accounts glossary

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Accounts - Glossary

Abnormal return (excess return): Difference between the actual returns on an

investment and the expected return on that investment, given market returns andinvestment's risk..

Accelerated depreciation: A depreciation method where more of the asset is written off

in earlier years and less in later years, over its lifetime, to reflect the aging of the asset.

Accounting beta: Beta estimated using accounting earnings for a firm and accounting

earnings for the market, rather than stock prices.

Accrual accounting: Accounting approach, wherethe revenue from selling a good or

service is recognized in the period in which the good is sold or the service is performed

(in whole or substantially). A corresponding effort is made on the expense side to match

expenses to revenues.

Acquisition premium: Difference between the price paid to acquire a firm and the

market price prior to the acquisition.

Acquisition price: Price that will be paid by an acquiring firm for each of the target

firm shares.

Adjustable rate preferred stock: Preferred stock where the preferred dividend rate is

pegged to an external index, such as the treasury bond rate.

Agency costs: Costs arising from conflicts of interest between two stakeholders;

examples would be managers & stockholders as well as stockholders & bondholders.

Allocation: Process of distributing a cost that cannot be directly traced to a revenue

center across different units, projects or divisions.

American options: An option that can be exercised any time until maturity.

Amortizable life: A period of time over which an intangible asset is written off.

Annual percentage rate (APR): A rate that has to be cited with loans and mortgages in

the United States. The rate incorporates an amortization of any fixed charges that have to

be paid up front for the initiation of the loan.

Annuity: A stream of constant cash flows that occur at regular intervals for a fixed

period of time.

Arbitrage position: A riskless position that yields a return that exceeds the riskfree rate.

Arbitrage principle: Assets that have identical cash flows cannot sell at different prices.

Asset beta: The beta of the assets of investments of a firm, prior to financial leverage.

Can be computed from the regression beta (top-down) or by taking a weighted average of

the betas of the different businesses (bottom-up).

Asset-backed borrowing: Bonds or debt secured by assets of any type. Mortgage bonds

and collateral bonds are special cases.

Assets-in-place: The existing investments of a firm.

Bad debts: Portion of loans that cannot be collected (if you are the lender) or will not be

paid (if you are the borrower).

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Balance sheet: A summary of the assets owned by a firm, the book value of these assets

and the mix of financing, debt and equity, used to finance these assets at a point in time.

Balloon payment bonds: Bonds where no principal repayment is made during the life of

the bond but the entire principal is repaid at maturity.

Bankrupt: The state in which a firm finds itself if it is unable to meet its contractual

commitments.Barrier options: An option where the payoff on, and the life of, the option are a function

of whether the underlying asset price reaches a certain level during a specified period.

Baumol model: Model for estimating an optimal cash balance, given the cost of selling

securities and the interest rate that can be earned on marketable securities, for firms with

certain cash inflows and outflows.

Best efforts guarantee: Underwriting agreement on a security issue where the

investment banker does not guarantee a fixed offering price.

Beta: A measure of the exposure of an asset to risk that cannot be diversified away (also

called market risk). It is standardized around 1. (Average = 1, Above average risk >1)

Binomial option pricing model: Option pricing model based upon the assumption thatstock prices can move to only one of two levels at each point in time.

Book value: Accounting estimate of the value of an asset or liability, usually from the

balance sheet of the firm.

Bottom-up betas: Beta computed by taking a weighted average of the betas of the

businesses that a firm is in. These betas, in turn, are estimated by looking at firms that

operate only or primarily in each of these businesses.

Building the book: Process of polling institutional investors prior to pricing an initial

offering, to gauge the extent of the demand for an issue.

Call market: A market where an auctioneer (or a market maker) holds an auction at

certain times in the trading day and sets a market-clearing price, based upon the ordersgrouped together at that time.

Callable bonds (debt): Debt (bonds), where the borrower has the right to pay the bonds

back at any time. The option to pay back will generally be used if interest rates decrease.

Cap: The maximum interest rate on a floating rate bond.

Capital expenses: Expenses that are expected to generate benefits over multiple periods.

Accounting rules generally require that these expenses be depreciated or amortized over

the multiple periods.

Capital lease: The lessee assumes some of the risks of ownership and enjoys some of

the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a

liability (for the lease payments) on the balance sheet.Capital rationing: Situation that occurs when a firm is unable to invest in projects that

earn returns greater than the hurdle rates because it has limited capital (either because of

internal or external constraints).

Capped call: A call where the payoff is restricted on the upside. If the price rises above

this level, the call owner does not get any additional payoff.

Cash flow to equity investors: Cash flows generated by the asset after all expenses and

taxes, and also after payments due on the debt.

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Cash flow to the firm: Cash flows generated by the asset for both the equity investor and

the lender. This cash flow is before debt payments but after operating expenses and taxes.

Cash slack: Combination of excess cash and limited project opportunities in a firm.

Cashflow return on investment (CFROI): Internal rate of return on the existing

investments of the firm, estimated in real terms, using the original investment in the

assets, their remaining life and expected cash flows.Catastrophe bond: A bond that allows for the suspension of coupon payments and/or

the reduction of principal, in the event of a specified catastrophe.

Certainty equivalent (cash flow): A guaranteed cash flow that you would agree to

accept in exchange for a much larger and riskier cash flow.

Chapter 11: Legal process governing bankruptcy proceedings.

Clientele effect: Clustering of stockholders in companies with dividend policies that

match their preferences for dividends.

Collateral bond: Bond secured with marketable securities

Combination leases: A lease that shares characteristics with both operating and capital

leases.Commercial paper: Short term notes issued by corporations to raise funds.

Commodity bond: A bond whose coupon rate is tied to commodity prices.

Competitive risk: Risk that the cash flows on projects will vary from expectations

because of actions taken by competitors.

Compound options: An option on an option.

Compounding: The process of converting cash flows today into cash flows in the future.

Concentration banking: System where firms pick banks around the country to process

checks, allowing for the faster clearing of checks

Consol bond: A bond with a fixed coupon rate that has no maturity (infinite life).

Consolidation (in mergers): A combination of two firms wherea new firm is createdafter the merger, and both the acquiring firm and target firm stockholders receive stock in

this firm.

Consolidation (in accounting statements): The accounting approach used to show the

income from ownership of securities in another firm, where it is a majority, active

investment. The balance sheets of the two are merged and presented as one balance sheet.

The income statements, likewise, represent the combined income statements of the two

firms.

Contingent liabilities: Potential liabilities that will be incurred under certain

contingencies, as is the case, for instance, when a firm is the defendant in a lawsuit.

Contingent value rights: Securities where holders receive the right to sell the shares inthe firm at a fixed price in the future; it is a long term put option on the equity of the firm.

Continuing value: present value of the expected cash flows from continuing an existing

investment through the end of its life.

Continuous market: A market where prices are determined through the trading day as

buyers and sellers submit their orders.

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Continuous price process: Price process where price changes becoming infinitesimally

small as time periods become smaller.

Conversion premium: Excess of convertible bond market value over its conversion

value.

Convertible bond: Abond that can be converted into a pre-determined number of shares

of the common stock, at the discretion of the bondholderconversion ratio (in convertible bond): Number of shares of stock for which a

convertible bond may be exchanged.

Convertible preferred stock:: Preferred stock that can be converted into common

equity, at the discretion of the preferred stockholder.

Cost of capital: Weighted average of the costs of the different sources of financing used

by a firm.

Cost of debt (pre-tax): Interest rate, including a default spread, that a borrower has to

pay to borrow money.

Cost of debt (after-tax): Interest rate, including a default spread, that a borrower has to

pay to borrow money, adjusted for the tax deductibility of interest.Cost of equity: The rate of return that equity investors in a firm expect to make on their

investment, given its riskiness.

Cumulative abnormal (excess) returns (cars): Difference between the actual return on

an investment and the expected return, given market returns and stock's risk, cumulated

over a period surrounding an event (such as an earnings announcement).

Current assets: Short-term assets of the firm, including inventory of both raw material

and finished goods, receivables (summarizing moneys owed to the firm) and cash.

Current PE: Ratio of price per share to earnings per share in most recent financial year.

Debentures: Unsecured bonds issued by firms with a maturity greater than 15 years.

Debt Exchangeable for Common Stock(decs).: Debt that can be exchanged forcommon stock, with the conversion rate depending upon the stock price.

Debt: Any financing vehicle that has a contractual claim on the cash flows and assets of

the firm, creates tax deductible payments, has a fixed life, and has priority claims on the

cash flows in both operating periods and in bankruptcy.

Default risk: Risk that a promised cash flow on a bond or loan will not be delivered.

Default spread: Premium over the riskless rate that you would pay (if you were a

borrower) because of default risk.

Deferred tax asset: Asset created when companies pay more in taxes than the taxes they

report in the financial statements.

Depreciation: Accountingadjustments to the book value of an asset for the aging andsubsequent loss of earning power on it. Applies when you have a capital expenditure.

Direct cost of bankruptcy: Costs include the legal and administrative costs, once a firm

declares bankruptcy, as well as the present value effects of delays in paying out the cash

flows.

Cost of bankruptcy (direct): Costs include the legal and administrative costs, once a

firm declares bankruptcy, as well as the present value effects of delays in paying out the

cash flows.

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Disbursement float: Lag between when a check is written and the time it is cleared,

when the firm is writing the check.

Discount rate: the rate used to move cash flows from the future to the present, in

discounting, or from the present to the future, in compounding.

Discounting: the process of converting cash flows in the future to cash flows today.

Divestiture value: Value of an asset to the highest potential bidder for it.

Divestiture: Sale of asset, assets or division of a firm to third party.

Dividend capture (arbitrage): Strategy ofbuying stock before the ex-dividend day,

selling it after it goes ex-dividend and collecting the dividend.

Dividend declaration date: Date on which the board of directors declares the dollar

dividend that will be paid for that quarter (or period).

Dividend payment date: Date on which dividends are paid to stockholders.

Dividend payout ratio: Ratio of dividends to net income (or dividends per share to

earnings per share).

Dividend yield: Ratio of dividends, usually annualized, to current stock price.

Down-and-out option: A call option that ceases to exist if the underlying asset risesabove a certain price.

Dual currency bond: Bond with some cash flows (eg. Coupons) in one currency and

other cash flows (eg. Principal) in another.

Duration: Weighted maturity of all the cash flows on an asset or liability.

Economic exposure: Effect of exchange rate changes on the value of a firm with

exposure to foreign currencies.

Economic order quantity (EOQ): The order quantity that minimizes the total costs of

new orders and the carrying cost of inventory.

Economic Value Added (EVA): Measure of dollar surplus value created by a firm or

project. It is defined to be the difference between the return on capital and the cost ofcapital multiplied by the capital invested.

Efficient Frontier: The line connecting efficient portfolios, i.e. Portfolios that yield the

highest expected return for each level of risk (standard deviation).

Enterprise value: Market value of debt and equity of a firm, net of cash.

Equity approach: The accounting approach used to show the income from ownership of

securities in another firm, where it is a minority, active investment. A proportional share

(based upon ownership proportion) of the net income and losses made by the firm in

which the investment was made, is used to adjust the acquisition cost.

Equity carve out(ECO): Action where a firm separates out assets or a division, creates

shares with claims on these assets, and sells them to the public. Firm generally retainscontrol of the carved out asset.

Equity risk: Measure of deviation of actual cash flows from expected cash flows.

Equity: Any financing vehicle that has a residual claim on the firm, does not create a tax

advantage from its payments, has an infinite life, does not have priority in bankruptcy,

and provides management control to the owner.

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Eurobonds: Bonds issued in the local currency but offered in foreign markets.

Eurodollar and Euroyen bonds are examples.

Eurodollar bonds: Bonds denominated in U.S. dollars and offered to investors globally.

European options: An option that can be exercised only at maturity.

Euroyen bonds: Bonds denominated in Japanese Yen and offered to investors globally.

Excess return (abnormal return): Difference between the actual returns on an

investment and the expected return, given market returns and investment's risk.

Ex-dividend date: Date by whichinvestors have to have bought the stock in order to

receive the dividend

Exercise Price (Strike Price): Price at which the underlying asset in an option can be

bought (if it is a call) or sold (if it is a put).

Exit value: Estimated value of a private firm in a year in which the owners plan to sell it

to someone else or to take it public.

Ex-rights price: Stock price without the rights attached to the stock, in a rights offering.

External financing: Cash flows raised outside the firm whether from private sources or

from financial markets.Factor beta: A measure of the exposure of an asset to a specified macroeconomic factor

(such as inflation or interest rates) or an unspecified market factor.

FIFO: An inventory valuation method, where the cost of goods sold is based upon the

cost of material bought earliest in the period, while the cost of inventory is based upon

the cost of material bought later in the year.

Financing expenses: Expenses arising from the non-equity financing used to raise capital

for the business

Firm: any business large or small, privately run or publicly traded, and engaged in any

kind of operation - manufacturing, retail or service.

Firm-specific risk: Risk that affects one or a few firms, and is thus risk that can bediversified away in a portfolio.

Fixed (exchange) rates: Exchange rate set and backed up by a government, rather than by

demand and supply.

Fixed assets: Long term and tangible assets of the firm, such as plant, equipment, land

and buildings.

Fixed-rate bond: Bond with a coupon rate that is fixed for the life of the bond.

Float: Lag between when the check is written and the time it is cleared.

Floating (exchange) rates: Exchange rates determined by demand and supply for the

currency, and thus change over time.

Floating rate bond: Bond with a coupon rate that is reset each period, depending upon aspecified market interest rate (prime or LIBOR).

Floor: The minimum interest rate on a floating rate bond.

Forward contracts: A contract to buy or sell an asset, security or currency in the future

at a fixed price (specified at the time of the contract)

Forward PE: Ratio of price per share to expected earnings per share in next financial

year.

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Forward price (rate): The price or rate quoted in a forward contract.

Free cash flow to equity: cash left over after operating expenses, net debt payments and

reinvestments.

Free cash flow to the firm: Cash flow left over after operating expenses, taxes and

reinvestment needs, but before any debt payments (interest or principal payments).

Free cash flows (Jensen): Cash flows from operations over which managers havediscretionary spending power.

Futures contract: Like a forward contract, it is an agreement to buy or sell an underlying

asset at a specified time in the future. However, it differs from a forward because it is

usually traded, requires daily settlement of differences and has no default risk.

Golden parachute: A provision in an employment contract that allows for the payment

of a lump-sum or cash flows over a period, if the manager covered by the contract loses

his or her job in a takeover.

Goodwill: The difference between the market value of an acquired firm and the book

value of its assets; arises only when purchase accounting is used in an acquisition.

Gordon growth model: Stable-growth dividend discount model, where the value of astock is the present value of expected dividends, growing at a constant rate forever.

Greenmail: Buying out the existing stake of a hostile acquirer in the firm, generally at a

price much greater than the price paid by the acquirer. In return, the acquirer usually

agrees not to go through with the takeover or buy additional stock in the firm for a period

of time (standstill agreement).

Growing annuity: A cash flow that occurs at regular interval and grows at a constant

rate for a specified period of time.

Growing perpetuity: A cash flow that is expected to grow at a constant rate forever.

Growth assets: Investments yet to be made by the firm; often markets will incorporate

their expectation of the value of these assets into the market value.Historical (risk) premium: Difference between returns on risky investments (usually

stocks) and riskless investments (usually government securities) over a specified past

time period.

Historical cost: The original price paid for an asset, when acquired, adjusted upwards for

improvements made to the asset since purchase and downwards for the loss in value

associated with the aging of the asset

Holder-of-record date: Date on whichcompany closes its stock transfer books and

makes up a list of the shareholders.

Hurdle rate: a minimum acceptable rate of return on projects; used to determine whether

to invest in a project or not.

Hybrid securities: Securities that share some characteristics with debt and some with

equity. Examples would be preferred stock and convertible debt.

Implied premium: The premium estimated based upon the current level of stock prices

and expected cash flows from buying stocks. The internal rate of return that would make

the present value of the cash flows equal to today's stock prices is the expected return on

equity. Subtracting out the riskless rate yields the implied premium.

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Income bonds: Bond on which interest payments are due only if the firm has positive

earnings.

Income statement: A statement which provides information on the revenues and

expenses of the firm, and the resulting income made by the firm, during a period.

Incremental cash flows: Cash flows that arise as a consequence of a new investment. It

is the difference between the cash flow a firm would have had without the newinvestment and the cash flow with the new investment.

Indirect costs of bankruptcy: Costs associated with the perception that a firm may go

bankrupt - lost sales, drop in employee morale, tighter supplier credit

Inflation rate: Change in purchasing power in a currency from period to period.

Inflation-indexed treasury bond: A government bond that guarantees a real interest

rate, rather than a nominal rate.

In-process R&D: Portion of an acquired firm's value that is attributed to past research.

This amount is usually written off right after the acquisition.

Intangible assets: Assets that do not have a physical presence but have value (either

because they generate cash or can be sold). Examples would include assets like patentsand trademarks as well as uniquely accounting assets such as goodwill that arise because

of acquisitions made by the firm

Interest rate parity: Equation that relates the differential between forward and spot

rates to interest rates in the domestic and foreign market.

Internal equity: Cash flows generated by the existing assets of a firm that are reinvested

back into the firm.

Internal rate of return (IRR): Discount rate that makes the net present value zero. It

can be considered a time-weighted, cash flow, rate of return on an investment.

International Fisher Effect: Specifies the relationship between changes in exchange

rates and differences in nominal interest rates in two countries.Jump price proces: Price process where price changes stay large even as the period gets

shorter.

Knockout option: An option that ceases to exist if the underlying asset reaches a certain

price.

Kurtosis:: Measure of the likelihood of large jumps in a distribution, captured in the tails

of the distribution.

Leveraged buyout: An acquisition of a firm by its own managers or a private entity,

financed primarily with debt.

Leveraged recapitalization: Using new debt to repurchase equity and increasing debt

ratio substantially in the process.Levered beta: Beta of a firm, reflecting its financial leverage. This will change as

leverage changes.

LIFO reserve: Difference in inventory valuation between FIFO and LIFO. Firms that

choose the LIFO approach to value inventories have to specify in a this difference.

LIFO: An inventory valuation method where the cost of goods sold is based upon the

cost of material bought towards the end of the period, resulting in inventory costs that

closely approximate current costs.

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Line of credit: A financing arrangement, under which the firm can draw on only if it

needs financing, up to the agreed limit.

Liquidating dividends: Dividends in excess of the retained earnings of a firm. This is

viewed as return of capital in the firm and taxed differently.

Liquidation value: net cash flow that the firm will receive from selling an asset today.

Lockbox system: System wherecustomer checks are directed to a post office box, ratherthan to the firm

Major bracket investment bankers: Investment bankers in the top tier, based upon

reputation and national focus.

Majority active investment: Categorization of ownership of securities by one firm in

another firm are treated, if the securities represent more than 50% of the overall

ownership of that firm.

Management buyouts: An acquisition of a publicly traded firm by its own managers.

Marginal investor: The investor or investors most likely to be involved in the next trade

on the securities issued by a firm. Not necessarily the largest investor in the firm.

Marginal return on equity (capital): Measures quality of marginal investments, ratherthan average investments. Computed as the change in income (net income or operating

income) divided by the change in equity or capital invested.

Marginal tax rate: Tax rate on the last dollar of income (or the next dollar of income).

Usually determined by the tax codes.

Market capitalization (market cap): Market value of equity in a firm.

Market conversion value: Current market value of the shares for which a convertible

bond can be exchanged.

Market efficiency: A measure of how much the price of an asset deviates from a firm

true value. The smaller and less persistent the deviations are, the more efficient a market

is.Market risk: Risk that affects many or all investments in a market. This risk cannot be

diversified away in a portfolio.

Market value: Estimate of how much an asset would be worth if sold in the market

today. If the asset is a traded asset, this is obtained by looking at the last traded price.

Markowitz portfolios: The set of portfolios, composed entirely of risky assets, that yield

the highest expected returns for each level of risk (standard deviation).

Merger: A combination of two firms where the boards of directors of two firms agree to

combine and seek stockholder approval for the combination. In most cases, at least 50%

of the shareholders of the target and the bidding firm have to agree to the merger. The

target firm ceases to exist and becomes part of the acquiring firm.Mezzanine bracket: Smaller investment banks that operate nationally.

Miller-Orr model: Model for estimating an optimal cash balance, given the cost of

selling securities and the interest rate that can be earned on marketable securities, for

firms with uncertain cash inflows and outflows.

Minority interest: The share of the firm that is owned by other investors,when one firm

owns a majority, active interest in another firm (more than 50%). The minority interest is

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shownon the liability side of the balance sheet. Shows up only in the event of

consolidation.

Minority, active investment: Categorization of ownership of securities by one firm in

another firm are treated, if the securities represent between 20% and 50% of the overall

ownership of that firm. Usually get accounted for using the equity approach.

Modified internal rate of return (MIRR): Internal rate of return estimated with theassumption that intermediate cash flows are reinvested at the cost of equity or capital

instead of the internal rate of return.

Mortgage bond: A bond secured by real property, such as land or buildings.

Mutually exclusive (projects): A set of projects where only one of the set can be

accepted by a firm.

Equivalent annuities: Annuity equivalent of the NPV of a multi-year project.

Near-cash investments: Investments that earn a market return, with little or no risk, and

can be quickly converted into cash.

Negative pledge clause: Clause in a bond issue that specifies that the bond is backed

only by the earning power of the firm, rather than specific assets.Net debt payments: Difference between debt repaid and new debt issued by a firm

during a period.

Net float: Difference between the disbursement and processing float.

Net lease: A capital lease where the lessor is not obligated to pay insurance and taxes on

the asset, leaving these obligations up to the lessee; the lessee consequently reduces the

lease payments.

Net operating losses (nols): Accumulated losses over time that can be used to offset

income and save taxes in future periods.

Net present value (NPV): Sum of the present values of all of the cash flows on an

investment, netted against the initial investment.Net present value profile: A graph that records the net present value as the discount rate

changes.

Nominal cash flow: A cash flow in nominal terms, or an expected cash flow that

includes the effects of inflation (higher prices for both inputs and output).

Nominal interest rate: Interest rate on a bond that incorporates expected inflation.

Non-cash working capital: Difference between non-cash current assets and non-debt

current liabilities.

Notes: Unsecured bonds issued by firms with maturity less than 15 years.

Offering price: Price of a stock at the initial public offering.

Open market repurchase: Stock repurchase wherefirms buy shares in securitiesmarkets at the prevailing market price, and do not have to offer the premiums required for

tender offers.

Operating expenses: Expenses that provide benefits only for the current period

Operating exposure: Economic exposure that measures the effects of exchange rate

changes on expected future cash flows and discount rates, and, thus, on total value.

Operating lease: The lessor (or owner of the asset) transfers only the right to use the

property to the lessee. At the end of the lease period, the lessee returns the property to the

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lessor. The lease expense is treated as an operating expense in the income statement and

the lease does not affect the balance sheet.

Operating leverage: A measure of the proportion of the costs that are fixed costs; the

higher the proportion the greater the operating leverage.

Opportunity costs: Costs associated with the use of resources that a firm may already

own.Option delta: Number of units of the underlying asset that are needed to create the

replicating portfolio for an option.

Option: Right to buy or sell an underlying asset at a fixed price sometime during the

option's life (American option) or at the end of the option life (European option).

Original-issue deep discount bond: Bond with a coupon rate that is much lower than

the market interest rate at the time of the issue. This bond will be priced well below par.

Payback: Period of time over which the initial investment on a project will be recovered.

PEG ratio: Ratio of PE ratio to expected growth rate in earnings.

Perpetuity: A stream of constant cash flows that occur at regular intervals forever.

Poison pills: Securities, the rights or cash flows on which are triggered by hostiletakeovers. The objective is to make it difficult and costly to acquire control

Pooling accounting: Accounting approach for acquisitions where the book values of the

two firm involved in the acquisition are added up, and the market value of the acquisition

is not shown on the balance sheet.

Preferred stock: Security that pays a fixed dividend, which is usually not tax deductible,

and has an infinite life; usually has no or limited voting rights;

Preferred stock: Security which a fixed dollar dividend that is usually not tax deductible

to the firm; if the firm does not have the cash to pay the dividend, the dividend is

cumulated and paid in a period when there are sufficient earnings.

Price/book value: Ratio of price per share to book value of equity per share.Price/earnings ratio (PE): Ratio of price per share to earnings per share.

Price/sales ratio (PS): Ratio of price per share to sales per share.

Principal exchange linked bonds(perls): Bonds where coupons and principal are

payable in US dollars, but the amount of the payment is determined by the exchange rate

between the US dollar and a foreign currency.

Private equity: Equity provided by private investors to companies, often with the intent of

taking the company from public to private status.

Private placement: An arrangement wheresecurities are sold directly to one or a few

investors.

Privately negotiated repurchases: Stock repurchase negotiated with a stockholder whoowns a substantial percentage of the shares.

Probit: Statistical technique used to estimate probability of an event occurring.

Processing float: Lag between when the check is written and the time it is cleared, when

the customer is writing the check to the firm.

Product cannibalization: The effect that the introduction of a new product may have on

a firm existing product sales.

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Profitability index: Ratio of net present value to initial investment in a project. Often

used when a firm faces capital rationing.

Project risk: Risk that affects the cash flows of a project will differ from expectations,

due to estimation errors or unanticipated events.

Purchase accounting: Accounting approach for acquisitions where the market value

paid for the acquired firm is shown on the balance sheet, and goodwill, which is thedifference between the book value and market value of the acquired firm, is shown as an

asset.

Purchase of assets: An action whereone firm acquires the assets of another, though a

formal vote by the shareholders of the firm being acquired is still needed.

Purchasing power parity: Equation that relates changes in exchange rates to differences

in inflation. Based upon the assumption that a specific basket of goods should sell for the

same price across different countries

Pure play: Beta or other input estimated for a project by looking at the betas of firms that

are involved only or primarily in similar investments.

Put-call parity: Arbitrage relationship governing the prices of a call and put option, withthe same strike price, same exercise price and on the same underlying asset.

Puttable bonds: Debt (bonds), where bond buyersare allowed to put their bonds back to

the firm and receive face value, in the event of an occurrence like a leveraged buyout.

Rainbow options: An option that is exposed to more than one type of uncertainty.

Real cash flow: A cash flow that is corrected for the loss of buying power over time,

associated with inflation.

Real interest rate: Interest rate on a bond after taking out the expected inflation

component.

Real interest rate: The compensation, in real goods, that has to be offered to get lenders

to postpone consumption and allow you to use their savings.Nominal interest rate: The compensation that has to be offered to lenders to induce

them to lend you money; the nominal component captures expected inflation.

Real options: An option on a real asset, as opposed to a financial asset.

Recapitalization: Changing financing mix by using new equity to retire debt or new debt

to reduce equity.

Red herring: Preliminary prospectus issued by a firm going public, while the registration

is being reviewed by the SEC.

Regular dividend: Dividend paid at regular intervals to stockholders.

Reinvestment rate: Proportion of after-tax operating income reinvested back into the

firm.Replicating portfolio: A portfolio of the underlying asset and the riskless asset that has

the same cash flows as an option.

Repo rate: Implied interest rate in a repurchase agreement, calculated based upon the

difference between the price at which a security is bought and the price at which it will be

sold back.

Repurchase agreement(repo): The sale of a security, with an agreement that the

security will be bought back at a specified price at the end of the agreement period

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Repurchase tender offer: Stock repurchase where firm specifies a price at which it will

buy back shares, the number of shares it intends to repurchase, and the period of time for

which it will keep the offer open.

Reverse repurchase agreement (reverse repo): The buying of a security, with an

agreement that the security will be soldback at a specified price at the end of the

agreement period.Rights offering: Offering whereexisting investors in the firm are given the right to buy

additional shares, in proportion to their current holdings, at a price generally much lower

than the current market price (subscription price).

Rights-on price: Stock price with the rights attached to the stock, in a rights offering.

Riskless rate: Expected rate of return on an asset with guaranteed returns.

Road shows: Stage in the public offering process that the investment banker and issuing

firm will present information to prospective investors in a series of presentations.

Safety inventory: Extra inventory cover the demand while an order is being replenished

Scenario analysis: Analysis where earnings, cash flows or other variables can be

forecast under a variety of different scenarios, some positive and some negative.Sector risk: Risk that the cash flows on projects will vary from expectations because of

events that affect an entire sector.

Secured debt: Bonds or debt with priority in claims on the assets of the firm, in the event

of bankruptcy.

Seed-money venture capital: Venture capital provided to start-up firms that want to test

a concept or develop a new product.

Serial bonds: Bonds where a percentage of the outstanding bonds mature each year, and

the maturity is specified on the serial bond.

Sinking funds: A fund into which a fixed amount is set aside each year to repay

outstanding bonds when they come due.Skewness: Bias towards positive or negative returns in a distribution.

Special dividend: Dividends paid in addition to regular dividend infrequently.

Spin off: Action thatseparates out assets or a division and creates new shares with claims

on this portion of the business. Existing stockholders in the firm receive these shares in

proportion to their original holdings. Firm usually gives up control over the assets.

Split off: Action that separates out assets or a division and creates new shares with

claims on this portion of the business.Existing stockholders are given the option to

exchange their parent company stock for these new shares.

Split up: Action where firm splits into different business lines, distributes shares in these

business lines to the original stockholders in proportion to their original ownership in thefirm, and then ceases to exist.

Spot rate: Current market rate; Often used in the context of commodities or foreign

currency.

Standard deviation: Measure of the squared deviations of actual returns from the

expected returns. This is the square root of the variance.

Stand-by guarantees: Underwriting agreement where the investment banker provides

back-up support, in case the actual price falls below the offering price.

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Standstill agreement: An agreement entered into between a hostile acquirer and a firm,

where the hostile acquirer (in return for a payment) agrees not to buy additional stock in

the firm for a period of time.

Start-up venture capital: Venture capital thatallows firms that have established

products and concepts to develop and market them.

Statement of cash flows: A statement which specifies the sources of cash to the firmfrom both operations and new financing, and the uses of this cash, during a period.

Step-down floating rate bond: A floating rate bond where thespread over the market

interest rate decreases over time instead of remaining fixed over the bond life.

Step-up floating rate bond: A floating rate bond where thespread over the market

interest rate increases over time instead of remaining fixed over the bond life.

Stock dividends: Dividend that takes the form of additional stock (in proportion to

existing holdings) in the firm.

Stock split: Action where additional shares are given to each stockholder in the firm, in

proportion to holdings in the firm.

Straight line depreciation: A depreciation method where an equal amount of the asset iswritten off each year, over an estimated lifetime, to reflect its aging.

Strike Price (Exercise Price): Price at which the underlying asset in an option can be

bought (if it is a call) or sold (if it is a put).

Subordinated debentures: Unsecured bond with claims against assets that are

subordinated to the claims of other lenders.

Subscription price: Price at which a rights offering is made by a firm.

Super-majority amendment: an amendment requiring an acquirer to acquire more than

the 51% that would normally be required to gain control of a firm.

Synergy: Increase in value arising from the combination of two firms, projects or assets

that would not arise if the firms, projects or assets were independently run.Synthetic rating: Bond rating estimated using a financial ratio or ratios for a firm. This

is in contrast to an actual rating that is usually provided by a ratings agency.

Tender offer: A solicitation whereone firm offers to buy the outstanding stock of the

other firm at a specific price and communicates this offer in advertisements and mailings

to stockholders.

Terminal price (value): Expected value of an asset at the end of forecast period. For

instance, if you forecast cash flows for 10 years, the terminal value is the value at the end

of the 10th year.

Time line: A line depicting the magnitude and timing of cash flows on an investment.

Tobin

Q: Ratio of firm value to replacement cost of the assets owned by the firm.Tombstone advertisement: Advertisement containing details of an initial public

offering, the name of the lead investment banker, and the names of other investment

bankers involved in the issue.

Tracking stock: Stock issued on a division of a firm. The owner is entitled to the

earnings and cash flows of the division, and the stock trades on that basis. Generally, the

parent company continues to maintain full control over the division.

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Trailing PE: Ratio of price per share to earnings per share over the most recent four

quarters.

Transactions exposure: Economic exposure faced by a firm because of exchange rate

movements which affect cash inflows and outflows on transactions entered into by the

firm.

Translation exposure: Effect of exchange rate changes on the current income statementand the balance sheet of a firm with exposure to foreign currencies.

Treasury bills: Short-term obligations issued by the U.S. government.

Treasury stock approach: Approach for dealing with options in valuation, where the

exercise value of the options is added to the value of the equity in the firm, and the total

amount is divided by the number of shares outstanding, including those covered by the

options.

Trust preferred stock: Preferred stock, structured in such a way that the fixed dividend

that is tax deductible to the firm.

Underwriting guarantee: Guarantee of a fixed price (offering price) offered by an

investment banker in a public offering of securities.Unlevered beta: The beta of a firm, under the scenario that it is all equity-financed. It is

determined by the businesses that the firm is in, and the operating leverage it maintains in

these businesses. Can be computed from the regression beta (top-down) or by taking a

weighted average of the betas of the different businesses (bottom-up).

Unsecured bonds: Bonds with the lowest claim on the cash flows and assets of the firm.

Up-and-out option: A put option that ceases to exist if the underlying asset falls below a

certain price.

Value ratio: Ratio of PBV Ratio to return on equity of a firm.

Value/sales ratio (VS),: Ratio of value per share to sales per share.

Variance: Measure of the squared deviations of actual returns from the expected returns.Venture capital method: Value estimated by applying a price-earnings multiple to the

earnings of the private firm are forecast in a future year, when the company can be

expected to go public.

Venture capitalist: An entity that provides equity financing to small and often risky

businesses in return for a share of the ownership of the firm.

Warrants: Securities whereholders receive the right to buy shares in the company at a

fixed price in the future; it is a long term call option on the equity of the firm.

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Variables Definition What it tries to

measure

Comments

Abnormal Return See Excess Returns

Accounts

Payable /Sales

Accounts Payable/

Sales (See also dayspayable)

Use of supplier credit

to reduce workingcapital needs (and to

increase cash flows).

There is a hidden cost.

By using supplier credit,you may deny yourself

the discounts that can be

gained from earlypayments.

Accounts

Receivable/Sales

Accounts Receivable/

Sales

Ease with which you

grant credit to

customers buying

your products andservices.

A focus on increasing

revenues can lead

companies to be too

generous in giving credit.While this may make the

revenue and earningsnumbers look good, it is

not good for cash flows.

In fact, one sign that a

company is playing thisshort term gain is a surge

in accounts receivable.

Alpha Difference between the

actual returns earned on

a traded investment(stock, bond, real asset)

and the return youwould have expected to

make on that

investment, given itsrisk.

Alpha = Actual Return

- Expected return givenrisk

In the specific case of a

regression of stockreturns against marketreturns for computing

the CAPM beta, it is

measured as follows:(Jensens) Alpha =

Intercept - Riskfree

Rate (1 - Beta)

Measures whether

you are beating the

market, afteradjusting for risk. In

practice, though, itcan be affected by

what risk and return

model you use tocompute the expected

return.

When portfolio managers

talk about seeking alpha,

they are talking aboutbeating the market.

However, what may looklike beating the market

may just turn out to be a

flaw in the risk andreturn model that you

used. (With the CAPM,

for instance, small capand low PE stocks

consistently have

delivered positive alphas,perhaps reflecting thefact that the model

understates the expected

returns for these groups)or sheer luck (In any

given year, roughly half

of all active investors

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If the regression is run

using excess returns on

both the stock and themarket, the intercept

from the regression is

the Jensen's alpha.

should beat the market).

Amortization See Depreciation &Amortization

Annual Returns Returns from both price

appreciation and

dividends or cash flowgenerated by an

investment during a

year. For stocks, it isusually defined as:

(Price at end of year -

Price at start +

Dividends duringyear) / Price at start of

year

A percentage return

during the course of a

period that can bethen compared to

what you would have

made on otherinvestments.

The annual return is

always defined in terms

of what you iinvested atthe start of the period,

though there are those

who use the averageprice during the year.

The latter makes sense

only if you make the

investments evenly overthe course of the year. It

cannot be less than

-100% for most assets(you cannot lose more

than what you invested)

but can be more than-100% if you have

unlimited liability. It is

unbounded on the plus

side, making thedistribution of returns

decidedly one-sided (or

asymmetric). Returns cantherefore never be

normally distributed,

though taking the naturallog of returns (the natural

log of zero is minus

infinity) may give you ashot.

Asset Beta See unlevered beta

(corrected for cash)

Beta (Asset) See unlevered beta

(corrected for cash)

Beta (CAPM) It is usually measuredusing a regression of

Risk in an investmentthat cannot be

Regression betas havetwo big problems:

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stock returns against

returns on a market

index; the slope of theline is the beta. The

number can change

depending on the timeperiod examined, the

market index used and

whether you break the

returns down into daily,weekly or monthly

intervals.

diversified away in a

portfolio (Also called

market risk orsystematic risk).

(a) Measured right, they

give you a fairly

imprecise estimate of thetrue beta of a company;

the standard error in the

estimate is very large.(b) They are backward

looking. You get the beta

for a company for the last

2 or last 5 years. If yourcompany has changed its

business mix or debt ratio

over this time period, theregression beta will not

be a good measure of the

predicted beta.

For a way around thisproblem, you can try

estimating bottom-up

betas. (See bottom-upbeta)

Beta (Market) See Beta (CAPM)

Beta (Regression) See Beta (CAPM)

Beta (Total) See Total Beta

Book Debt Ratio See Debt Ratio (Book

Value)

Book Value ofCapital

Book Value of Debt +Book Value of Equity

(See book value of

invested capital)

A measure of thetotal capital that has

been invested in the

existing assets of thefirm. It is what

allows the firm to

generate the incomethat it does.

This is one of the fewplaces in finance where

we use book value, not so

much because we trustaccountants but because

we want to measure what

the firm has invested inits existing projects.

(Market value includes

growth potential and isthus inappropriate)

There is a cost we incur.Every accounting actionand decision (from

depreciation methods to

restructuring and one-

time charges) as well asmarket actions (such as

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stock buybacks) can have

significant implications

for the book value. Largerestructuring charges and

stock buybacks can

reduce book capitalsignificantly.

Finally, acquisitions pose

a challenge because the

premium paid on theacquisition (classified as

goodwill) may be for the

growth opportunities forthe target firm (on which

you have no chance of

earning money now).

That is why manyanalysts net goodwill out

of book capital.

Book Value ofEquity

Shareholder's equity onbalance sheet; includes

original paid-in capital

and accumulated

retained earnings sinceinception. Does not

include preferred stock.

A measure of theequity invested in the

existing assets of the

firm. It is what

allows the firm togenerate the equity

earnings that it does.

The book value of equity,like the book value of

capital, is heavily

influenced by accounting

choices and stockbuybacks or dividends.

When companies pay

large special dividends or

buy back stock, the bookequity will decrease. In

some cases, years ofrepeated losses can make

the book value of equity

negative.

Book Value ofInvested Capital

Book Value of Debt +Book Value of Equity -

Cash & Marketable

Securities(See book value of

capital)

Invested capitalmesures the capital

invested in the

operatinig assets ofthe firm.

Netting out cash allowsus to be consistent when

we use the book value of

capital in thedenominator to estimate

the return on capital. Thenumerator for this

calculation is after-taxoperating income and the

denominator should

therefore be only thebook value of operating

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assets (invested capital).

Bottom-Up Beta Weighted average Beta

of the business or

businesses a firm is in,adjusted for its debt to

equity ratio. The betasfor individualbusinessess are usually

estimated by averaging

the betas of firms ineach of these

businesses and

correcting for the debt

to equity ratio of thesefirms.

The beta for the

company, looking

forward, based uponits business mix and

financial leverage.

There are two keys to

estimating bottom-up

betas. The first isdefining the business or

businesses a firm is inbroadly enough to beable to get at least 10 and

preferably more firms

that operate in thatbusiness. The second is

obtaining regression

betas for each of these

firms.Bottom up betas are

generally better than

using one regression betabecause (a) they have

less standard error; the

average of 20 regressionsbetas will be more

precise than any one

regression beta and (b)

they can reflect thecurrent or even expected

future business mix of a

firm.

Cap Ex/Depreciation

Estimated by dividingthe capital expenditures

by depreciation. For the

sector, we estimate theratio by dividing the

cumulated capital

expenditures for thesector by the cumulated

depreciation and

amortization.

Capital (BookValue) This is the book valueof debt plus the book

value of common

equity, as reported onthe balance sheet.

Capital

Expenditures

Capital Spending +

Investments in R&D,

exploration or human

Investment intended

to create benefits

over many years; a

The accounting measure

of cap ex (usually found

in the statement of cash

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capital development +

Acquisitions

factory built by a

manufacturing firm,

for instance.

flows under investing

activities) is far too

narrow to measureinvestment in long term

assets. To get a more

sensible measure, wetherefore convert

expenses like R&D and

exploration costs (treated

as operating expenses bymost firms) into capital

expenditures. (See R&D

(capitalized) for moredetails) and acquisitions,

including those funded

with stock. After all, if

we want to count thegrowth from the latter,

we have to count the cost

of generating thatgrowth.

Cash Cash and Marketable

Securities reported in

the balance sheet.

Cash and close-to-

cash investments

held by a firm for avariety of motives:

precautionary (as a

cushion against bad

events), speculative(to use on new

investments) andoperational (to meet

the operating needs

of the company).

At most firms, cash and

marketable securities are

invested in short term,close to riskless

investments. As a

consequence, they earn

fairly low returns.However, since that is

what you would requirethem to earn cash usually

is a neutral investment; it

does not hurt or helpanyone. Investors,

though, may sometimes

discount cash in the

hands of some managers,since they fear that it will

be wasted on a badinvestment.

Correlation withthe market

This is the correlationof stock returns with

the market index, using

the same time period asthe beta estimation (see

Measures howclosely a stock moves

with the market.

The beta for a stock canactually be written as:

Beta = Correlation of

stock with market *Standard deviation of

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beta) . Bounded

between -1 and +1.

stock/ Standard deviation

of the market

As a consequence,holding all else constant,

the beta for a stock will

rise as its correlation withthe market rises. If we do

not hold the standard

deviation of the stock

fixed, though, it isentirely possible (and

fairly common) for a

stock to have a lowcorrelation and a high

beta (if a stock has a very

high standard deviation)

or a high correlation anda low beta (if the stock

has a low standard

deviation.

Cost of Capital The weighted average

of the cost of equity

and after-tax cost of

debt, weighted by themarket values of equity

and debt:

Cost of Capital = Cost

of Equity (E/(D+E)) +After-tax Cost of Debt

(D/(D+E))

Measures the current

long-term cost of

funding the firm.

The cost of capital is a

market-driven number.

That is why we use

market value weights(that is what you would

pay to buy equity and

debt in the firm today

and the current costs ofdebt and equity are based

upon the riskfree ratetoday and the expected

risk premiums today.

When doing valuation orcorporate finance, you

should leave open the

possibility that the inputs

into cost of capital (costsof debt and equity,

weights) can change overtime, leading your cost ofcapital to change.

If you have hybrids (such

as convertible bonds),you should try to break

them down into debt and

equity components and

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put them into their

respective piles. For what

to do with preferredstock, see Preferred

stock.

Cost of Debt(After-tax)

After-tax cost of debt =Pre-tax Cost of debt (1marginal tax rate)

(See pre-tax cot of debt

and marginal tax rate)

Interest is taxdeductible and itsaves you taxes on

your last dollars of

income. Hence, wecompute the tax

benefit using the

marginal tax rate.

The marginal tax ratewill almost never be inthe financial statements

of a firm. Instead, look at

the tax code at whatfirms have to pay as a tax

rate.

Note, though, that the tax

benefits of debt areavailable only to money

making companies. If a

money losing company iscomputing its after-tax

cost of debt, the marginal

tax rate for the next yearand the near-term can be

zero.

Cost of Debt (Pre-

tax)

This is estimated by

adding a default spreadto the riskfree rate.

Pre-tax cost of debt =

Riskfreee rate +

Default spreadThe default spread can

be estimated by (a)

finding a bond issuedby the firm and looking

up its current market

interest rate or yield tomaturity (b) finding a

bond rating for the firm

and using that rating toestimate a default

spread or (c) estimatinga bond rating for the

firm and using thatrating to come up with

a default spread.

The rate at which the

firm can borrow longterm today. The key

words are long term -

we implicitly assume

that the rolled overcost of short term

debt converges on the

long term rate- andtoday - we really

don't care about what

rate the firmborrowed at in the

past (a book interest

rate).

A company's pre-tax cost

of debt can and willchange over time as

riskfree rates, default

spreads and even the tax

rate change over time.We are trying to estimate

one consolidated cost of

debt for all of the debt inthe firm. If a firm has

senior and subordinated

debt outstanding, theformer will have a lower

interest rate and default

risk than the former, butyou would like to

estimate one cost of debtfor all of the debt

outstanding.

Cost of Equity In the CAPM: Cost of

Equity = Riskfree Rate

The rate of return

that stockholders in

Different investors

probably have different

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+ Beta (Equity Risk

Premium)

In a multi-factor model:Cost of Equity =

Riskfree Rate + Beta

for factor j * Riskpremium for factor j

(across all j)

your company expect

to make when they

buy your stock. It isimplicit with equities

and is captured in the

stock price.

expected returns, siince

they see different

amounts of risk in thesame investment. It is to

get around this problem

that we assume that themarginal investor in a

company is well

diversified and that the

only risk that gets pricedinto the cost of equity is

risk that cannot be

diversified away.The cost of equity can be

viewed as an opportunity

cost. This is the return

you would expect tomake on other

investments with similar

risk as the one that youare investing in.

Cost of preferred

stock

Preferred dividend

yield = Preferred

(annual) dividends pershare/ Preferred stock

price

The rate of return

that preferred

stockholders demandfor investing in a

company

The cost of preferred

stock should lie

somewhere between thecost of equity (which is

riskier) and the pre-tax

cost of debt (which is

safer). Preferreddividends are generally

not tax deductible; hence,not tax adjustment is

needed.

In Latin America,preferred stock usually

refers to common stock

with no voting rights but

preferences when itcomes to dividends.

Those shares should betreated as commonequity.

D/(D+E) See Debt Ratio

D/E Ratio See Debt/Equity Ratio

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Debt Interest bearing debt +

Off-balance sheet debt

Borrowed money

used to fund

operations

For an item to be

categorized as debt, it

needs to meet threecriteria: (a) it should give

rise to a fixed

commitment to be met inboth good and bad times,

(b) this commitment is

usually tax deductible

and (c) failure to meetthe commitment should

lead to loss of control

over the firm. With thesecriteria, we would

include all interest

bearing liabilities (short

term and long term) asdebt but not non-interest

bearing liabilities such as

accounts payable andsupplier credit. We

should consider the

present values of leasecommitments as debt.

Debt (Market

value)

Estimated market value

of book debt

Market's estimate of

the value of debt

used to fund the

business

At most companies, debt

is either never traded (it

is bank debt) or a

significant portion of thedebt is not traded.

Analysts consequentlyassume that book debt =

market debt. You can

convert book debt intomarket debt fairly easily

by treating it like a bond:

the interest payments are

like coupons, the bookvalue is the face value of

the bond and theweighted maturity of thedebt is the maturity of the

bond. Discounting back

at the pre-tax cost of debtwill yield an approximate

market value for debt.

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Debt Ratio (Book

Value)

Book value of debt/

(Book value of debt +

Book value of equity)

This is the

accountant's estimate

of the proportion ofthe book capital in a

firm that comes from

debt.

It is a poor measure of

the true financial

leverage in a firm, sincebook value of equity can

not only differ

significantly from themarket value of equity,

but can also be negative.

It is, however, often the

more common usedmeasure and target for

financial leverage at

firms that want tomaintain a particular debt

ratio.

Debt Ratio

(Market Value)

Market value of debt/

(Market value of debt +Market value of equity)

This is the proportion

of the total marketcapital of the firm

that comes from debt.

The market value debt

ratio, with debt definedto include both interest

bearing debt and leases,

will never be less than0% or higher than 100%.

Since a signfiicant

portion or all debt at

most firms is non-traded,analysts often use book

value of debt as a proxy

for market value. While

this is a resonableapproximation for most

firms, it will break downfor firms whose default

risk has changed

significantly since thedebt issue. For these

firms, it makes sense to

convert the book debt

into market debt bytreating the aggregate

debt like a coupon bond,with the interestpayments as coupons and

discounting back to today

using the pre-tax cost ofdebt as the discount rate.

Debt/Equity Ratio Debt/ Equity This measures the The debt to equity ratio

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number of dollars of

debt used for every

dollar of equity.

and the debt to captial

ratio are linked. In fact,

Debt/Equity = (D/(D+E))/ (1- D/(D+E))

Thus, if the debt to

capital is 40%, the debtto equity is 66.667%

(.4/.6)

In practical terms, the

debt to capital ratio isused in computing the

cost of capital and the

debt to equity to leverbetas.

Default spread Default spread:

Difference between the

pre-tax cost of debt fora firm and the riskfree

rate

Measures the

additional premium

demanded by lendersto compensate for

risk that a firm will

default.

The default spread

should always be greater

than zero. If the riskfreerate is correctly defined,

no firm, no matter how

safe, should be able toborrow at below this rate.

The default spread can be

computed in one of three

ways:a. Finding a traded bond

issued by a company and

looking up the yield to

maturity or interest rateon that bond.

b. Finding a bond ratingfor a firm and using it to

estimate the default

spreadc. Estimating a bond

rating for a firm and

using it to estimate the

default spread

Deferred Tax

(Asset)

Deferred Tax asset (on

balance sheet)

Measures the credit

that the firm expectsto get in future

periods foroverpaying taxes in

current and past

periods. The creditwill take the form of

For this asset to have

value, the firm has toanticipate being a going

concern, profitable andbeing able to claim the

overpayments as tax

deduction in future timeperiods. In other words,

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lower taxes in future

periods (and a lower

effective tax rate)

there would be no value

to this asset if the firm

were liquidated today.

Deferred Tax(Liability)

Deferred tax laibility(on balance sheet)

Measures the liabilitythat the firm sees in

the future as aconsequences ofunderpaying taxes in

the current or past

perios. The liabilitywill take the form of

higher taxes in future

periods (and a higher

effective tax rate)

It is not clear that this is aliability in the

conventional sense. Ifyou liquidated the firmtoday, you would not

have to meet this liablity.

Consequently, it shouldnot be treated like debt

when computing cost of

capital or even when

going from firm value toequity value. The most

effective way of showing

it in a valuaton is to buildit into expected tax

payments in the future

(which will result inlower cash flows)

Depreciation and

Amortization

Accounting write-off of

capital investments

from previous years.

Reflects the depletion

in valuation of

existing assets -depreciation for

tangible and

amortization for

intangible.

Accounting depreciation

and amortization usually

is not a good reflection ofeconomic depletion,

since the depreciation

choices are driven by tax

rules and considerations.Consequently, you may

be writing off too much

of some assets and toolittle of others. While

depreciation is an

accounting expense, it isnot a cash expense.

However, it can affect

taxes because it is taxdeductible. The tax

benefit from depreciationin any given year can be

written as:Tax benefit from

depreciation =

Depreciation * Marginaltax rate

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balance has to be

expected price

appreciation.

make investing in bonds

issued by the same

company because youwill augment it with price

appreciation. There are

some stocks that havedividend yields that are

higher than the riskfree

rate. While they may

seem like a bargain, thedividends are not

guaranteed and may not

be sustainable. Studies ofstock returns over time

seem to indicate that

investing in stocks with

high dividend yields is astrategy that generates

positive excess or

abnormal returns.Finally, the oldest cost of

equity model is based

upon adding dividendyield to expected growth:

Cost of equity =

Dividend yield +Expected growth rate

This is true only if youassume that the firm is instable growth, growing at

a cosntant rate forever.

Dividends Dividends paid by firm

to stockholders

Cash returned to

stockholders

Dividends are

discretionary and firmsdo not always pay out

what they can afford to in

dividends. This is

attested to by the largeand growing cash

balances at firms. Modelsthat focus on dividendsoften miss two key

components: (a) Many

companies have shiftedto return cash to

stockholders with stock

buybacks, instead of

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dividends and (b) The

potential dividends can

be very different fromactual dividends. For a

measure of potential

dividends, see FreeCashflow to Equity.

Earnings Yield Earnings per share/

Stock price

This is the inverse of

the PE ratio and

mesures roughlywhat the firm

generates as earnings

for every dollar

invsted in equity. It isusually compared to

the riskfree or

corporate bond rateto get a measure of

how attractive or

unattractive equityinvestments are.

Analysts read a lot more

into earnings yields than

they should. There aresome who use it as a

measure of the cost of

equity; this is true only

for mature companieswith no growth

opportunities with

potential excess returns.One nice feature of

earnings yields is that

they can be computedand used even if earnings

are negative. In contrast,

PE ratios become

meaningless whenearnings are negative.

EBITDA Earnings before interest

expenses(or income),

taxes, depreciation andamortization

Measures pre-tax

cash flow from

operations before thefirm makes any

investment back to

either maintainexisting assets or for

growth

EBITDA is used as a

crude measure of the

cash flows from theoperating assets of the

firm. In fact, there are

some who argue that it isthe cash available to

service interest and other

debt payments. That viewis misguided. Firms that

have large depreciaton

charges often have largecapital expenditure needs

and they still have to paytaxes. In fact, it is

entirely possible for afirm to have billions in

EBITDA and no cash

available to service debtpayments (See Free Cash

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Flow to the Firm for a

more complete measure

of operating cash flow)

Economic Profit,Economic Value

Added or EVA

(Return on InvestedCapital - Cost of

Capital) (Book Valueof Invested Capital)(See Excess Returns)

Measures the dollarexcess return

generated on capitalinvested in acompany

To the degree that thebook value of invested

capital measures actualcapital invested in theoperating assets of the

firm and the after-tax

operating is a cleanmesure of the true

operating income, this

captures the quality of a

firm's existinginvestments. As with

other single measures,

though, it can be easilygamed by finding ways

to write down capital

(one-time charges), notshow capital invested (by

leasing rather than

buying) or overstating

current operating income.

Effective tax rate Taxes payable/ Taxable

income

Measures the average

tax rate paid across

all of the income

generated by a firm.It thus reflects both

bracket creep (where

income at lowerbrackets get taxed at

a lower rate) and tax

deferral strategiesthat move income

into future periods.

Attesting to the

effectiveness of tax

lawyers, most companies

report effective tax ratesthat are lower than their

marginal tax rates. The

difference is usually thesource of the deferred tax

liability that you see

reported in financialstatements. While the

effective tax rate is not

particularly useful forcomputing the after-tax

cost of debt or leveredbetas, it can still be

useful when computingafter-tax operating

income (used in the Free

Cashflow to the Firm andreturn on invested capital

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computations) at least in

the near term. It does

increasingly dangerous toassume that you can

continue to pay less than

your marginal tax rate forlonger and longer

periods, since this

essentially allows for

long-term or evenpermanent tax deferral.

Enterprise Value Market value of equity

+ Market value of debt

- Cash + MinorityInterests

Measures the

market's estimate of

the value of operatingassets. We net out

cash because it is a

non-operating assetsand add back

minority interests

since the debt andcash values come

from fully

consolidated

financial statements.(See Minority

Interests for more

details)

In practice, analysts often

use book value of debt

because market value ofdebt may be unavailable

and the minority interest

item on the balancesheet. The former

practice can be

troublesome fordistressed companies

where the market value

of debt should be lower

than book value and thelatter practice is flawed

because it measures the

book value of the

minority interests whenwhat you really want is a

market value for theseinterests.

This computation can

also sometimes yieldnegative values for

companies with very

large cash balances.

While this represents abit of puzzle (how can a

firm trade for less thanthe cash on its balancesheet?), it can be

explained by the fact that

it may be impossible totake over the firm and

liquidiate it or by the

reality that the cash

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balance you see on the

last financial statment

might not be the cashbalance today.

Enterprise Value/

Invested Capital

(Market value of equity

+ Debt - Cash +Minority Interests)/(Book value of equity +

Debt - Cash + Minority

Interests)(See descriptions of

Enterprise value and

Invested Capital )

Market's assessment

of the value ofoperating assets as apercentage of the

accountant's estimate

of the capitalinvested in these

assets

By netting cash out of the

both the numerator andthe denominator, we aretrying to focus attention

on just the operating

assets of the firm. Thisratio, which has an equity

analog in the price to

book ratio, is determined

most critically by thereturn on invested capital

earned by the firm; high

return on invested capitalwill lead to high

EV/Capital ratios.

Enterprise Value/

EBITDA


+ Debt - Cash +Minority Interests)/

EBITDA

(See descriptions ofEnterprise Value and

EBITDA)

Multiple of pre-tax,

pre-reinvestmentoperating cash flow

that the firm trades at

Commonly used in

sectors with biginfrastructure

investments where

operating income can bedepressed by

depreciation charges.

Allows for comparison of

firms that are reportingoperating losses and

diverge widely on

depreciation methodsused. It is also a multiple

used by acquirers who

want to use significantdebt to fund the

acquisition; the

assumption is that theEBITDA can be used to

service debt payments.Cash is netted out from

the firm value becausethe income from cash is

not part of EBITDA.

However, the same canbe said of minority

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holdings in other

companies - the income

from these holdings isnot part of EBITDA -

and the estimated value

of these holdings shouldbe netted out as well.

With majority holdings,

the consolidation that

follows creates adifferent problem: the

market value of equity

includes only the portionof the subsidiary owned

by the parent but all of

the other numbers in the

computation reflect all ofthe subsidiary. This

should explaiin why

minority interests areadded back to the

numerator.

Enterprise Value/

Sales


+ Debt - Cash +Minority Interests)/

Revenues

Market's assessment

of the value ofoperating assets as a

percentage of the

revenues of the firm.

While the price to sales

ratio is a more widelyused multiple, the

enterprise value to sales

ratio is more consistent

because it uses themarket value of operating

assets (which generatethe revenues) in the

numerator.

Equity EVA (Return on Equity -

Cost of Equity) (BookValue of Equity)

(See Excess Returns

(on Equity))

Measures the dollar

excess returngenerated on equity

invested in a

company

To the degree that the

inputs into the equationare reasonable estimates,

this becomes a measure

of the success a companyhas shown with its

existing equityinvestments. However,

both the return on equityand book value of equity

are accounting numbers,

and can be skewed bydecisions (such as stock

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buybacks and

restructuring charges). At

the limit, it becomesmeaningless when the

book value of equity

becomes negative.EquityReinvestment

Rate

((Capital Expenditures- Depreciation) -

Change in non-cash

Working Capital -(Principal repaid - New

Debt Issued))/ Net

Income

Measures theproportion of net

income that is

reinvested back intothe operating assets

of the firm

The conventionalmeasure of equity

reinvestmnt is the

retention ratio, whichlooks at the proportion of

earnings that do not get

paid out as dividends.

The equity reinvestmentis both more focused and

more general. It is more

focused because it looksat the portion of the

earnings held back that

get invested into theoperating assets of the

firm and more general

because it can be a

negative value (for firmsthat are letting their

assets run down) or

greater than 100% (for

firms that are issuingfresh equity and

investing it back into thebusiness).

Equity Risk

Premium (ERP)

Expected Returns on

Equity Market Index -

Riskfreee Rate

Premium over the

riskfree rate

demanded byinvestors for

investing the average

risk stock

The ERP is a key

component of the cost of

equity for all companies,since it is multiplied by

the beta to get to the cost

of equiity. If you overestimate the ERP, you

are going to under valueall companies.

Equity RiskPremium -

Historical

Average Annual Returnon Stocks - Average

Annual Return on

Riskfree investment

Actual premiumearned by investors

on stocks, relative to

riskfree investment,

over the time period

The historical riskpremium is usually

estimated by looking at

long time period. For

instance, in the United

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States, it is usually

estimated over eight

decades (going back to1926). There are two

dangers in using this

historical risk premium.The first is that the long

time period

notwithstanding, the

historical risk premium isan estimate with a

significant standard error

(about 2% for 80 years ofday). The second is that

the market itself has

probably changed over

the last 80 years, makingthe historical risk

premium not a good

indicator for the future.

Equity Risk

Premium -

Implied

Growth rate implied in

today's stock prices,

given expected cash

flows and a riskfreerate. (Think of it as a

internal rate of return

for equities

collectively).

Reflects the risk that

investors see in

equities rght now. If

investors thinkequities are riskier,

they will pay less for

stocks today.

The implied equity risk

premium moves

inversely with stock

prices. When stock pricesgo up, the implied equity

risk premium will be

low. When stock prices

go down, the impliedpremium will be high.

Notwithstanding the factthat you have to use an

expected growth rate for

earnings and a valuationmodel, the implied equity

risk premium is both a

forward looking number

(relative to historicalpremiums) and

constantly updated.Excess Returns Return on Invested

Capital - Cost of capital

Measure the returns

earned over andabove what a firm

needed to make on an

investment, given itsrisk and funding

Excess returns are the

source of value added ata firm; positive net

present value investments

and value creatinggrowth come from excess

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choices (debt or

equity).

returns. However, excess

returns themselves are

reflections of the barriersto entry or competitive

advantages of a firm. In a

world with perfectcompetition, no firm

should be able to

generate excess returns

for more than an instant.

Excess Returns

(on equity)

Return on Equity - Cost

of Equity

Measures the return

earned over and

above the required

return on an equityinvestment, given its

risk. It can be at the

level of the firmmaking real

investments and at

the level of theinvestor picking

individual stocks for

her portfolio.

To generate excess

returns. you have to bring

something special to the

table. For firms, this maycome from a brand name,

economies of scale or a

patent. For investors, it ismore difficult but it can

be traced to better

information, betteranalysis or more

discipline than other

investors.

Firm Value Market Value of Equity+ Market Value of Debt

Measures the marketvalue of all assets of

a firm, operating as

well as non-

operating.

Since the value of thefirm includes both

operating and non-

operating assts, it will be

greater than enterprisevalue. To the extent that

we are looking at how

value relates to operatingitems (operating income

or EBITDA), you should

not use firm value butshould use enterprise

value instead; the income

from cash is not part ofoperating income or

EBITDA.

Fixed

Assets/TotalAssets

Fixed Assets/ Total

Assets

Measures how much

of a firm'sinvestments are in

tangible assets.

This ratio should be

higher for manufacturingfirms than for service

firms and reflects the bias

in accounting towards

tangible assets. Many

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lenders seem to share this

bias and are willing to

lend more to firms withsignificant fixed

assets.The ratio can also

be affected by the age ofthe assets, since older

assets, even if

productive, will be

written down to lowervalues.

Free Cash Flow to

Equity (FCFE)

FCFE

accounts glossary

Documents