A few financial terms

Present value is the current value to an individual of the stream of cash flows generated by a particular security. It is essentially a personal value reflecting the time and risk value of money to an individual or corporation. When the resulting present value is estimated and compared to the cost of the security or investment, it determines whether the security of investment should be bought or sold.

Financial statements are balance sheets, income statements, and cash flow statements prepared by the firm to reflect its operations.

Return is the rate of return received on an asset – the percentage increase or decrease in value received from an investment. The risk of the investment is the uncertainty attached to receiving that rate of return; that is, risk is the probability of unfortunate events occurring so that you don’t earn the rate of return you expect.

Capital structure is the firm’s choice between debt and equity financing and its choice between short- versus long-term debt. It is the choice a firm makes in its long-term financing.

Dividend is the decision the firm makes on how much of its cash it retains within the firm to reinvest and how much it distributes to stockholders. The cash can either be distributed as a cash dividend or be used to repurchase the firm’s stock.

Mergers and acquisitions together are the decision a firm makes to either buy the assets owned by another corporation – which is an acquisition – or combine its operations with those of another firm – a merger. As well as referring to acquiring assets, M&A more generally refers to corporate restructuring, including the spinning off or sale of assets the firm no longer needs and changes in the form of corporate organization.

The Option Pricing Theory is the pricing of underlying securities where the payoff, or what you receive, depends upon certain events occurring. The classic example is a call option where you have the right, but not the obligation, to buy shares at a fixed “exercise” price. If the price goes above the exercise price, you buy; if it stays below it, you throw away your option. Option Pricing Theory received a huge boost when Fischer Black and Myron Scholes developed the Black-Scholes model to value options. The ideas have been extended to a whole series of other types of options.

International finance is the extension of standard finance problems to cover foreign securities or foreign corporations. For example, it is the implication of exchange rates for domestic corporations involved in the trade, purchase, and management of foreign assets; it is the acquisition and divestiture of foreign corporations; and the asset allocation decision as to what proportion of foreign securities to hold in a portfolio.

The simplest test of market efficiency is whether or not you can make money in the stock market by using simple decision rules and publicly available data. For example, believers in the “dogs of the Dow” theory trust that you can outperform the stock market by buying the ten stocks in the Dow with the largest dividend yields. Efficient market theory would argue that this cannot happen. There are more rigid interpretations of efficient markets, but the simplest one is: “Can you use publicly available information to outperform a simple buy-and-hold strategy of holding bonds and equities?”

Risk-return tradeoff is the pricing of risk in the capital market. We know equities are riskier than bonds, but how much extra can we expect to earn on equities given this riskiness? Historically the answer is about 5 percent, which is the standard estimate of the market risk premium.

Default risk is the risk of non-performance on financial contracts. This risk exists with any financial contract except those issued by the Federal government, which are termed default-free. Default risk is rated by the major credit rating agencies, such as Standard and Poors (S&P): AAA, the highest, down to D for in default. Professionals have to be able to understand the pricing of credit risk because so many contracts are not with AAA credits or with the government; they are with people where there is a risk of nonperformance. So credit risk, particularly at a stage when we have a slow economy recovering from recession, is a very important factor in most personal investment decisions.

A term of obvious importance is time value of money, which is the most basic concept in finance, but it consistently confuses people, even some in the finance business. The fact is that the value of a dollar in five years’ time is not equivalent to the value of a dollar today, since it is always possible to invest a dollar today to get more than a dollar in five years. Many misrepresentations are due to failing to understand or report fully the implications of the time value of money. For example, a few years back people were taken to court for misrepresenting the value of Florida land. The deal seemed excellent – you spent $10,000 for a piece of land in Florida, and also got a $10,000 bond backed by the U.S. government. This was marketed as a “risk-free” investment. What the ads forgot to mention was that the land was largely under water, and so essentially worthless, and the $10,000 bond didn’t pay off for 25 years. The present value of the bond was a few thousand dollars, so people paid $10,000 for something actually worth a few thousand dollars – in practice, just throwing $7,000 or $8,000 away. Tricks played with time value of money in terms of discounting are still the fundamentals of finance.