their intrinsic vaue" such as during proonged bear markets.
':9C 8orm +98 0@A'
A filing with the :ecurities and 9(change Commission 5:9C1 that must be filed by or on
behalf of a registrant when a shareholder vote is re6uired. :9C 8orm +98 0@A is most
commonly used in con?unction with an annual meeting pro(y. The form should provide
security holders with sufficient information to allow them to make an informed vote at an
upcoming security holders' meeting or to authori!e a pro(y to vote on their behalf. It
includes information about the date, time and place of the meeting of security holders>
revocability of pro(y> dissenter's right of appraisal> persons making the solicitation> direct
or indirect interest of certain persons in matters to be acted upon> modification or
e(change of securities> financial statements> voting procedures> and other details.
8orm +98 0@A, which is also known as 7definitive pro(y statement7, is re6uired under
:ection 0@5a1 of the :ecurities 9(change Act of 0&%@. This form is filed with the :9C
when a definitive pro(y statement is given to shareholders and helps the :9C ensure
that shareholders' rights are upheld.
There are both differences and similarities between capital and money markets. 8rom
the issuer or seller's standpoint, both markets provide a necessary business function"
maintaining ade6uate levels of funding. The goal for which sellers access each market
varies depending on their li6uidity needs and time hori!on. :imilarly, investors or buyers
have uni6ue reasons for going to each market" Capital markets offer higher/risk
investments, while money markets offer safer assets> money market returns are often
low but steady, while capital markets offer higher returns. The magnitude of capital
market returns is often a direct correlation to the level of risk, however that is not always
the case.
Although markets are deemed efficient in the long run, short/term inefficiencies allow
investors to capitali!e on anomalies and reap higher rewards that may be out of
proportion to the level of risk. Those anomalies are e(actly what investors in capital
markets try to uncover. Although money markets are considered safe, they have
occasionally e(perienced negative returns. Inadvertent risk, although unusual, highlights
the risks inherent in investing / whether long or short term, money markets or capital
markets.
Cyclical Industry
A type of an industry that is sensitive to the business cycle, such that revenues are
generally higher in periods of economic prosperity and e(pansion, and lower in periods
of economic downturn and contraction.
Companies in cyclical industries can deal with this type of volatility by implementing cuts
to compensations and layoffs during bad times, and paying bonuses and hiring en
masse in good times. Cyclical industries include those that produce durable goods such
as raw materials and heavy e6uipment. A type of an industry that is sensitive to the
business cycle, such that revenues are generally higher in periods of economic
prosperity and e(pansion, and lower in periods of economic downturn and contraction.
Companies in cyclical industries can deal with this type of volatility by implementing cuts
to compensations and layoffs during bad times, and paying bonuses and hiring en
masse in good times. Cyclical industries include those that produce durable goods such
as raw materials and heavy e6uipment.
8or e(ample, the airline industry is a fairly cyclical industry> in good economic times,
people have more disposable income and, therefore, they are more willing to take
vacations and make use of air travel.
Conversely, during bad economic times, people are much more cautious about
spending. As a result, they tend to take more conservative vacations closer to home 5if
they go at all1 and avoid e(pensive air travel.
-e!!anine 8inancing
A hybrid of debt and e6uity financing that is typically used to finance the e(pansion of
e(isting companies. -e!!anine financing is basically debt capital that gives th:ince
me!!anine financing is usually provided to the borrower very 6uickly with little due
diligence on the part of the lender and little or no collateral on the part of the borrower,
this type of financing is aggressively priced with the lender seeking a return in the )C/
%CF range.e lender the rights to convert to an ownership or e6uity interest in the
company if the loan is not paid back in time and in full. It is generally subordinated to
debt provided by senior lenders such as banks and venture capital companies.
-e!!anine financing is advantageous because it is treated like e6uity on a company's
balance sheet and may make it easier to obtain standard bank financing. To attract
me!!anine financing, a company usually must demonstrate a track record in the industry
with an established reputation and product, a history of profitability and a viable
e(pansion plan for the business 5e.g. e(pansions, ac6uisitions, I3=1.
Standstill A#reement
0. A contract that stalls or stops the process of a hostile takeover. The target firm
either offers to repurchase the shares held by the hostile bidder, usually at a
large premium, or asks the bidder to limit its holdings. This act will stop the
current attack and give the company time to take preventative measures against
future takeovers.
). An agreement between a lender and borrower in which the lender stops
demanding the repayment of the loan. A new deal is negotiated, usually altering
the loan's original repayment schedule. This is used as an alternative to
bankruptcy or foreclosure when the borrower can't repay the loan.
$ri%ate $lacement
The sale of securities to a relatively small number of select investors as a way of raising
capital. Investors involved in private placements are usually large banks, mutual funds,
insurance companies and pension funds. 3rivate placement is the opposite of a public
issue, in which securities are made available for sale on the open market.
-anagement ;uyout
A transaction where a companyNs management team purchases the assets and
operations of the business they manage. A management buyout 5-;=1 is appealing to
professional managers because of the greater potential rewards from being owners of
the business rather than employees. -;=s are favored e(it strategies for large
corporations who wish to pursue the sale of divisions that are not part of their core
business, or by private businesses where the owners wish to retire. The financing
re6uired for an -;= is often 6uite substantial, and is usually a combination of debt and
e6uity that is derived from the buyers, financiers and sometimes the seller.
An -;= is different from a management buy/in 5-;I1, in which an e(ternal management
team ac6uires a company and replaces the e(isting management team. It also differs
from a leveraged management buyout 5.-;=1, where the buyers use the company
assets as collateral to obtain debt financing.
An -;=Ns advantage over an -;I is that as the e(isting managers are ac6uiring the
business, they have a much better understanding of it and there is no learning curve
involved, which would be the case if it were being run by a new set of managers. The
advantage of an -;= over an .-;= is that the companyNs debt load may be lower,
giving it more financial fle(ibility.
4owever, there are several drawbacks to the -;= structure as well. hile the
management team can reap the rewards of ownership, they have to make the transition
from being employees to owners, which re6uires a change in mindset from managerial
to entrepreneurial. Hot all managers may be successful in making this transition.
Also, the seller may not reali!e the best price for the asset sale in an -;=. If the e(isting
management team is a serious bidder for the assets or operations being divested, the
managers have a potential conflict of interest. That is, they could downplay or
deliberately sabotage the future prospects of the assets that are for sale to buy them at a
relatively low price.
-;=s are viewed as good investment opportunities by hedge funds and large financiers,
who usually encourage the company to go private so that it can streamline operations
and improve profitability away from the public eye, and then take it public at a much
higher valuation down the road. hile private e6uity funds may also participate in -;=s,
their preference may be for -;Is, where the companies are run by managers they know
rather than the incumbent management team.
8ree Cash 8lows to 96uity
The formula for free cash flow to equity is net income minus capital expenditures minus
change in working capital plus net borrowing.
The free cash flow to equity formula is used to calculate the equity available to
shareholders after accounting for the expenses to continue operations and future capital
needs for growth.
sNet Income is found on a firm's income statement and is the firm's earnings after
expenses, including interest expenses and taxes. Net income may also be found on the
cash flow statement which may save time considering other factors of the free cash flow
to equity formula are on there as well. Net income may be referred to as the bottom
line.
! firm's prior capital expenditures can be found on its cash flow statement and
represents capital used for long term or fixed assets.
! firm's working capital is current assets minus current liabilities. The term current
implies that the assets and liabilities are liquid, generally representing less than one
year, and used for short term operations. "urrent assets and current liabilities can be
found on a firm's balance sheet.s
Net borrowing is the difference between the amount a company borrows and what debt
it repays. It is important to not include interest as this is already figured into net income
#interest expense$. Net borrowing can be found by comparing changes on a company's
balance sheet.
Use of the FCFE Formula
The free cash flow to equity formula may be used by investors and analysts in replace of
dividends when analy%ing a company. &ne of the most notable examples of this is in the
free cash flow to equity model for valuing a stock. The free cash flow to equity model
differs from the dividend discount method only in that it uses free cash flow to equity
instead of dividends.
To understand the use the free cash flow to equity formula, one must understand the
components of it and how it differs from dividends. ! company's net income is also
referred to its earnings. ! company pays some of the earnings out to investors in the
form of dividends and the amount retained is used for future growth. The formula for
cash flow to equity starts with the company's earnings. "apital expenditures is
substracted to account for the amount needed for assets used for growth. The next
variable, change in working capital, is subtracted to account for an increase in capital
needed for short term operations. 'astly, net borrowing is added, or subtracted if
negative, to account for any capital received from taking new debt, or lost due to
repayment of debt. These factors all resolve to the amount available to equity, or
shareholders.
!lthough the free cash flow to equity may calculate the amount available to
shareholders, it does not necessarily equate to the amount that is paid out to
shareholders
&C&& ' C&( ) After ta* interest - C&+
&C&, ' -et +ncome . /Cape* . Depreciation0 . -WC ) -et Borrowin#s
C&( ' -+ ) Depreciation ) Deferred Ta*es . -WC
C&+ ' CA$,1
2xampes of Investing activities are
• $urchase or Sae of an asset %assets can be and" buiding" e*uipment" marketabe
securities" etc.&
• 3oans made to suppiers or received from customers
• $ayments reated to mergers and ac*uisition.
"(( ) "ash flow from financing
4FF 5 6et 1orrowings 7 Dividends
Financing activities incude the infow of cash from investors such as banks and sharehoders"
as we as the outfow of cash to sharehoders as dividends as the company generates income.
8ther activities which impact the ong#term iabiities and e*uity of the company are aso
isted in the financing activities section of the cash fow statement.
9nder IAS :"
• 3ayments of dividends
• 3ayments for repurchase of company shares
• 8or non/profit organi!ations, receipts of donor/restricted cash that is limited to long/
term purposes
Items under the financing activities section incude;
• +ividends paid
• :ale or repurchase of the company's stock
• Het borrowings
• 3ayment of dividend ta(
• Repayment of debt principal, including capital leases
•
23 Ta* Benefits elated to ,mployee Stoc4 (ptions 5:ee '0 on Amgen C8= statement1
AmgenO's C8= was boosted by almost & million because a company gets a ta( deduction
when employees e(ercise non/6ualified stock options. As such, almost PF of AmgenO's C8=
is not due to operations and is not necessarily recurring, so the amount of the PF should be
removed from C8=. Although AmgenO's cash flow statement is e(ceptionally legible, some
companies bury this ta( benefit in a footnote.
To review the ne(t two ad?ustments that must be made to reported C8=, we will consider
*eri!onO's statement of cash flows below.
53 6nusual Chan#es to Wor4in# Capital Accounts 5receivables, inventories and payables1
5Refer to ') on *eri!onO's C8= statement.1
Although *eri!onO's statement has many lines, notice that reported C8= is derived from net
income with the same two sets of add backs we e(plained above" non/cash e(penses are
added back to net income and changes to operating accounts are added to or subtracted
from it"
•
Hotice that a change in accounts payable contributed more than B).$ billion to reported C8=.
In other words, *eri!on created more than B).$ billion in additional operating cash in )CC% by
holding onto vendor bills rather than paying them. It is not unusual for payables to increase as
revenue increases, but if payables increase at a faster rate than e(penses, then the company
effectively creates cash flow by 7stretching out7 payables to vendors. If these cash inflows are
abnormally high, removing them from C8= is recommended because they are probably
temporary. :pecifically, the company could pay the vendor bills in ,anuary, immediately after
the end of the fiscal year. If it does this, it artificially boosts the current/period C8= by
deferring ordinary cash outflows to a future period.
*ivident +ayout , Total *iv - Net Income )note the denominator is net income
&perating margin , ./IT - sales
0
3oison put
0
Coattail +n%estin#
An investment strategy in which investors mimic the trades of well/known and historically
successful investors.
A bond that allows bondholders to redeem before maturity at a high price should certain, named
events take place. These events commonly include restructuring, a leveraged buyout, an attempted
hostile takeover, or paying dividends in excess of a certain amount or percentage. Poison-put bonds
can act as an anti-takeover measure; they help management discourage takeovers by raising their
expense. n the other hand, when the company is going through a difficult time, poison-put bonds
can limit management!s restructuring options for the same reason.
0. In bond trading, a bond indenture that gives the bondholder the right to demand
redemption before maturity at its high par value in case certain event happen. :uch pre/
designated events include restructuring of the bond issuing company, e(cessive dividend
distribution to its stockholders, a leveraged buyout, or a hostile takeover attempt. A poison
put helps the management of the target company to deter the takeover attempt by making it
very costly for the bidder. In times of low li6uidity, however, this put works against the
management as the bond holders can pressure the company into a reorgani!ation or to
increase its borrowing costs.
). In stocks trading, the rights assigned to common stockholders that sharply escalates the
price of their stockholding, or allows them to purchase the company's shares at a very
attractive fi(ed price, in case of a hostile takeover attempt. also called event risk covenant
Risk based haircut
A reduction in the recogni!ed value of an asset in order to produce an estimate for the
level of margin or financial leverage that is acceptable to use when purchasing or
continuing to own the asset. An analyst undertaking a risk/based haircut of an asset
attempts to determine the chances of the asset's value falling below its current level, so
that a sufficient buffer can be established to protect against a margin call.
A risk/based haircut is important to do in order to provide a margin of safety to protect
against the possibility of a margin call or similar type of over/leveraged position in a
security. ;y artificially reducing the recogni!ed value of an asset before undertaking a
leveraged position in it, the actual market value of the asset must fall by an increased
amount than if no haircut was applied in order for a margin call to take place. This
decreases the chances of an ill/time margin call or forced sale of the security for a low
price taking place in the investors account.
+ebt/for/e6uity swap
In a debt#for#e*uity swap" a company's creditors generay agree to cance some or a of the
debt in exchange for e*uity in the company.
Debt for e*uity deas often occur when arge companies run into serious financia troube"
and often resut in these companies being taken over by their principa creditors. This is
because both the debt and the remaining assets in these companies are so arge that there is no
advantage for the creditors to drive the company into bankruptcy. Instead the creditors prefer
to take contro of the business as a going concern. As a conse*uence" the origina
sharehoders' stake in the company is generay significanty diuted in these deas and may
be entirey eiminated" as is typica in a 4hapter -- bankruptcy.
:ub/prime mortgage crisisQeditR
Debt#for#e*uity swaps are one way of deaing with sub#prime mortgages. A househoder
unabe to service his debt on a <-=.k mortgage for exampe" may by agreement with his bank
have the vaue of the mortgage reduced %say to <->?k or :?@ of the house's current vaue&" in
return for which the bank wi receive ?.@ of the amount by which any resae vaue" when
the house is resod" exceeds <->?k.
1ondhoder haircutsAeditB
A debt#for#e*uity swap may aso be caed a Cbondhoder haircut.C 1ondhoder haircuts at
arge banks were advocated as a potentia soution for the subprime mortgage crisis by
prominent economists;
2conomist Doseph StigitE testified that bank baiouts C...are reay baiouts not of the
enterprises but of the sharehoders and especiay bondhoders. There is no reason that
American taxpayers shoud be doing this.C +e wrote that reducing bank debt eves by
converting debt into e*uity wi increase confidence in the financia system. +e beieves that
addressing bank sovency in this way woud hep address credit market i*uidity issues.
AFB
2conomist Deffrey Sachs has aso argued for bondhoder haircuts; CThe cheaper and more
e*uitabe way woud be to make sharehoders and bank bondhoders take the hit rather than
the taxpayer. The Fed and other bank reguators woud insist that bad oans be written down
on the books. 1ondhoders woud take haircuts" but these osses are aready priced into
deepy discounted bond prices.C
A>B
If the key issue is bank sovency" converting debt to e*uity via bondhoder haircuts presents
an eegant soution to the probem. 6ot ony is debt reduced aong with interest payments" but
e*uity is simutaneousy increased. Investors can then have more confidence that the bank
%and financia system more broady& is sovent" heping unfreeEe credit markets. Taxpayers do
not have to contribute doars and the government may be abe to Gust provide guarantees in
the short#term to further support confidence in the recapitaiEed institution.
For exampe" one of the argest 9.S. banks owed its bondhoders <FH: biion per its F..=
annua report.
AIB
A F.@ haircut woud reduce this debt by about <?I biion" creating an e*ua
amount of e*uity in the process" thereby recapitaiEing the bank significanty.
:econd .ien +ebt
hen lenders issue loans to borrowers, they commonly re6uire that collateral be made
against the principal of the loan to ensure that the principal can be repaid in the future.
In the case of a real estate mortgage, the lender effectively places a lien on the asset so
that if it is sold, the lender will be first in line to receive funds. If a second mortgage is
taken out on the same property, the second loan will be considered second lien debt to
the first mortgage, and will be subordinate to the first in terms of return of principal. 8or
this reason, second lien debt is usually considered riskier than higher lien debt and often
comes with a higher interest rate as a result.
'Revolving Credit'
A line of credit where the customer pays a commitment fee and is then allowed to use
the funds when they are needed. It is usually used for operating purposes, fluctuating
each month depending on the customer's current cash flow needs.
Roll up
"rite down all of you debt balances and the minimum monthly payment for each. Then,
divide the balances by the minimum monthly payment. This gives you a number called the
#divisor# which is assigned to each debt.
$ext, order your debts starting with the one with the largest divisor, working your way down
the list. %f two debts have e&ual divisors, list the one with the lowest interest rate first.
$ow, for every debt except the bottom debt, you only make the absolute minimum payment
for each. 'or the bottom debt however, you pay the minimum plus whatever extra amount
that you have. (ou do this each month until that bottom debt is fully paid off.
$ext, you roll up the amount that you had been paying on the bottom debt, and start
applying it to the next debt above it on the list. (ou keep doing this until all the debts are
gone.
+I3 financing
8inancing arranged by a company while under the Chapter 00 bankruptcy process. +I3
financing is uni6ue from other financing methods in that it usually has priority over
e(isting debt, e6uity and other claims.
Chapter 00 gives the debtor a fresh start, which is, however, sub?ect to the debtor's
fulfillment of its obligations under its plan of reorgani!ation.
An individual or corporation that has filed for Chapter 00 bankruptcy protection and
remains in control of property that a creditor has a lien against, or retains the power to
operate a business. A debtor who files a Chapter 00 bankruptcy case becomes the
debtor in possession 5+I31. The +I3 continues to run the business and has the powers
and obligation of a trustee to operate in the best interest of any creditors. A +I3 can
operate in the ordinary course of business, but is re6uired to seek court approval for any
actions that fall outside of the scope of regular business activities. The +I3 must also
keep precise financial records and file appropriate ta( returns.
After filing for Chapter 00 bankruptcy, new bank accounts are opened that name the
debtor in possession on the account. A debtor in possession can be terminated and the
court will appoint a trustee in the event that assets are improperly managed or the debtor
in possession is not following court orders. The <nited :tates Trustee's office maintains
guidelines that specify the duties of a debtor in possession.
Credit event
Any sudden and tangible 5negative1 change in a borrower's credit standing or decline in
credit rating. A credit event brings into 6uestion the borrower's ability to repay its debt. It
is the defining trigger in a credit derivative contract, or credit default swap. If the
borrower e(periences a credit event, then the buyer of the contract must pay the seller
an agreed/upon sum to cover the loss.
Credit events include bankruptcies or violating a bond indenture or other loan
agreement. Any decline in the borrower's credit rating can trigger the swap. Credit
events always refer to the condition of the borrower pertaining to the underlying asset
and not to either the lender or the purchaser of the swap.
Credit +efault :wap / C+:
A swap designed to transfer the credit e(posure of fi(ed income products between
parties. A credit default swap is also referred to as a credit derivative contract, where the
purchaser of the swap makes payments up until the maturity date of a contract.
3ayments are made to the seller of the swap. In return, the seller agrees to pay off a
third party debt if this party defaults on the loan. A C+: is considered insurance against
non/payment. A buyer of a C+: might be speculating on the possibility that the third
party will indeed default.
The buyer of a credit default swap receives credit protection, whereas the seller of the
swap guarantees the credit worthiness of the debt security. In doing so, the risk of
default is transferred from the holder of the fi(ed income security to the seller of the
swap. 8or e(ample, the buyer of a credit default swap will be entitled to the par value of
the contract by the seller of the swap, should the third party default on payments. ;y
purchasing a swap, the buyer is transferring the risk that a debt security will default.
+ebentures
A type of debt instrument that is not secured by physical assets or collateral. +ebentures
are backed only by the general creditworthiness and reputation of the issuer. ;oth
corporations and governments fre6uently issue this type of bond in order to secure
capital. .ike other types of bonds, debentures are documented in an indenture.
+ebentures have no collateral. ;ond buyers generally purchase debentures based on
the belief that the bond issuer is unlikely to default on the repayment. An e(ample of a
government debenture would be any government/issued Treasury bond 5T/bond1 or
Treasury bill 5T/bill1. T/bonds and T/bills are generally considered risk free because
governments, at worst, can print off more money or raise ta(es to pay these type of
debts.
Convertible +ebentures
A type of loan issued by a company that can be converted into stock by the holder and,
under certain circumstances, the issuer of the bond. ;y adding the convertibility option
the issuer pays a lower interest rate on the loan compared to if there was no option to
convert. These instruments are used by companies to obtain the capital they need to
grow or maintain the business.
Convertible debentures are different from convertible bonds because debentures are
unsecured> in the event of bankruptcy the debentures would be paid after other fi(ed
income holders. The convertible feature is factored into the calculation of the diluted per/
share metrics as if the debentures had been converted. Therefore, a higher share count
reduces metrics such as earnings per share, which is referred to as dilution.
arrant
A derivative security that gives the hoder the right to purchase securities %usuay e*uity& from
the issuer at a specific price within a certain time frame. 0arrants are often incuded in a new
debt issue as a CsweetenerC to entice investors.
The main difference between warrants and call options is that warrants are issued and
guaranteed by the company, whereas options are e(change instruments and are not
issued by the company. Also, the lifetime of a warrant is often measured in years, while
the lifetime of a typical option is measured in months.
Cash from 8inancing Activities
Cash received from Issuing 96uity 2 +ividends 3aid out 2 Interest payments
A positive number for cash fow from financing activities means more money is fowing into the
company than fowing out" which increases the company,s assets. 6egative numbers can mean
the company is servicing debt" but can aso mean the company is retiring debt or making dividend
payments and stock repurchases" which investors might be gad to see. Investors can aso get
information about cash fow from financing activities from the baance sheet,s e*uity and ong#
term debt sections and possiby the footnotes. 4ash fow from financing activities is one of the
three main sections of a company,s cash fow statement" the other two being cash fow from
operations and cash fow from investing. This section of the cash fow statement measures the
movement of cash between a firm and its owners and creditors.
Financing activities that generate positive cash fow incude receiving cash from issuing stock
and receiving cash from issuing bonds. Financing activities that generate negative cash fow
incude spending cash to repurchase previousy issued stock" to pay down debt" to pay interest on
debt and to pay dividends to sharehoders.
Total Capital /
Total capital E :hareholderNs e6uity STotal +ebt
The debt/to/capital ratio gives users an idea of a company's financial structure, or how it
is financing its operations, along with some insight into its financial strength. The higher
the debt/to/capital ratio, the more debt the company has compared to its e6uity. This
tells investors whether a company is more prone to using debt financing or e6uity
financing. A company with high debt/to/capital ratios, compared to a general or industry
average, may show weak financial strength because the cost of these debts may weigh
on the company and increase its default risk.
Jross 3rofit E :ales 2 C=J:
9;IT E Jross 3rofit 2 :JTA / +epreciation
3ercent of sales method
Inventory E F of sales
C=J: E F of sales
:JTA E F of sales
CA39D E F of sales
+epreciation E F of CA39D
+eferred Ta(es E F of CA39D
HI E F of sales
+ividend E F of HI
Ta( E marginal ta( rate
Addition to R9 E F of HI
Incremental investment rate 2investment in fi(ed asset 5fi(ed 3391 re6uired per dollar
increment in sales
1995 1996 1997 1998 1999

%ncremental
'ixed
)apital
%nvestments
-*+., -+,.- -.,+., --././ -.0+.+

1ales ,,232.,0 +,0,+..0 2,.*,.30 3,423.*0 /,24+.20


%ncremental
1ales
*3+.- -,,+/.*0 -,.+/.+0 -,-34..0 -,-33.20

%ncremental
'ixed
)apital
%nvestment
5ate
*.336 ,.*-6 -/.306 -0.*36 -3.4+6

Net New Financing 7 Pro8ected Assets - Pro8ected 9iabilities and :&uity
;igh :P1 < investors are more willing to pay for the share
%f revenue tells us how much money is flowing into the company, :P1 tells us how much of
that money is flowing down to stock holders. :P1 tells you how much money the company is
making in profits per every outstanding share of stock. The higher the :P1 is, the more
money your shares of stock will be worth because investors are willing to pay more for
higher profits.
5ead more= http=>>www.nasda&.com>investing>do?en>earnings-per-
share.aspx@ix??,,4b/A+l2
;igh P>: < has positive upside. Aarket thinks that share price will rise in future. 9ow P>: is Bvote of no
confidenceC
0hat does +-. tell you1 The +-. gives you an idea of what the market is willing to pay for the
company2s earnings. The higher the +-. the more the market is willing to pay for the company2s
earnings. 3ome investors read a high +-. as an overpriced stock and that may be the case,
however it can also indicate the market has high hopes for this stock2s future and has bid up the
price.
.+3 , Net Income- 4 "3 outstanding
So looking at the EPS ratio, you should go buy Company A with an EPS of 10, right? EPS is not the
only basis of comparing two companies, but it is one of the methods used.
Note that there are three types of EPS numbers:
Trailing EPS – last year’s numbers and the only actual EPS
Current EPS – this year’s numbers, which are still projections
Forward EPS – future numbers, which are obviously projections
EPS doesn’t tell you whether it’s a good stock to buy or what the market thinks of it.
PE Ratio :
If there is one number that people look at than more any other number, it is the “Price to Earning Ratio
(P/E)”. The P/E is a ratio that investors throw around with confidence as if it told the complete story.
Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the
most popular stock analysis ratio, although it is not the only one you should consider.
You calculate the P/E by taking the share price and dividing it by the company’s EPS (Earnings Per
Share that we saw above)
P/E = Stock Price / EPS
For example: A company with a share price of Rs.40 and an EPS of 8 would have a P/E of: (40 / 8) =
5
What does P/E tell you?
Some investors read a high P/E as an “overpriced stock”.
However, it can also indicate the market has high hopes for this stock’s future and has bid up the
price.
Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean that the
market has just overlooked the stock. Many investors made their fortunes spotting these overlooked
but fundamentally strong stocks before the rest of the market discovered their true worth.
In conclusion, the P/E tells you what the market thinks of a stock. It tells you whether the market likes
or dislikes the stock.