The Basics: Finance

PART I
Concepts and tools
1
1
The world of finance
3
2
The financial statements
21
3
Financial concepts and tools
48
PART II
Instruments and transactions
77
4
Common and preferred stock
79
5
Loans and bonds
103
6
Investment funds
132
7
Derivatives and insurance
152
8
Corporate finance
185
PART III
Participants and marketplaces
205
9
Financial participants
207
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10 The global financial markets
225
Selected references
242
Index
255
Contents
vi
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ILLUSTRATIONS
Tables
2.1
ABC Co.’s historical, current, and industry ratio data
42
2.2
Cash budgeting framework
45
3.1
Standard deviations of projects 1 and 2
50
3.2
Risk/return tradeoffs 1
53
3.3
Risk/return tradeoffs 2
53
3.4
Sample projects, NPVs and IRRs
72
5.1
Debt- and equity-financed income statements
105
5.2
ABC Co.: leveraged and unleveraged results
108
5.3
ABC Co.’s borrowing costs
114
5.4
Impact of interest rates on bond prices
129
7.1
Risk decision framework
155
7.2
Long/short forward relationships
163
7.3
ABC Co.’s net cost of debt
167
7.4
Long/short options relationships
172
7.5
Futures options positions
175
7.6
Primary differences between exchange-traded and OTC
derivatives
175
8.1
Company estimates
200
10.1 Interest rates and financial market impact
229
10.2 Inflation and financial market impact
230
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10.3 GDP and financial market impact
231
10.4 Sample of key economic measures
232
Figures
1.1
The three-stage cycle of the financial process
15
1.2
The complete financial picture
17
1.3
Three pillars of finance
19
2.1
The financial reporting process
23
2.2
Sample US GAAP balance sheet
28
2.3
Sample UK GAAP balance sheet
29
2.4
ABC Co.’s US GAAP balance sheet
30
2.5
ABC Co.’s UK GAAP balance sheet
30
2.6
Sample income statement
32
2.7
ABC Co.’s income statement
33
2.8
Sample statement of cash flows
34
2.9
Common sources and uses of cash
35
2.10 ABC Co.’s statement of cash flows
36
3.1
Risk and return
51
3.2
High- and low-risk projects
51
3.3
Probability distributions
52
3.4
Diversifiable and non-diversifiable risks
56
3.5
A stock’s beta
57
3.6
Hypothetical yield curve
61
3.7
Sample yield curves
62
3.8
IRR, NPV and decision rules
73
3.9
IRR, NPV and WMCC
74
4.1
Income statement, balance sheet and net income
83
4.2
Equity accounts on the corporate balance sheet
95
4.3
Impact of shares on paid-in capital
99
5.1
Base yield curve scenarios
110
5.2
ABC Co.’s borrowing costs
114
5.3
Loans and bonds on the corporate balance sheet
117
6.1
Risk, return and efficient portfolios
135
6.2
General fund balance sheet
138
6.3
General fund categories
140
6.4
Open-end fund legal vehicles/participants
142
6.5
Onshore/offshore hedge fund structure
145
6.6
Process of creating/trading an ETF
149
Illustrations
viii
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6.7
Secondary trading activity in funds
150
7.1
The risk management framework
156
7.2
Derivative classes
159
7.3
Forward contract flows
162
7.4
Long forward
163
7.5
Short forward
164
7.6
Long forward /short asset hedge position
165
7.7
Interest rate swap flows
166
7.8
ABC Co.’s fixed/floating swap hedge
167
7.9
Call option flows: initial and exercise
168
7.10 Put option flows: initial and exercise
169
7.11 Long call option
170
7.12 Short call option
170
7.13 Long put option
171
7.14 Short put option
172
7.15 Insurance classes
179
7.16 Converting full insurance to partial insurance
182
7.17 Structure of a captive
183
8.1
Earnings cycles and earnings stability
188
8.2
Horizontal and vertical acquisitions
191
8.3
LBO structure
194
9.1
The complete picture of financial participants
219
9.2
Disintermediation of select financial functions
223
10.1a Tools to slow economic growth/inflation
234
10.1b Tools to expand economic growth
235
10.2 Forces of change and market impact
240
Illustrations
ix
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ACKNOWLEDGEMENTS
Great thanks are due to Andrea Hartill, commissioning editor at
Routledge, for her support and guidance on this project. David
Avital, assistant editor, deserves gratitude for his assistance on
many points related to the early preparation of the book. Thanks
are also due to Marianne Bulman and the production and market-
ing teams at Routledge for their help in preparing and distributing
the book. Several referees at Merrill Lynch, Barclays, and Citi-
bank, who provided helpful comments during the preparation of
this text, also deserve recognition.
Most of all my deepest thanks go – yet again – to Milena.
EB
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