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BUS202 Study Guide

Site: Saylor Academy
Course: BUS202: Principles of Finance
Book: BUS202 Study Guide
Printed by: Guest user
Date: Monday, March 9, 2026, 9:59 PM

Table of contents

Navigating this Study Guide

Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

  • questions for you to answer independently;
  • a brief summary of the learning outcome topic; and
  • and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

 

How to Use this Study Guide

  1. Review the entire course by reading the learning outcome summaries and suggested resources.
  2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Introduction to Finance


1a. Explain the primary goal of financial management

  • What is the goal of financial management?
  • How does maximizing shareholder wealth differ from maximizing profits?
  • Why are financial managers important to firms?
  • How are the roles of shareholders and financial managers interdependent?

Financial Management refers to the strategic planning, organizing, directing, and controlling of finances within an organization. This can include financial analysis, valuation, capital, and more. The primary goal of financial management for financial managers (professionals who oversee an organization's financial operations and make strategic financial decisions) is to maximize shareholder wealth, also referred to as maximizing the price of the firm's existing common stock. This is different from maximizing profit (the amount of money remaining after all expenses are subtracted from revenue) because while wealth maximization (a long-term strategy focused on increasing the overall value of the firm and shareholder equity) focuses on long-term value creation and sustainability, profit maximization (a strategy aimed at generating the highest possible profits, often emphasizing short-term gains) may prioritize short-term gains at the expense of long-term growth and shareholder value. Financial managers have to consider many factors when making decisions. They are trusted agents in firms who must engage in ethical practices to meet the firm's goals. Maximizing shareholder wealth is a goal that considers the risks and realities of the firm's operating environment and the impact of financial decisions.

Changes in financial market stock prices (the current market values at which shares of publicly traded companies are bought and sold) are a proxy for investor sentiment toward a firm's decisions. If investors react positively, stock prices increase; they decrease if they react negatively. The value of the stock price is a measure of shareholder wealth.

Shareholders are the ultimate owners of the firm because each share represents a piece of the firm that has been bought. Therefore, the shareholder who purchased that stock has ownership and voting rights over the percentage of the company the shareholder owns. Financial managers should make sound decisions, accounting for the appropriate operating context. A firm that maximizes shareholder wealth still must act ethically, be a good steward of organizational resources, and increase profitability.

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1b. Differentiate the advantages and disadvantages of the main forms of business organization in the United States

  • What are the advantages and disadvantages of the sole proprietor business organization?
  • What are the advantages and disadvantages of partnerships?
  • What are the advantages and disadvantages of corporations?

Entrepreneurs have several choices in how they legally organize their companies. Sole proprietorships are easy to start, the owner maintains complete control over decision-making, and the company profits are only taxed at the individual level. However, this form has a large disadvantage of unlimited liability. In addition, when the owner dies, the business ceases to exist.

Partnerships continue to have the advantage of being easy to set up, like sole proprietors, and also enjoy single taxation. However, decision-making and responsibilities now must be divided among the partners, which can create conflict. Partnerships also have the disadvantage of unlimited liability.

Corporations gain the advantage of being a legal entity and having greater access to capital. Most importantly, the owners in the corporate structure have limited liability, meaning they stand to lose their investment, but not their personal assets. The main disadvantages of corporations are double taxation (income taxed at the corporate level and then again at the individual level when dividends are paid) and the paperwork complexity required to form and report.

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1c. Explain the importance of ethical decision-making in the field of finance

  • What is ethics?
  • Why is ethical behavior important for financial professionals?
  • Are legal and ethical the same thing?

Ethics is a system for determining whether an action is right or wrong. Someone's judgment about what is ethical might depend on the consequences of their actions, following a set of universal rules or religion, their moral identity, or the social norms of their society. Because ethics can be defined differently, individuals and corporations can disagree on an ethical course of action. Ethical behavior is paramount for financial professionals as it fosters trust, maintains market integrity, and ensures the long-term stability of the financial system.

Legal and ethical are not always the same. An action such as environmental pollution might be legal in an undeveloped country, but it is unethical because the manager knows their actions will harm people. Financial managers must always review ethical considerations before making decisions. Their personal ethics may be involved, but they also need to consider the ramifications to stock price and company reputation if actions are taken that stakeholders perceive as unethical, even if the manager does not.

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1d. Explain the impact of agency issues and conflict of interest on financial management

  • How is the agency problem defined?
  • What is a fiduciary duty?
  • What are the potential costs of agency problems to a firm?

The agency problem occurs when one party (the principal) expects another (the agent) to act on their behalf, but the agent may actually pursue their own interests, which will be regarded as a conflict of interest. Thus, a conflict of interest is a situation where someone's personal interests conflict with their professional duties, leading to biased or unethical decisions. In a corporation, the stockholders pick managers to act as their agents and pursue the goal of maximizing shareholder wealth. In practice, managers may act to maximize their own wealth, therefore creating an agency problem. Organizations try to minimize agency issues by providing incentives for managers to act in the interest of owners, including instruments such as stock options, to align incentives.

Conflicts of interest can lead to significant costs for a firm. These are known as agency costs and can be both direct and indirect, ultimately affecting profitability, shareholder value, and the firm's reputation.

Fiduciary duty means that the agent is legally obligated to pursue the financial interests of the principal. Failure to do so can result in penalties or legal action.

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Unit 1 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • agency problem
  • conflict of interest
  • corporation
  • ethical behavior
  • ethics
  • fiduciary duty
  • financial manager
  • limited liability
  • partnership
  • profit
  • profit maximization
  • shareholder
  • sole proprietorship
  • stock price
  • wealth maximization

Unit 2: Financial Statements and Financial Analysis


2a. Use income statements, balance sheets, and cash flow statements to inform decision-making

  • Where do firms record their financial transactions?
  • How do firms report and track their activities to others?
  • What is the purpose of financial statements?
  • How are financial statements used to analyze a firm's operations and performance?

Firms keep official records of their operating activities, cash flows, and assets for tax purposes, general bookkeeping, regulatory reporting requirements, historical records, and information transparency to investors and other interested parties. These official records, which come in multiple types, are collectively called financial statements. The reporting requirements can differ based on company size, firm organizational structure, and whether or not a firm is publicly or privately owned. The three most common financial statements are the balance sheet, the income statement, and the statement of cash flows. These statements are produced at least yearly and contain key firm accounts and activities. The statements stand individually but are also connected because they either share the same information or provide information that informs the creation of one of the other statements. The purpose of financial statements is to allow businesses to understand their financial standing.

The balance sheet is the first statement created. It gives a portrait of the company's financial position at one point in time, which is most commonly at the end of the firm's calendar year. It shows the relationship between a firm's assets (what it owns) and its liabilities (debts and obligations that the company owes to external parties) and owners' equity (who has a claim on what the firm owns). The accounts on the balance sheet are grouped by whether they are assets, liabilities, or owner's equity. Within those categories, accounts are further separated by whether they are current (due or used within a year or less) or long-term (due or used in a period of greater than 12 months). The balance sheet is governed by the equation: assets = liabilities + owner's equity. For the statement to be correct, the sum of all assets must always equal the sum of liabilities and owners' equity. This maintains the balance.

The income statement shows how the company has created and allocated its income over the year. The major source of a firm's income is called sales revenue. Therefore, the income statement's equation is Sales – Expenses = Net Income. The income statement is connected to the balance sheet because some balance sheet accounts, especially those considered "current", are reflected as expenses on the income statement. Net income (the total profit remaining after all expenses, taxes, and costs have been subtracted from total revenue) is found at the bottom of the income statement. With net income, a firm can reinvest it in the company by putting it into the retained earnings account, or it can pay dividends. The retained earnings account is listed on the balance sheet. A firm's tax liability and depreciation are also on the income statement.

The statement of cash flows depicts the annual inflow and outflow of cash within the firm. It separates the firm's cash-generating activities into three categories: operating activities, investing activities, and financing activities.

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2b. Calculate major financial ratios to evaluate a company's performance

  • How are financial statements used to analyze a firm's operations and performance?
  • How do firms compare their performance across time and with their peers?
  • What are the categories of financial ratios?

Financial statements provide a comparison of the firm's financial activities over time. Financial ratios are another tool that helps managers evaluate a firm's performance. Financial ratios are a unique evaluation tool because they allow for comparing a firm's performance against its peers and against industry averages, not only against its own performance.

Financial ratios are percentages created by using various accounts on the financial statements. Five categories of performance are measured by financial ratios: liquidity or solvency, asset efficiency or turnover, profitability, financial leverage or debt, and market value. Comparisons across companies and within an industry can be made based on a specific ratio, a category of ratios, or over time. Ratio analysis is a multidimensional analysis technique that facilitates benchmarking and trend analysis. Firms also compare their performance across time and with their peers using trend analysis and common-size analysis. These tools help managers, investors, and analysts assess a company's financial health, efficiency, and competitiveness.

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2c. Use pro forma financial statements to evaluate a company's future performance

  • What would a firm use to plan operations for the future?
  • How can firms use historical performance to predict future performance?
  • How do pro forma financial statements differ from standard financial statements?

While important for assessing performance, a firm's financial statements are backward-looking. There is a lag between when activities occur and when the reports are created. Financial statements provide information about transactions and activities that have already happened at the firm. While analysis can be conducted from existing financial statements, there are times when it's necessary to have a forward-looking perspective about the firm's activities. Therefore, financial statements are forecasted into the future, using assumptions to create pro forma financial statements. Business managers can create a pro forma balance sheet, a pro forma income statement, and a pro forma cash budget.

Pro forma financial statement analysis is useful when assessing the firm's future state under assumed circumstances or an anticipated change in market conditions. Pro forma financial statements are also used as a valuation method for a firm. Many firms undergoing potential sale, acquisition, merger, or buyout activities will use pro forma financial statements to estimate the firm's future worth. The assumptions used in building pro forma statements can come from market averages and benchmark metrics or the company's past performance as exhibited in its financial statements.

To create a pro forma statement, the firm or an analyst can use the most recent financial statement as a starting point, change assumptions for the percentage growth of each category on the financial statements, and then calculate that multiple against the current values on the financial statement used as a base. The resulting figure will be what is placed on the pro forma statement. Applying the multiple can be done for one period or many periods. The percentages applied can also be changed each iteration of creating a new statement. The result would be creating a pro forma statement that, using certain assumptions, gives an idea of the company's future financial condition.

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2d. Interpret a company's financial statements

  • How do you use ratio analysis, pro forma statements, and industry information to judge a company's financial health?
  • Why are trend analysis and competitor comparisons important when judging a firm's financial health?
  • How do financial statements help in assessing a company's risk and return potential?

When analyzing a firm's financial health, analysts utilize all the tools of ratio analysis, pro forma statement analysis, and industry comparisons to judge a firm's financial health. After calculating all the appropriate financial ratios, the analyst will utilize databases and competitor information to find industry averages to compare against.

An overall picture of a company's financial health can be reached by looking at the performance versus these benchmarks (standard reference points or comparison metrics, such as industry averages, competitor performance, or historical company data, used to evaluate and measure a company's financial performance) for each ratio category. The analyst must also analyze the trends for the company being reviewed over time and compare those to the benchmarks over time. A detailed assessment of financial health can be made by looking at a trend analysis and a comparison to competitors in the industry.

It is important to remember that analyzing a company's financial statements leads to questions the investor discovers about its operations. Economic or extenuating factors may sometimes explain poor financial comparisons, and investors might want to see strategic plans to make changes. Conducting modeling is important, as various scenarios must be examined to judge potential future results.

In summary, financial statements allow stakeholders to assess return through evaluating profitability and efficiency; assessing risk by measuring liquidity, solvency, and stability. This will enable them to make informed investment, lending, or strategic decisions.

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Unit 2 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • asset
  • balance sheet
  • benchmark
  • financial ratio
  • financial statement
  • income statement
  • liability
  • net income
  • owners' equity
  • pro forma financial statement
  • ratio analysis
  • statement of cash flows

Unit 3: Time Value of Money


3a. Explain the time value of money

  • Why does the value of money change over time?
  • What is the difference between discounting and compounding?

While the value of money is relatively stable in the American economy, time does affect its value. Time is a measure of risk in finance. Economic conditions, inflation, interest rates, the money supply, and investor expectations all change over time and, therefore, affect the value of money. The saying is true: "A dollar today is worth more than a dollar tomorrow". This is true because no one can accurately predict what will happen between today and tomorrow or between now and the next minute. There is a risk when investing or holding money in any form for any period. The more money or assets held in forms less liquid than cash, the greater the risks.

Financial calculations take into account the relationship between time and monetary value. These calculations compute what is called the time value of money. When computing the value of money over multiple time periods, finance uses formulas to reflect that the value of a lump sum in the future (future value) or the value of a future lump sum in the present (present value) differs based on the interest rate, whether the investment earns simple or compound interest, the number of periods interest is earned for, and the total life of the investment.

The process of calculating the future value of an investment by applying interest or returns to both the original principal and previously accumulated interest over multiple periods is called compounding. Calculating values back to the present is called discounting. To find the present value, you will give a discount (a reduction applied to a future value to account for the time value of money and determine what that future amount is worth in today's dollars) on the present value. To find the future value of a lump sum, you compound it into the future.

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3b. Compute present and future values

  • What is the difference between present value and future value?
  • How do we calculate the future value of a lump sum?
  • How do we calculate the present value of a future lump sum?

Finance has two ways of computing the value of a lump sum of money over a period of time to account for changes in the time value of money. An investor needs to answer two basic questions in money valuation: 1. How much is a lump sum worth at n periods into the future? and 2. How much is a future lump sum worth today?

These questions represent the future value and present value, respectively. To answer the first question, you need to compound; to answer the second question, you need to discount. To compound a lump sum, you multiply it by the compound factor. To discount a lump sum, you multiply it by the discount factor.

The valuation of every type of financial instrument or transaction is a variation on the present value or future value computation. Present value is the current worth of a future sum of money or stream of cash flows, discounted at a specific interest rate. Future Value is the amount of money an investment made today will grow to at a specified interest rate over time.

To accurately calculate the present or future value, you need some standard inputs, such as the interest rate (which becomes the discount rate or compound rate), the number of times in one year the investment compounds, the total number of years in the life of the investment, and the lump sum amount. The lump sum amount is multiplied by all of the other elements of the equation, which combine to form either a compound factor or a discount factor. The compound factor and the discount factor are inverses of each other. Future and present values can be computed for lump sums or multiple flows. The future value of multiple flows and the present value of multiple flows require the same basic components.

The present value and future value equations are:

Present Value: FV(1+r)t
Future Value: PV(1+r)t
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3c. Compute rates of return and their use in financial decision-making

  • How do we compute the profit earned on an investment?
  • Why is profit earned quoted as a percentage rate?
  • How do rates of return influence investment decisions?

The ultimate goal of investing is to profit from the investment. In finance, the profit is called return. The rate of return (or yield), expressed as a percent, is the ratio of the profit to the amount invested. Sometimes, firms or investors desire a certain rate of return before entering into a transaction. After calculating the potential value, the investor can decide not to enter the transaction if the rate of return is unacceptable. A predetermined rate of return can also be used as the discount rate when valuing a transaction. A desired rate of return can be arbitrarily chosen based on market conditions or historical returns an investor has received. Thus, rates of return influence investment decisions by measuring and comparing investment attractiveness to determine profitability. It helps determine if return justifies risk, guides acceptance/rejection based on required returns, and supports allocation to maximize overall portfolio return.

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3d. Calculate simple and compound interest

  • What is the difference between simple interest and compound interest?
  • How do we compute simple interest?
  • How do we compute compound interest?

Interest is the amount paid for or earned on a transaction, depending on which side of the transaction you sit on. An interest rate is a price paid for money, stated as a percentage of the principal or some other specified amount. There are many interest rates in the economy, and they differ based on the relevant product and market.

There are two main ways to calculate interest: simple or compound interest. With simple interest, you only earn interest on the principal amount. Simple interest is calculated by multiplying the stated interest rate by the principal amount. The product of that operation is the amount of interest for the given period. Repeat these steps for each period interest is earned. For the final step, sum all the interest amounts for each period to get the total interest earned on the transaction using simple interest.

We can calculate simple interest using the formula 𝐼 = 𝑃 x r x t

Compound interest differs from simple interest because it allows one to earn interest on their interest. This means that in the equation, over multiple periods, the interest calculation includes the principal and interest from all prior periods. This results in a final amount when using compound interest that is greater than the simple interest, which would use the same inputs for the equation. We can calculate compound interest using the formula A=P(1+r/n)nt

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3e. Calculate present values, future values, and payments using non-annual compounding

  • How does the frequency of compounding change the future value?
  • What is non-annual compounding, and how does it differ from annual compounding?
  • How do you calculate time value of money problems using non-annual compounding?

Financial investments are typically held over a period of time or usually earn interest over a period of time. When calculating future or present value, the investment can last for one period or multiple periods. Each period represents a period of compounding.

When computing future value, the greater the number of periods, the greater the final amount will be. The time horizon matters, as well. The longer the time the investment compounds, the greater the final future value after multiple compounding periods. The opposite is true when calculating the present value for multiple periods. The more frequently the investment is discounted and the longer the investment's life, the smaller the present value.

Non-annual compounding refers to the process of calculating interest more than once per year, such as monthly, quarterly, semiannually, or even daily. It contrasts with annual compounding, where interest is added to the principal only once a year. When multiple periods are used, the value of n in the equations below is greater than one. Compounding for one period usually uses the word annual, whereas compounding for multiple periods uses words other than annual, such as daily, continuously, biannually, semiannually, or quarterly. The value of n is always written in comparison to annual terms. For example, an investment that compounds every two years (biannually) would have an n of 0.5, whereas something compounding every six months (semiannually) would have an n of 2.

Try these examples:

  1. You invest $1,000, earning 5% interest compounded semiannually. How much will you have in total at the end of three years?
  2. You invest $1,000, earning 5% interest compounded biannually. How much will you have in total at the end of three years?
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Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • annual
  • compound factor
  • compounding
  • compound interest
  • discount
  • discount factor
  • discount rate
  • future value
  • interest rate
  • present value
  • rate of return
  • simple interest
  • time value of money

Unit 4: Stocks, Bonds, and Financial Markets


4a. Compare stocks and bonds

  • What is the difference between stocks and bonds?
  • What are the advantages and disadvantages of stocks?
  • What are the advantages and disadvantages of bonds?
  • How do stocks and bonds generate returns for investors?

Stocks represent an equity interest in a corporation, while bonds represent debt to the company. Stockholders are the firm's owners and have voting rights to elect the board of directors and major issues of the company. Stockholders may receive dividends and earn a return through the appreciation of the stock price, but dividends can be reduced or canceled in poor financial conditions, and returns are not fixed. Stocks offer potential for higher returns through growth but come with higher risk and volatility.

Bondholders receive interest payments and repayment of the principal upon the bond's maturity. Bonds have the advantage of high liquidity, legal protection, and relatively low volatility, but do not have voting rights and cannot share in the upside success of the firm. Stocks have the possibility of price appreciation and dividends, but they have no legal claim to payments and are a higher risk than bonds. Bonds provide stable, predictable income and are generally less risky, especially for conservative investors. Bonds usually offer lower long-term returns than stocks, especially in periods of low interest rates or inflation.

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4b. Compute the value of a bond

  • How do you calculate the value of a bond?
  • How does a bond's value vary with interest rates?
  • How does the time to maturity affect a bond's value?

Bond values are calculated using the present value approach. The price of a bond is equal to the present value of the interest payments plus the present value of the principal repayment at maturity. The interest payments represent an annuity, so the PV of an annuity must be calculated. The principal is a lump sum, so the PV of a single amount is used. Both present values are added together to calculate the value of the bond. The easiest way to calculate the PV of a bond is to use Excel or a calculator application. The mathematical formula is given below:

\(P=\left(\frac{C}{1+i}+\frac{C}{{(1+i)^2}}+...+\frac{C}{(1+i)^{N}}\right)+\frac{M}{(1+i)^{N}}\\ =\left(\sum_{n=1}^{N}\frac{C}{(1+i)^{n}}\right)+\frac{M}{(1+i)^{N}}\\ =C\left(\frac{1-(1+i)^{-N}}{i}\right)+M(1+i)^{-N}\)

The interest rate used to calculate the bond's value is the discount rate based on the yield of similar investments, or the market rate. As interest rates increase, the price of a bond will decrease, and vice versa. This inverse relationship means that bond prices increase in value during times of decreasing interest rates and decrease in value when rates rise.

The time to maturity significantly affects a bond's value due to its impact on the present value of future cash flows (coupon payments and face value).

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4c. Compute the value of a share of stock

  • What is the difference between the intrinsic value and the market value of a stock?
  • How do you calculate the value of a share of stock?
  • How do investors use the P/E ratio?

The intrinsic value of a stock is the theoretical or estimated worth of a stock based on fundamental analysis, such as future cash flows, earnings, dividends, and growth potential. Meanwhile, the market value of a stock is the current trading price in the stock market: what buyers are willing to pay and what sellers are willing to accept.

The value of a share of stock is equal to the present value of the expected returns associated with the stock. The returns may include dividends or price appreciation, known as capital gains. The Gordon Growth Model, known as the dividend discount model, is the mathematical formula to calculate the value of stock under constant growth rate assumptions:

\(P=D\times \sum^{\infty}_{i=1}(1+g1+k)i=D \times 1+gk-g\)

The value of a stock can also be calculated using the P/E ratio. Knowing the stock's historical P/E ratio and the EPS, you can calculate the expected stock price.

P/E = market price/EPS

A high P/E ratio can indicate a stock that is expected to grow in the future, or that a stock is overpriced. A low P/E ratio can indicate a value stock, a stock that is not seen as attractive.

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4d. Explain the role of financial intermediaries in US financial markets

  • What is the role of financial intermediaries in the US financial markets?
  • What are the main types of financial intermediaries?
  • How do financial intermediaries differ from direct finance?

A financial intermediary helps transfer funds from those who have excess to those who need funds. Intermediaries include banks, mutual funds, credit unions, insurance companies, brokers, and pension funds. Stock exchanges allow companies to raise capital by selling shares to the investing public, transferring money from investors to corporations.

Banks help companies raise capital by underwriting and issuing securities; provide advisory services. Mutual funds pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities. Pension funds manage retirement savings for employees by investing in long-term assets. Insurance companies collect premiums to provide protection against risks and invest the collected funds in capital markets. Financial brokers act as intermediaries between buyers and sellers in financial markets. They do not own the assets being traded but help facilitate transactions, often for a commission or fee.

Financial intermediaries help by pooling savings, managing risk, and ensuring liquidity. Meanwhile, direct finance offers potentially lower costs for borrowers but requires more transparency and investor knowledge.

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4e. Identify the markets investors use to trade securities

  • What are financial markets, and why are they important for investors?
  • What are the different types of market organizations for trading securities?
  • What is the difference between a primary market and a secondary market?

Financial markets are platforms or systems where buyers and sellers come together to trade financial assets such as stocks (equity securities), bonds (debt securities), commodities, currencies, and derivatives (like options or futures). Financial markets connect savers (investors) with borrowers (companies, governments). They are essential for building personal wealth, funding business expansion, and facilitating efficient economic activity. Without financial markets, investors would find it much harder to invest, trade, or evaluate risk and return.

There are three main types of market organization for trading securities: an auction market, a brokered market, and a dealer market. An auction market brings buyers and sellers together directly to execute orders. The NYSE is the most famous auction market. Brokered markets are when an intermediary finds trading partners for their clients directly, such as the municipal bond market. Dealer markets have quote systems where dealers provide continuous bids for securities investors want to buy or sell. NASDAQ is the most notable dealer market.

Primary markets deal with the issue of new securities. When a company goes public for the first time through an initial public offering (IPO), that is a primary market transaction. In contrast, secondary markets facilitate trading securities previously issued between owners and subsequent buyers. Markets are important in providing liquidity for investors and price transparency.

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Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • auction market
  • bond
  • brokered market
  • capital gains
  • dealer market
  • dividend discount model
  • financial broker
  • financial intermediary
  • initial public offering (IPO)
  • insurance company
  • mutual fund
  • pension fund
  • P/E ratio
  • primary market
  • secondary market
  • stock

Unit 5: Risk, Return, and the CAPM


5a. Explain the relationship between risk and reward

  • What is risk?
  • What is a reward or return?
  • What is the relationship between risk and return?
  • What types of risk are there?

Every financial transaction has an element of risk, meaning an investor can make or lose money on the transaction. The gain an investor makes on a transaction is called a reward or return. Risk is the uncertainty of future cash flows. There are many types of risk, such as liquidity risk, operational risk, market risk, price risk, credit risk, counterparty risk, maturity risk, default risk, geopolitical risk, and many more. For every risk, there is an accompanying risk premium. The types of risk are derived from the understanding that elements or events could jeopardize the expected cash flows from a transaction. In finance, the common saying is, "The greater the risk, the greater the expected reward".

Return is the reward one gets for bearing risk. The riskier a transaction, the greater the payout you should expect. Sometimes investors want to maximize the return portion of an investment portfolio while minimizing the risk. To achieve that, there are primarily three options for risk mitigation: diversification, hedging, and purchasing insurance of some type. Purchasing insurance on a financial position or investment is pretty straightforward to understand. Hedging requires the investors to take an opposite and offsetting position.

Since there is a chance that an investor may not profit from a transaction, investors can compute an expected return. The expected return is the total return anticipated after considering both the expected payout and the likelihood of that payout occurring. To compute the expected value of one investment, multiply the investment's expected payout (profit or loss) times the probability that that payout will occur. This technique can be used to compare the expected value of investments so that you can determine how to best allocate funds, or it can be done for a group of investments (known as a portfolio) that the investor has simultaneously invested in to determine the total expected return of all investments held.

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5b. Compute expected values when risk issues need to be considered in finance

  • What does "expected value" mean in the context of finance?
  • How do you calculate the expected value of an investment?
  • What is probability?

In finance, the expected value represents the average outcome of an uncertain event, weighted by the probabilities of all possible outcomes. It helps investors and managers make rational decisions under risk or uncertainty. It provides a quantitative measure of what an investment or decision is worth on average over time. It helps compare alternatives in risk-based financial decisions (investments, project selection, insurance). It's a core concept in probability, portfolio theory, and capital budgeting.

The expected value is calculated using the weighted average of all possible outcomes. We can calculate the expected return for an investment by multiplying the potential return by the probability that each scenario will occur and summing each product.

Probability is the likelihood that an event or scenario will occur. For example, a weather forecaster may judge that there is a 40% chance of rain based on their analysis of weather patterns. Likewise, an investor may foresee a 30% probability of a bear market and a 70% probability of a bull market. Probabilities must add up to 100%: all scenarios must be considered.

Since these scenarios are not certain, they contain an element of risk. Investors may estimate the likelihood of how much return they will achieve across a range of possible economic scenarios. The expected return is found by multiplying the probability of each scenario by the return that will be earned if that scenario occurs. Each product is added to find the overall expected return, the weighted average of the various possibilities. 

Here is the formula to calculate the expected return:

E[R]= (Probabilitya)×(Returna)+(Probabilityb)×(Returnb)+(Probabilityc)×(Returnc) + …..

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5c. Compare systematic and unsystematic risk

  • What is the difference between systematic and unsystematic risk?
  • How do systematic and unsystematic risks affect an investor differently?
  • Can investors diversify away all risk?

We can classify investment risk as systematic or unsystematic (specific) risk. Systematic risk is the risk associated with the overall market. Factors such as economic conditions and political events impact the entire market. Systematic risk cannot be diversified away by holding multiple assets. Thus, systematic risk can be caused by interest rate changes, inflation or deflation, economic recessions, political instability, and global crises (like COVID-19 or oil shocks). Systematic risk has an impact on investors because it cannot be eliminated through diversification; it affects all assets, regardless of industry or company; influences the overall return of a portfolio; investors are compensated for bearing this risk; and high beta stocks are more sensitive to systematic risk.

Unsystematic risk can be caused by company mismanagement, product recalls, labor strikes, legal issues, and industry-specific regulations. The impact of unsystematic risk can be reduced or eliminated through diversification; it affects only individual companies or sectors; well-diversified portfolios will see little impact from any single unsystematic event; and it is not compensated for in expected return models.

Diversification is a technique for reducing risk by combining assets that behave differently in response to the same stimuli. Unsystematic, or specific risk, is the risk associated with one individual security. Factors that impact one security include things such as management changes, operation disruptions, or recalls. If you hold enough securities, the impact of one of these events that affects a single company is minimal on your overall portfolio. This risk, therefore, can be diversified away. Unsystematic risk does not factor into an investment's risk premium since this type of risk can be diversified away.

5c
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5d. Recommend investments that take advantage of diversification

  • How can an investor lower their risk through diversification?
  • What is the impact of correlation on portfolio diversification?
  • How many different assets are needed to create a diversified portfolio?

Diversification follows the old advice to "not put all your eggs in one basket". A diversified portfolio allows an investor to maximize return while minimizing risk. By holding multiple assets, an investor reduces the overall risk of losing because of negative results with one asset. If you hold only one stock and that company has financial trouble, you will lose much of your investment. If you hold ten stocks and one of them has financial trouble, the overall impact on your return will be less.

To obtain the optimal gains from diversification, investors should combine assets with limited correlation (a statistical measure that indicates the degree to which two or more assets move in relation to each other, ranging from -1 to +1, where values closer to 0 indicate little relationship between asset movements). A positively correlated asset will respond in the same direction to an event. Negatively correlated assets will move in opposite directions of an event.

An example of positively correlated stocks might be car and tire manufacturers. Both will gain if car demand increases. Negatively correlated stocks could be sunscreen and umbrella manufacturers.

Research has shown that a portfolio with 30 stocks will enjoy most of the gains from diversification. However, these 30 stocks must not be in the same industry or region to benefit from diversification.

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5e. Discuss CAPM measures and their components.

  • What is the CAPM used for?
  • What are the assumptions underlying the CAPM?
  • What does Beta measure?

The capital asset pricing model (CAPM) is a financial model used to price securities by accounting for the relationship between risk and return. CAPM determines the asset's rate of return, assuming it will be added to a well-diversified portfolio by accounting for the asset's systematic risk. The CAPM relies on beta to express the asset's risk.

The CAPM is based on several key assumptions that simplify the real world to make the model analytically tractable. These assumptions are crucial to understanding both the strengths and limitations of CAPM. Some of the key assumptions include: investors are rational and risk-averse, markets are efficient, all investors have homogeneous expectations, investors can borrow and lend freely at the risk-free rate, a single-period investment horizon, no taxes or transaction costs, all assets are perfectly divisible and liquid, returns are normally distributed, and only systematic risk matters.

Beta measures how a specific asset fluctuates compared to the overall market. Beta is determined by looking at the individual stock's past returns compared to the overall market's past returns, and seeing how correlated the returns are. A beta of less than one means the stock is less risky than the overall market, a beta equal to one is the same as the market, and a beta greater than one means the stock is riskier than the overall market.

CAPM shows that investors are only rewarded for bearing systematic risk since unsystematic risk can be mitigated by constructing a diversified portfolio.

Using the CAPM model, the stock's expected return equals the risk-free rate of return plus beta times the difference between the expected return on the market and the risk-free rate. The risk-free rate is the rate that short-term T-bills pay.

Since there is virtually no chance of losing money on an investment in government-issued short-term T-bills, they are used as a proxy for the risk-free rate. This is the "rent" investors demand for giving up the use of their funds, even though they know they will get it back. The market's expected return is usually approximated by the return for the S&P 500 or a similar index. Beta can be calculated or looked up through many investment sites. The rate calculated by using CAPM can thus help determine the appropriate stock price investors should be willing to pay – the price that will project the return determined by the model.

\(E(R_i)=R_f+\beta (E(R_m)-R_f)\)

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Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • beta
  • capital asset pricing model (CAPM)
  • correlation
  • diversification
  • expected value
  • portfolio
  • probability
  • return
  • risk
  • systematic risk
  • unsystematic risk

Unit 6: Capital Budgeting Techniques


6a. Explain the purpose of capital budgeting techniques

  • How do firms use money from their capital budgets to invest?
  • What is a "project" to a firm?
  • How do firms decide which projects to invest in?

Firms have finite financial resources and must make capital budgeting (the process of evaluating, planning, and selecting long-term investment opportunities that require significant financial resources) decisions about capital investments. Capital investments are called projects (specific investment opportunities or initiatives that require substantial financial commitment and are expected to generate returns over multiple periods). Firms have to choose which projects to invest in by ranking projects based on the outcome of capital budgeting techniques. To do so, they use project evaluation criteria.

The most common project evaluation criteria of capital budgeting are net present value (NPV) and internal rate of return (IRR). However, there are others, such as the payback period or the profitability index. Each capital budgeting technique has its own decision criteria that must be considered after calculating the return. Capital budgeting decision tools allow a company to invest capital in a manner that will maximize shareholder value.

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6b. Calculate the NPV, Payback, Profitability Index, and IRR of investment options

  • How do you calculate NPV?
  • How do you calculate the payback period?
  • How do you calculate the profitability index?
  • How do you calculate IRR?

Net present value uses a technique called discounted cash flow valuation, which is a financial analysis method that estimates the value of an investment by calculating the present value of its expected future cash flows, using a discount rate to account for the time value of money and risk. Net present value (NPV) is a variation on the present value calculation that allows for calculating both cash inflows and outflows and changing discount rates and maturities. The initial investment for the project is subtracted from the PV of the expected future cash flows. The decision criteria for an NPV calculation are as follows:

  • If the NPV > 0, accept the project.
  • If the NPV < 0, reject the project.
  • If the NPV = 0, accept or reject the project based on preference or other factors.

If more than one project has a positive NPV (an NPV > 0), the project with the highest NPV should be accepted.

Payback period is a capital budgeting metric that measures the amount of time it takes for an investment to recover its initial cost from the cash inflows it generates.

Payback period = Amount to be initially invested / Estimated annual net cash inflow

The payback period does not consider the time value of money. It also does not account for cash flows that occur after the payback period. Accept a project if the payback period is less than the required payback; reject if it is greater.

Profitability index (PI) = PV of future cash flows / Initial investment

As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project:

  • If PI > 1, then accept the project
  • If PI < 1, then reject the project

The internal rate of return (IRR) on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. In more specific terms, the IRR of an investment is the discount rate when the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. A project should be accepted if the IRR is greater than the required return.

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6c. Discuss capital budgeting methods and their effectiveness in making sound investment decisions

  • What are the pros and cons of the main capital budgeting methods?
  • Which decision technique is most accurate?
  • Why is it important to use multiple capital budgeting methods when evaluating a project?

The IRR method is easily understood and considers the time value of money. However, the IRR can't be used when evaluating mutually exclusive projects or those of different durations. The payback period is easily calculated and easy to understand. However, it does not take into account the time value of money.

The profitability index translates the amount of value created per unit of investment. It is therefore useful for ranking projects. It does not directly show the amount of value created. NPV is considered the most accurate capital budgeting method. It directly shows the increase in value resulting from the project, considers the time value of money, and does not have the limitations associated with the other methods. NPV requires an accurate discount rate; may be harder to understand for non-finance stakeholders; and does not show return as a percentage.

Using multiple capital budgeting methods when evaluating a project is important because it provides a more complete, balanced, and reliable assessment of the project's financial viability. Each method has unique strengths and weaknesses, and using several together can compensate for individual limitations.

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6d. Discuss cash flow analysis and other factors when making capital budgeting decisions

  • What types of cash flows are relevant in capital budgeting analysis?
  • How do we utilize the incremental approach in capital budgeting?
  • How are sunk costs and opportunity costs treated in capital budgeting?

In capital budgeting, only relevant cash flows, those that are directly affected by the investment decision, should be included in the analysis. These are the cash flows that help determine whether a project will add value to the firm. Since capital budgeting aims to assess future value creation, only incremental, forward-looking, cash-based flows matter.

The incremental cost approach is optimal to use when comparing only two projects. It focuses on both cost increases and decreases. Only those costs and revenues that differ between the two projects being considered are the costs and revenues discounted cash flow analysis needs to be applied. The final result of an incremental NPV analysis should be the same as the final result from using the total cost approach of NPV, which is the more common approach.

Sunk costs are costs that have already been incurred and cannot be recovered, regardless of whether the project goes forward or not. Opportunity costs represent the benefits foregone by choosing one alternative over another. In capital budgeting, both sunk costs and opportunity costs are important, but are treated very differently. Sunk costs are ignored in capital budgeting decisions and are not included in the analysis of project cash flows. Opportunity costs are included in capital budgeting analysis, and they are considered relevant costs because they represent real trade-offs.

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Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • capital budgeting
  • discounted cash flow valuation
  • incremental cost approach
  • internal rate of return (IRR)
  • net present value (NPV)
  • opportunity cost
  • payback period
  • profitability index (PI)
  • project
  • sunk cost

Unit 7: Corporate Capital Structure


7a. Explain the components of a company's capital structure

  • What is capital?
  • What are the major sources of a firm's capital?
  • What does the term "capital structure" mean?

Firms have two sources of capital (the funds or financial resources that companies use to finance their operations, investments, and growth): debt and equity, or some variation of those two. Firms finance all of their activities with capital. Capital is not free. There is a cost to obtain and use it, which is represented normally by the interest rate charged. If you recall, an interest rate is nothing more than a price paid for money.

The major components of a company's capital structure (the specific mix or combination of debt and equity financing that a company uses to fund its operations and growth) are common stock, preferred stock, long-term debt, and short-term debt. Common and preferred stock are equity. Long-term and short-term debts are liabilities. There are different costs to each form of capital. Each firm has different percentages of its capital financed by each source. It is possible that a firm is all-equity and has no cost for liability financing. The WACC aims to match the capital source with the cost.

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7b. Explain the Modigliani-Miller theorem in finance

  • What is the Modigliani-Miller theorem?
  • What assumptions must hold for the theorem to apply?
  • What are the two primary propositions of the M&M theorem, and how do they differ?

Even using the WACC computation within finance, capital structure is not the primary determinant of a firm's value. The Modigliani-Miller (MM) Theorem states that capital structure does not determine a firm's value. The MM Theorem states that the value of a firm is based on its earning power and that that value is not affected by how a firm finances itself with debt or equity. Essentially, financing decisions are irrelevant to firm value.

In addition, the theorem also states that a firm's cost of equity increases with its debt-equity ratio. The MM Theorem holds this as true given the following assumptions: no transactions costs for financial transactions, equal borrowing costs for companies and investors, the firm responsibly invests excess cash, debt financing does not affect earnings before interest and taxes (EBIT) (a measure of a company's operating profitability that shows how much profit the company generates from its core business operations before accounting for interest expenses and tax payments), and firms and investors have access to the same information (there is no asymmetric information).

While Proposition I states that "In a world without taxes, bankruptcy costs, or asymmetric information, the value of a firm is independent of how it is financed", Proposition II states that "As a firm increases its leverage (debt), the required return on equity increases linearly to compensate equity holders for additional financial risk". In summary, the propositions argue that debt financing can change the risk and return profile for investors but does not increase the firm's total value in a perfect market.

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7c. Compute the market and book value of a company

  • What is market value?
  • What is book value?
  • What are the pros and cons of each valuation method?

There are many ways to assess the value of a company. The most common methods are market value and book value. Market value is the value communicated by the information available in financial markets, such as stock price, the number of shares of stock a firm has in the market, and investor sentiment.

The market capitalization or market value of a publicly traded company equals the price of one share of the company's stock times the total number of shares of stock the company currently has in the stock market. It is presumed that market value can be less stable and more reactionary depending on economic conditions and investor expectations; however, it is a more immediate and readily available indicator of the value of a firm. There is also an alternate way to compute a firm's market value using a firm's assets as the basis.

In contrast, a company's book value is primarily derived from an analysis of a company's financial statements. The balance sheet is the guiding financial statement used to assess book value. The value of the assets is used as the company's book value.

The biggest criticism of a company's book value is that it is said to represent the historical value of a company because balance sheet assets are recorded at the prices paid when the asset is acquired. Over time, the value of an asset can increase or decrease, and this change in value is not always captured on the balance sheet unless the asset is sold for a gain or loss. For example, if a firm owns land (an asset that normally appreciates), the purchase price of the land appears on the balance sheet, not any gains in that land's value unless the land is sold and the cash from the sale of the land is recorded. Fixed assets like a plant, property, and equipment will age.

Although depreciation is recorded on the balance sheet, the value attributed to depreciation might not be sufficient to cover the replacement cost of acquiring a new asset to replace one that has aged beyond use. It is also possible that the book value of the equipment underestimates the true value of the equipment because it doesn't account for the salvage value. An asset's salvage value is the amount realized from the sale of the used equipment when the firm has no further use for the equipment. To attempt to account for the intricacies of interpreting book value, some assets may be valued using a separate analysis and then added back to the firm's book value, or a premium on the existing book value can be added to or subtracted from the firm's total asset value on the balance sheet.

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7d. Apply the WACC formula for estimating a company's cost of capital

  • What is capital?
  • What is the weighted average cost of capital (WACC)?
  • What is the basic formula for calculating WACC?

Capital refers to the financial resources a company uses to fund its operations and growth. This includes equity capital (money raised from shareholders via ownership) and debt capital (money borrowed through loans or bonds).

Often used to invest in assets, pay for day-to-day operations, or expand the business, the weighted average cost of capital (WACC) is a concept and formula designed to identify a firm's sources of capital and its cost for each form of capital to determine the overall average cost of capital a firm pays across all sources.

Use this problem to practice computing the WACC.

The formula to compute the weighted average cost of capital is given by WACC = (% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)

\(WACC = w_dr_d(1-T)+W_{ps}r_{ps}+w_sr_s\).

Use this formula to compute the WACC for this example:

A firm has $1,500,000 in debt and $1,000,000 in equity, for a total value of $2,500,000. Its cost of debt is 10%, and its cost of equity is 2%. Its tax rate is 35%. What is this firm's WACC? Remember that in this problem, the firm has no preferred stock.

wdrd(1 − T): (1,500,000/2,500,000)(.10)(1 - .35) = 0.039
wpsrps:    (0/2,500,000) (0) = 0
wsrs: (1,000,000/2,500,000) (.02) = 0.008

WACC = .039 + 0 + .008 = 0.055 or 5.5%

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Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • book value
  • capital
  • capital structure
  • earnings before interest and taxes (EBIT)
  • market capitalization
  • market value
  • Modigliani-Miller (MM) Theorem
  • salvage value
  • weighted average cost of capital (WACC)

Unit 8: Working Capital Management


8a. Illustrate the objectives of working capital management

  • What is working capital?
  • How do you define a current asset?
  • What is a current liability?
  • What are the tradeoffs involved when managing working capital?

Working capital is defined as current assets minus current liabilities. Current assets are expected to be sold or used up in the next year or operating cycle. Examples of current assets include cash, accounts receivable, and inventory. Current liabilities are debts that must be paid in the next year or operating cycle. Current liabilities include accounts payable, wages payable, and short-term debt.

Working capital is a measure of liquidity (whether a company has enough short-term assets available to pay expected short-term obligations). Current assets generally don't earn a high return, so companies try to ensure they have enough to pay their short-term obligations, but not too much, so they lose earnings potential. Having too little working capital can mean that a company cannot meet its short-term obligations. However, having too much can mean assets are not being invested as productively as possible.

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8b. Explain the principles of cash management

  • What is cash management?
  • Why is it important for a company to have cash on hand?
  • Why is the cash conversion cycle important?

Cash management refers to the process of collecting, managing, and (short-term) investing a company's cash to ensure it has enough liquidity to meet its obligations while optimizing returns on any excess cash.
Companies need cash on hand to meet their financial obligations, including paying their vendors, paying their employees, and reacting to emergencies. However, since cash is a relatively low-earning asset, companies do not want to maintain cash reserves that are too high and could be invested into higher-earning assets. Managing cash involves balancing the tradeoff between liquidity and earnings.

The cash conversion cycle (CCC) is the time between when a firm collects cash from customers and has to pay out cash related to the purchase of inventory or inputs of production. By managing this process, a company aims to minimize the amount of earnings tied up in cash. Some strategies for improving the cash conversion cycle include speeding up the collection of funds and slowing down the disbursement of funds. A shorter CCC means the firm converts resources into cash faster. It helps firms avoid liquidity issues and maintain smooth operations. CCC shows how well the company is managing inventory, receivables, and payables. It also signals efficiency in the supply chain, credit policy, and cash management.

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8c. Identify the sources of short-term financing for a firm

  • What is short-term financing, and how does it differ from long-term financing?
  • Why do firms need short-term financing?
  • What are the main sources of short-term financing for a business?

Short-term financing is any funding option a firm uses to meet its operational needs and obligations due in the short term, usually within 12 months. Short-term financing is quick, flexible, and used for day-to-day needs, while long-term financing is geared toward strategic investments and growth. A balanced mix of both helps firms remain liquid while pursuing expansion.

Firms need short-term financing to cover working capital gaps, finance inventory purchases, handle unexpected expenses, take advantage of discounts, fund seasonal or cyclical fluctuations, maintain liquidity and creditworthiness, and avoid selling long-term assets.

Firms that need cash to cover short-term obligations have a variety of products available to obtain funds. They can borrow money with short-term loans such as overdrafts, credit cards, payday loans, and money market loans. They can also factor their accounts receivable, which involves selling their accounts receivable to a third party at a discount. Companies can also issue commercial paper to meet their short-term obligations.

Commercial paper is a short-term money market instrument that can provide a cheaper source of financing for the company and increased returns for the investor. Companies can also use trade credit, which involves using the accounts payable from their suppliers.

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8d. Identify factors involved in setting inventory management policies

  • What are the different types of inventory?
  • What are the different types of inventory accounting techniques?
  • What factors are involved in deciding the appropriate inventory levels?

Inventory in manufacturing organizations is divided into raw materials, works in process, and finished goods.

Raw materials are materials used in making a product. Works in process are units that are started but not completed. Finished goods are goods completed and ready to sell to the customer. Companies can account for their inventory using LIFO, FIFO, or the average cost method. The last-in, first-out (LIFO) method of inventory accounting where the latest purchase price is used to calculate the cost of goods sold (COGS). With first-in, first-out (FIFO), the oldest purchase price is used to calculate the COGS.

The average cost method takes a weighted average of all the inventory purchases and calculates the COGS using that average. The choice of accounting technique can influence the reported COGS on the income statement and the balance of inventory on the balance sheet.

When determining the appropriate amount of inventory to hold, companies must consider their demand, seasonality, economies of scale, cost pressures, and perishability, among other factors. Companies generally want to have enough inventory on hand to service customers, but do not want to tie up excess funds in inventory or risk obsolescence or spoilage. One method businesses use to determine the appropriate level of inventory to hold is the economic order quantity (EOQ) technique. The EOQ is the order quantity that minimizes total inventory holding costs and ordering costs.

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Unit 8 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • average cost method
  • cash conversion cycle (CCC)
  • cash management
  • commercial paper
  • current asset
  • current liability
  • economic order quantity (EOQ) technique
  • factor
  • finished good
  • first-in, first-out (FIFO)
  • last-in, first-out (LIFO)
  • liquidity
  • raw material
  • short-term financing
  • trade credit
  • working capital
  • work in process