Economic Factors - Price Changes in the Economy

InflationInflation is the economic condition characterized by continuously rising prices for goods and services. As a result, the purchasing power of a country's currency deteriorates as its value decreases and interest rates rise. 

What exactly causes inflation and how does it affect your investments and standard of living? See the tutorial: All About Inflation for the answers

There are two generally recognized types of inflation: demand-pull inflation and cost-push inflation.

• Demand-Pull Inflation: The money supply is seen as the cause of this type of inflation. In this situation, the money supply is too large when compared with the supply of produced goods in the economy. Interest rates rise as a result, making it more expensive to borrow money. As a result, the money supply begins to shrink with the drop in lending activity.
  
• Cost-Push Inflation: The rising cost of raw materials used to produce goods is seen as the cause of this type of inflation. Since manufacturers now need to pay more for these materials, they raise the prices on their products to compensate. As a result, retailers must pay more for goods, so they increase prices to pass the difference on to the consumer.

DeflationConversely, deflation is a persistent decline in the prices of goods and services usually caused by slowing market demand with a level supply. Purchasing power increases as a result of stagnant demand, fixed-income securities become more appealing, and producers must lower their prices to compete for the limited demand. 

Inflation usually has a negative effect on security prices, especially those equities that are particularly interest-rate sensitive, such as financials, smaller companies that rely on debt financing to grow, and cyclical businesses such as durable goods like heavy machinery, automobile and steel manufacturers, and other capital goods industries.

Read more: http://www.investopedia.com/exam-guide/finra-series-6/economic-factors/price-changes-economy.asp#ixzz1yhPyxhMx

Corporate Finance - Dividend Payment Procedures

Dividend payouts follow a set procedure as follows:

Declaration date
Ex-dividend date
Holder-of-record date
Payment date

1.Declaration DateDeclaration dateis the announcement that the company's board of directors approved the payment of the dividend.

2.Ex-Dividend DateThe ex-dividend date is the date on which investors are cut off from receiving a dividend. If for example, an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend. This date is two business days before the holder-of-record date. 

The ex-dividend date is important as, from this date and forward, new stockholders will not receive the dividend. As a result, the stock price of the company will be reflective of this. For example, on and after the ex-dividend date, a stock most likely trades at lower price, as the stock price is adjusted for the dividend that the new holder will not receive.

3. Holder-of-Record DateThe holder-of-record (owner-of-record) date is the date on which the stockholders who are to receive the dividend are recognized.

Look Out!
Remember that stock transactions typically settle in three business days.



Understanding the dates of the dividend payout process can be tricky. We clear up the confusion in the following article:

- Declaration, Ex-Dividend and Record Date Defined

4.Payment dateLast is the payment date, the date on which the actual dividend is paid out to the stockholders of record.

Example: dividend paymentSuppose Newco would like to pay a dividend to its shareholders. The company would proceed as follows:

1.On Jan 28, the company declares it will pay its regular dividend of $0.30 per share to holders of record on Feb 27, with payment on Mar 17.
2.The ex-dividend date for the dividend is Feb 23 (usually four days before of the holder-of-record date). On Feb 23 new buyers do not have a right to the dividend.
3.At the close of business on Feb 27, all holders of Newco's stock are recorded, and those holders will receive the dividend.
4.On Mar 17, the payment date, Newco mails the dividend checks to the holders of record.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-payment-procedures.asp#ixzz1yhItvcPN

Financing a capital project with equity may be a signal to investors that a company's prospects are not good.

Corporate Finance - Signaling Prospects Through Financing Decisions

One of the key assumptions Modigliani and Miller make in their work is that market information is symmetric, meaning companies and investors have the same information with respect to the company's future projects/investments. This assumption, however, is not realistic. When making capital decisions, a company's management should have more information than an investor, which implies asymmetric information. 

A financing decision is a way in which a company can inadvertently signal its prospects to investors. For example, suppose Newco decides to finance a new project with equity. Newco's additional equity would in fact dilute stockholder value. Since companies typically try to maximize stockholder value, would an equity offering be a bad signal? The answer is yes.

There would be some benefit from the project to the stockholders; however, the dilution from the offering would offset some of that benefit. If a company's prospects are good, management will finance new projects with other means, such as debt, to avoid giving any negative signals to the market. 

Look Out!Financing a capital project with equity may be a signal to investors that a company's prospects are not good.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/signaling-prospects-financing-decisions.asp#ixzz1yhFwj3bz

Corporate Finance - Types of Risk

Like anything, projects do have risks. There are three types of project risks associated with capital budgeting:
1. Stand-alone risk
2. Corporate risk
3. Market risk

1.Stand-Alone Risk This risk assumes the project a company intends to pursue is a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk.

2.Corporate RiskThis risk assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings.
3.Market RiskThis looks at the risk of a project through the eyes of the stockholder. It looks at the project not only from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect the project may have on the company's beta.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/types-of-risk.asp#ixzz1yhCYuBuY

Portfolio Management - Return Objectives and Investment Constraints

Return objectives can be divided into the following needs:

1. Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this objective, the return objective should, at a minimum, be equal to the inflation rate. In other words, nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital.

2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the return objective should be equal to a return that exceeds the expected inflation. With this objective, an investor's intention is to grow his existing capital base.
3. Current Income -Current income is the need to create income from the investor's capital base. With this objective, an investor needs to generate income from his investments. This is frequently seen with retired investors who no longer have income from work and need to generate income off of their investments to meet living expenses and other spending needs.

4. Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation.

Investment ConstraintsWhen creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement. They are as follows:

1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or cash. For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor.
2. Time Horizon - A time horizon constraint develops a timeline of an investor's various financial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to accept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon whose ability to accept risk may be lower because he would not have the ability to recoup any losses.
3. Tax Concerns - After-tax returns are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it may be important to focus on investments that would not make the investor's situation worse, like investing more heavily in tax-deferred investments.

4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one often can't be changed and must not be overlooked.

5. Unique Circumstances - Any special needs or constraints not recognized in any of the constraints listed above would fall in this category. An example of a unique circumstance would be the constraint an investor might place on investing in any company that is not socially responsible, such as a tobacco company.

The Importance of Asset AllocationAsset Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio. 

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% equities.
Citizens in other countries around the world would have different asset allocation strategies depending on the types and risks of securities available for placement in their portfolio. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, since the U.S. Government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities, such as that of the U.S.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/return-objectives-investment-constraints.asp#ixzz1yfCssLbg

Portfolio Management - The Portfolio Management Process

The portfolio management process is the process an investor takes to aid him in meeting his investment goals.

The procedure is as follows:

1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments.
2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements.
4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan toadjust for the changes that have occurred.

Policy StatementA policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process.The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and ReturnReturn objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk ToleranceAn investor's risk tolerance can be affected by many factors:

• Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
• Family situation - an investor may have higher income needs if they are supporting a child in college or an elderly relative.
• Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
• Psychological - an investor may simply have a lower tolerance for risk based on his personality.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-management/portfolio-management-process.asp#ixzz1yfBLNFTr

Equity Investments - Analyzing a Company - Types of Stock

1. Growth Company and Growth StockA growth company is a company that consistently grows by investing in projects that will generate growth. A growth stock, however, is a stock that earns a higher rate of return over stocks with a similar risk profile.
   
   Feasibly, a company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.

2. Defensive Company and Defensive StockA defensive company is a company whose earnings are relatively unaffected in a business cycle downturn. A defensive company is typically reflective of products that we "need" versus "want". A food company, such as Kellogg, is considered a defensive company. A defensive stock, however, will hold its value relatively well in a business cycle downturn.

3. Cyclical Company and Cyclical StockA cyclical company is a company whose earnings are affected relative to a business cycle. A cyclical company is typically reflects products we "want". A retail store, such as The Gap, is considered a cyclical company. A cyclical stock, however, will move with the market in relation to the business cycle.

4. Speculative Company and Speculative Stock.A speculative company is a company that invests in a business with an uncertain outcome. An oil exploration company is an example of a speculative company. A speculative stock, however, is a stock that has potential for a large return, as well as the potential for considerable losses. An example of speculative stocks can be found in the tech bubble, where investors put money into speculative stocks, but the investor could have been hurt financially or made large gains depending on the stock the investor invested in.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/equity-investments/analyzing-companies-stock-types.asp#ixzz1yf8SKSRC

Corporate Finance - Dividend Growth Rate and the Effect of Changing Dividend Policy

Signaling An Earning's Forecast Through Changes in Dividend PolicyMuch like a company can signal the state of its operations through its use of capital-financing projects, management can also signal its company's earnings forecast through changes in its dividend policy. 

Dividends are paid out when a company satisfies its internal needs for cash. If a company cuts its dividends, stockholders may become worried that the company is not generating enough earnings to satisfy its internal needs for cash as well as pay out its current dividend. A stock may decline in this instance. 

Suppose for example Newco decides to cuts its dividend to $0.25 per share from its initial value of $0.50 per share. How would this be perceived by investors?

Most likely the cut in dividend by Newco would be perceived negatively by investors. Investors would assume that the company is beginning to go through some tough times and the company is trying to preserve cash. This would indicate that the business may be slowing or earnings are not growing at the rate it once had. 

To learn more about dividends, please read: The Importance of Dividends

The Clientele Effect.A company's change in dividend policy may impact in the company's stock price given changes in the "clientele" interested in owning the company's stock. Depending on their personal tax situation, some stockholders may prefer capital gains over dividends and vice versa as capital gains are taxed at a lower rate than dividends. The clientele effect is simply different stockholders' preference on receiving dividends compared to capital gains.

For example, a stockholder in a high tax bracket may favor stocks with low dividend payouts compared to a stockholder in a low tax-bracket who may favor stocks with higher dividend payouts.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf633Zet

Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf57n9sb

Corporate Finance - Dividend Theories

Dividend Irrelevance TheoryMuch like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

Bird-in-the-Hand TheoryThe bird-in-the-hand theory, however, states that dividends are relevant. Remember that total return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner (Gordon/Litner) took this equation and assumed that k would decrease as a company's payout increased. As such, as a company increases its payout ratio, investors become concerned that the company's future capital gains will dissipate since the retained earnings that the company reinvests into the business will be less. 

Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital gains.

Tax-Preference TheoryTaxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. This is known as the "tax Preference theory". 

Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control. 

Capital gains are also not realized in an estate situation. For example, suppose an investor purchased a stock in a company 50 years ago. The investor held the stock until his or her death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation. 

The Dividend-Irrelevance Theory and Company ValuationIn the determination of the value of a company, dividends are often used. However, MM's dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. 

For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own. 

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. 

MM's dividend-irrelevance theory assumes that investors can affect their return on a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decision since they can simulate their own dividend policy.

How Any Shareholder Can Construct His or Her Own Dividend Policy.

Recall that the MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. As a result, a stockholder can construct his or her own dividend policy. 

• Suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations.
• Likewise, if, from an investor's perspective, a company's dividend is too small, an investor can sell some of the company's stock to replicate the cash flow the investor expected.

As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy since they can simulate their own.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-theories.asp#ixzz1yf1Ugmp6