Introduction - Introduction To Corporate FinanceCorporate finance is the study of a business's money-related decisions, which are essentially all of a business's decisions. Despite its name, corporate finance applies to all businesses, not just corporations. The primary goal of corporate finance is to figure out how to maximize a company's value by making good decisions about investment,financing and dividends. In other words, how should businesses allocate scarce resources to minimize expenses and maximize revenues? How should companies acquire these resources - through stock or bonds, owner capital or bank loans? Finally, what should a company do with its profits? How much should it reinvest into the company, and how much should it pay out to the business's owners? This walkthrough will explore each of these business decisions in greater depth.Corporate Finance - Agent-Principle Relationship

Potential Agency ProblemsAn agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem", arises when there is a conflict of

interest between the needs of the principal and the needs of the agent. 

In finance, the two primary agency relationships that exist are between:Managers and stockholdersManagers and creditors

1. Stockholders versus Managers

If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists.

Managers, at times, may make decisions that have the potential to be in conflict with the best interests of the shareholders. For example, managers may grow their firm to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is the main concern of creditors.

Stockholders, however, have control of such decisions through the managers.

Since stockholders will make decisions based on their best interest, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

Motivating Managers to Act in Shareholder's Best Interest Four primary mechanisms are used to motivate managers to act in stockholders' best interests:

Managerial compensation Direct intervention by stockholders Threat of firing Threat of takeovers

1. Managerial CompensationManagerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible. 

This is typically done with an annual salary plus performance bonuses and company shares.

Company shares are typically distributed to managers either as:

o Performance shares, where managers will receive a certain number shares based on the company's performance.

o Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of the stockholders as they themselves will be stockholders.

2. Direct Intervention by StockholdersToday, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders have the ability to exert influence on mangers and, as a result, the firm's operations.

3. Threat of FiringIf stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may even re-elect a

new board of directors that will accomplish the task.

4. Threat of TakeoversIf a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the coIntroduction - Forms Of Business OrganizationA business can be organized in one of several ways, and the form its owners choose will affect the company's and owners' legal liability and income tax treatment. Here are the most common options and their major defining characteristics. 

Sole ProprietorshipThe default option is to be a sole proprietor. With this option there are fewer forms to file than with other business organizations. The business is structured in such a manner that legal documents are not required to determine how profit-sharing from business operations will be allocated. 

This structure is acceptable if you are the business's sole owner and you do not need to distinguish the business from yourself. Being a sole proprietor does not preclude

you from using a business name that is different from your own name, however. In a sole proprietorship all profits, losses, assets and liabilities are the direct and sole responsibility of the owner. Also, the sole proprietor will pay self-employment tax on his or her income.

Sole proprietorships are not ideal for high-risk businesses because they put your personal assets at risk. If you are taking on significant amounts of debt to start your business, if you've gotten into trouble with personal debt in the past or if your business involves an activity for which you might potentially be sued, then you should choose a legal structure that will better protect your personal assets. Nolo, a company whose educational books make legal information accessible to the average person, gives several examples of risky businesses, including businesses that involve child care, animal care, manufacturing or selling edible goods, repairing items of value, and providing alcohol. These are just a few examples. There are many other activities that can make your business high risk.

If the risks in your line of work are not very high, a good business insurance policy can provide protection and peace of mind while allowing you to remain a sole proprietor. One of the biggest advantages of a sole

proprietorship is the ease with which business decisions can be made. 

LLCAn LLC is a limited liability company. This business structure protects the owner's personal assets from financial liability and provides some protection against personal liability. There are situations where an LLC owner can still be held personally responsible, such as if he intentionally does something fraudulent, reckless or illegal, or if she fails to adequately separate the activities of the LLC from her personal affairs.

This structure is established under state law, so the rules governing LLCs vary depending on where your business is located. According to the IRS, most states do not allow banks, insurance companies or nonprofit organizations to be LLCs.

Because an LLC is a state structure, there are no special federal tax forms for LLCs. An LLC must elect to be taxed as an individual, partnership or corporation. You will need to file paperwork with the state if you want to adopt this business structure, and you will need to pay fees that usually range from $100 to $800. In some states, there is an additional annual fee for being an LLC.

You will also need to name your LLC and file some simple documents, called articles of organization, with your state. Depending on your state's laws and your business's needs, you may also need to create an LLC operating agreement that spells out each owner's percentage interest in the business, responsibilities and voting power, as well as how profits and losses will be shared and what happens if an owner wants to sell her interest in the business. You may also have to publish a notice in your local newspaper stating that you are forming an LLC.

CorporationLike the LLC, the corporate structure distinguishes the business entity from its owner and can reduce liability. However, it is considered more complicated to run a corporationbecause of tax, accounting, record keeping and paperwork requirements. Unless you want to have shareholders or your potential clients will only do business with a corporation, it may not be logical to establish your business as a corporation from the start - an LLC may be a better choice.

The steps for establishing a corporation are very similar to the steps for establishing an LLC. You will need to choose a business name, appoint directors, file articles of

incorporation, pay filing fees and follow any other specific state/national requirements. (Find out how becoming a corporation can protect and further your finances. See Should You Incorporate Your Business?)

There are two types of corporations: C corporations (C corps) and S corporations (S corps). C corporations are considered separate tax-paying entities. C corps file their own income tax returns, and income earned remains in the corporation until it is paid as a salary or wages to the corporation's officers and employees. Corporate income is often taxed at lower rates than personal income, so you can save money on taxes by leaving money in the corporation.

If you're only making enough to get by, however, this won't help you because you'll need to pay almost all of the corporation's earnings to yourself. If the corporation has shareholders, corporate earnings become subject to double taxation in the sense that income earned by the corporation is taxed and dividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation.

S corporations are pass-through entities, meaning that

their income, losses, deductions and credits pass through the company and become the direct responsibility of the company's shareholders. The shareholders report these items on their personal income tax returns, thus S corps avoid the income double taxation that is associated with C corps.

All shareholders must sign IRS form 2553 to make the business an S corp for tax purposes. The IRS also requires S corps to meet the following requirements:

Be a domestic corporation Have only allowable shareholders, including

individuals, certain trusts and estates Not include partnerships, corporations or non-

resident alien shareholders Have no more than 100 shareholders Have one class of stock Not be an ineligible corporation (i.e., certain financial

institutions, insurance companies and domestic international sales corporations)

General Partnerships, Limited Partnerships (LP) and Limited Liability Partnerships (LLP)A partnership is a structure appropriate to use if you are not going to be the sole owner of your new business.

In a general partnership, all partners are personally liable for business debts, any partner can be held totally responsible for the business and any partner can make decisions that affect the whole business. 

In a limited partnership, one partner is responsible for decision-making and can be held personally liable for business debts. The other partner merely invests in the business. Although the general structure of limited partnerships can vary, each individual is liable only to the extent of their invested capital. 

LLPs are most commonly used by professionals such as doctors and lawyers. The LLP structure protects each partner's personal assets and each partner from debts or liability incurred by the other partners. Different states have varying regulations regarding these establishments of which business owners must take note. 

Partnerships must file information returns with the IRS, but they do not file separate tax returns. For tax purposes, the partnership's profits or losses pass through to its owners, so a partnership's income is taxed at the individual level. LPs and LLPs are also state entities and must file paperwork and pay fees similar to those involved in establishing an LLC. 

Regardless of the way a business is structured, its owners will have the same overarching goals when it comes to the company's financial management.mpany and bring in their own managers.Corporate Finance - Capital Budgeting Basics

What is Capital Budgeting?Capital budgeting is defined as the process of planning for projects on assets with cash flows of a period greater than one year.

These projects can be classified as:

· Replacement decisions to maintain the business· Existing product or market expansion· New products and services· Regulatory, safety and environmental· Other, including pet projects or difficult to evaluate projects

Additionally, projects can also be classified as mutually exclusive or independent:- Mutually exclusive projects indicate there is only one project among all possible projects that can be accepted.

- Independent projects are potential projects that are unrelated, and any combination of those projects can be accepted.

The Importance of Capital BudgetingCapital budgeting is important for many reasons:- Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period.- When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset.- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.Goals Of Financial ManagementAll businesses aim to maximize their profits, minimize their expenses and maximize their market share. Here is a look at each of these goals. 

Maximize Profits A company's most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales.

There are three key profit-margin ratios: gross profit margin, operating profit margin and net profit margin. 

1. Gross Profit Margin 

The gross profit margin tells us the profit a company makes on its cost of sales or cost of goods sold. In other words, it indicates how efficiently management uses labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales

Suppose that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1 million - $600,000/$1 million).

The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.

Gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.

2. Operating Profit MarginBy comparing earnings before interest and taxes (EBIT) to sales, operating profitmargins show how successful a company's management has been at generating income from the operation of the business:

Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%. 

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

Because the operating profit margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin. 

3. Net Profit Margin

Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%.

Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability.

Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs.

For example, the international airline industry has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies have much higher gross and net margin numbers. These differences provide some insight into these industries' distinct cost structures: compared to its bigger,

international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries.

In the software business, gross margins are very high, while net profit margins are considerably lower. This shows that marketing and administration costs in this industry are very high, while cost of sales and operating costs are relatively low.

When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times, leaving them even better positioned when things improve again.

Like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company's industry and its position in the business

cycle. Margins tell us a lot about a company's prospects, but not the whole story. 

Minimize CostsCompanies use cost controls to manage and/or reduce their business expenses. By identifying and evaluating all of the business's expenses, management can determine whether those costs are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through methods such as cutting back, moving to a less expensive plan or changing service providers. The cost-control process seeks to manage expenses ranging from phone, internet and utility bills to employee payroll and outside professional services.

To be profitable, companies must not only earn revenues, but also control costs. If costs are too high, profit margins will be too low, making it difficult for a company to succeed against its competitors. In the case of a public company, if costs are too high, the company may find that its share price is depressed and that it is difficult to attract investors.

When examining whether costs are reasonable or unreasonable, it's important to consider industry standards. Many firms examine their costs during the

drafting of their annual budgets.

Maximize Market ShareMarket share is calculated by taking a company's sales over a given period and dividing it by the total sales of its industry over the same period. This metric provides a general idea of a company's size relative to its market and its competitors. Companies are always looking to expand their share of the market, in addition to trying to grow the size of the total market by appealing to larger demographics, lowering prices or through advertising. Market share increases can allow a company to achieve greater scale in its operations and improve profitability.

The size of a market is always in flux, but the rate of change depends on whether the market is growing or mature. Market share increases and decreases can be a sign of the relative competitiveness of the company's products or services. As the total market for a product or service grows, a company that is maintaining its market share is growing revenues at the same rate as the total market. A company that is growing its market share will be growing its revenues faster than its competitors. Technology companies often operate in a growth market, while consumer goods companies generally operate in a mature market.

New companies that are starting from scratch can experience fast gains in market share. Once a company achieves a large market share, however, it will have a more difficult time growing its sales because there aren't as many potential customers available. 

Next we'll take a look at the potential conflicts of interest that can arise in the management of a business's finances. 

The Agency ProblemAn agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the agent.

In finance, there are two primary agency relationships:

Managers and stockholders Managers and creditors

1. Stockholders versus Managers 

If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists.

Managers may make decisions that conflict with the best interests of the shareholders. For example, managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors 

Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is a creditors' main concern.

Stockholders, however, have control of such decisions through the managers.

Since stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

Motivating Managers to Act in Shareholders' Best Interests 

There are four primary mechanisms for motivating managers to act in stockholders' best interests:

Managerial compensation Direct intervention by stockholders Threat of firing Threat of takeovers

1. Managerial CompensationManagerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible.

This is typically done with an annual salary plus performance bonuses and company shares.

Company shares are typically distributed to managers either as:

o Performance shares, where managers will receive a certain number shares based on the company's performance

o Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of

the stockholders as they themselves will be stockholders.

2. Direct Intervention by StockholdersToday, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders can exert influence on mangers and, as a result, the firm's operations.

3. Threat of FiringIf stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task.

4. Threat of TakeoversIf a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers. 

In the next section, we'll examine the financial

institutions and financial markets that help companies finance their operations.Types Of Financial Institutions And Their RolesA financial institution is an establishment that conducts financial transactions such as investments, loans and deposits. Almost everyone deals with financial institutions on a regular basis. Everything from depositing money to taking out loans and exchanging currencies must be done through financial institutions. Here is an overview of some of the major categories of financial institutions and their roles in the financial system.

Commercial BanksCommercial banks accept deposits and provide security and convenience to their customers. Part of the original purpose of banks was to offer customers safe keeping for their money. By keeping physical cash at home or in a wallet, there are risks of loss due to theft and accidents, not to mention the loss of possible income from interest. With banks, consumers no longer need to keep large amounts of currency on hand; transactions can be handled with checks, debit cards or credit cards, instead.

Commercial banks also make loans that individuals and businesses use to buy goods or expand business

operations, which in turn leads to more deposited funds that make their way to banks. If banks can lend money at a higher interest rate than they have to pay for funds and operating costs, they make money.

Banks also serve often under-appreciated roles as payment agents within a country and between nations. Not only do banks issue debit cards that allow account holders to pay for goods with the swipe of a card, they can also arrange wire transfers with other institutions. Banks essentially underwrite financial transactions by lending their reputation and credibility to the transaction; a check is basically just a promissory note between two people, but without a bank's name and information on that note, no merchant would accept it. As payment agents, banks make commercial transactions much more convenient; it is not necessary to carry around large amounts of physical currency when merchants will accept the checks, debit cards or credit cards that banks provide. 

Investment BanksThe stock market crash of 1929 and ensuing Great Depression caused the United States government to increase financial market regulation. The Glass-Steagall Act of 1933resulted in the separation of investment

banking from commercial banking.

While investment banks may be called "banks," their operations are far different than deposit-gathering commercial banks. An investment bank is a financial intermediary that performs a variety of services for businesses and some governments. These services include underwriting debt and equity offerings, acting as an intermediary between an issuer of securities and the investing public, making markets, facilitating mergers and other corporate reorganizations, and acting as a broker for institutional clients. They may also provide research and financial advisory services to companies. As a general rule, investment banks focus on initial public offerings (IPOs) and large public andprivate share offerings. Traditionally, investment banks do not deal with the general public. However, some of the big names in investment banking, such as JP Morgan Chase, Bank of America and Citigroup, also operate commercial banks. Other past and present investment banks you may have heard of include Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston.

Generally speaking, investment banks are subject to less regulation than commercial banks. While investment banks operate under the supervision of regulatory bodies,

like the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions when it comes to maintaining capital ratios or introducing new products.

Insurance CompaniesInsurance companies pool risk by collecting premiums from a large group of people who want to protect themselves and/or their loved ones against a particular loss, such as a fire, car accident, illness, lawsuit, disability or death. Insurance helps individuals and companies manage risk and preserve wealth. By insuring a large number of people, insurance companies can operate profitably and at the same time pay for claims that may arise. Insurance companies use statistical analysis to project what their actual losses will be within a given class. They know that not all insured individuals will suffer losses at the same time or at all. 

BrokeragesA brokerage acts as an intermediary between buyers and sellers to facilitate securities transactions. Brokerage companies are compensated via commission after the transaction has been successfully completed. For example, when a trade order for a stock is carried out, an individual often pays a transaction fee for the brokerage

company's efforts to execute the trade.

A brokerage can be either full service or discount. A full service brokerage provides investment advice, portfolio management and trade execution. In exchange for this high level of service, customers pay significant commissions on each trade. Discount brokers allow investors to perform their own investment research and make their own decisions. The brokerage still executes the investor's trades, but since it doesn't provide the other services of a full-service brokerage, its trade commissions are much smaller. 

Investment CompaniesAn investment company is a corporation or a trust through which individuals invest in diversified, professionally managed portfolios of securities by pooling their funds with those of other investors. Rather than purchasing combinations of individual stocks and bonds for a portfolio, an investor can purchase securities indirectly through a package product like a mutual fund.

There are three fundamental types of investment companies: unit investment trusts(UITs), face amount certificate companies and managed investment

companies. All three types have the following things in common:

An undivided interest in the fund proportional to the number of shares held

Diversification in a large number of securities Professional management Specific investment objectives

Let's take a closer look at each type of investment company.

Unit Investment Trusts (UITs)A unit investment trust, or UIT, is a company established under an indenture or similar agreement. It has the following characteristics: 

The management of the trust is supervised by a trustee.

Unit investment trusts sell a fixed number of shares to unit holders, who receive a proportionate share of net income from the underlying trust.

The UIT security is redeemable and represents an undivided interest in a specific portfolio of securities.

The portfolio is merely supervised, not managed, as it remains fixed for the life of the trust. In other

words, there is no day-to-day management of the portfolio.

Face Amount CertificatesA face amount certificate company issues debt certificates at a predetermined rate of interest. Additional characteristics include: 

Certificate holders may redeem their certificates for a fixed amount on a specified date, or for a specific surrender value, before maturity.

Certificates can be purchased either in periodic installments or all at once with a lump-sum payment.

Face amount certificate companies are almost nonexistent today.

Management Investment CompaniesThe most common type of investment company is the management investment company, which actively manages a portfolio of securities to achieve its investment objective. There are two types of management investment company: closed-end andopen-end. The primary differences between the two come down to where investors buy and sell their shares - in the primary or secondary markets - and the type of securities the investment company sells.

Closed-End Investment Companies: A closed-end investment company issues shares in a one-time public offering. It does not continually offer new shares, nor does it redeem its shares like an open-end investment company. Once shares are issued, an investor may purchase them on the open market and sell them in the same way. The market value of the closed-end fund's shares will be based on supply and demand, much like other securities. Instead of selling at net asset value, the shares can sell at a premium or at a discount to the net asset value.

Open-End Investment Companies: Open-end investment companies, also known as mutual funds, continuously issue new shares. These shares may only be purchased from the investment company and sold back to the investment company. Mutual funds are discussed in more detail in the Variable Contracts section.

Read more: Series 26 Exam Guide: Investment Companies

Nonbank Financial InstitutionsThe following institutions are not technically banks but provide some of the same services as banks. 

Savings and LoansSavings and loan associations, also known as S&Ls or thrifts, resemble banks in many respects. Most consumers don't know the differences between commercial banks and S&Ls. By law, savings and loan companies must have 65% or more of their lending in residential mortgages, though other types of lending is allowed.

S&Ls emerged largely in response to the exclusivity of commercial banks. There was a time when banks would only accept deposits from people of relatively high wealth, with references, and would not lend to ordinary workers. Savings and loans typically offered lower borrowing rates than commercial banks and higher interest rates on deposits; the narrower profit margin was a byproduct of the fact that such S&Ls were privately or mutually owned.

Credit UnionsCredit unions are another alternative to regular commercial banks. Credit unions are almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on deposits and charge lower rates on loans in

comparison to commercial banks.

In exchange for a little added freedom, there is one particular restriction on credit unions; membership is not open to the public, but rather restricted to a particular membership group. In the past, this has meant that employees of certain companies, members of certain churches, and so on, were the only ones allowed to join a credit union. In recent years, though, these restrictions have been eased considerably, very much over the objections of banks.

Shadow BanksThe housing bubble and subsequent credit crisis brought attention to what is commonly called "the shadow banking system." This is a collection of investment banks, hedge funds, insurers and other non-bank financial institutions that replicate some of the activities of regulated banks, but do not operate in the same regulatory environment.

The shadow banking system funneled a great deal of money into the U.S. residential mortgage market during the bubble. Insurance companies would buy mortgage bonds from investment banks, which would then use the proceeds to buy more mortgages, so that they could

issue more mortgage bonds. The banks would use the money obtained from selling mortgages to write still more mortgages.

Many estimates of the size of the shadow banking system suggest that it had grown to match the size of the traditional U.S. banking system by 2008.

Apart from the absence of regulation and reporting requirements, the nature of the operations within the shadow banking system created several problems. Specifically, many of these institutions "borrowed short" to "lend long." In other words, they financed long-term commitments with short-term debt. This left these institutions very vulnerable to increases in short-term rates and when those rates rose, it forced many institutions to rush to liquidate investments and make margin calls. Moreover, as these institutions were not part of the formal banking system, they did not have access to the same emergency funding facilities. (Learn more in The Rise And Fall Of The Shadow Banking System.)

Next, let's learn about the types of financial markets in which these financial institutions operate.Types Of Financial Markets And Their RolesA financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. Financial markets are typically defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade.

Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others - like the New York Stock Exchange (NYSE) and the forex markets - trade trillions of dollars daily.

Investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century.

Capital MarketsA capital market is one in which individuals and institutions trade financial securities. Organizations and institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds. Thus, this type of market is composed of both the

primary and secondary markets. 

Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.

Stock MarketsStock markets allow investors to buy and sell shares in publicly traded companies. They are one of the most vital areas of a market economy as they provide companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. 

This market can be split into two main sections: the primary market and the secondary market. The primary market is where new issues are first offered, with any subsequent trading going on in the secondary market.

Bond MarketsA bond is a debt investment in which an investor loans money to an entity (corporate or governmental), which borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds can be bought and sold by investors on credit markets around the world. This market is alternatively referred to as the debt, credit or fixed-income market. It is much larger in nominal terms that the world's stock markets. The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which

are collectively referred to as simply "Treasuries." (For more, see the Bond Basics Tutorial.)

Money MarketThe money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), banker's acceptances, U.S. Treasury bills, commercial paper, municipal notes, eurodollars, federal funds and repurchase agreements (repos). Money market investments are also called cash investments because of their short maturities.

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due the highly liquid nature of the securities and short maturities. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities. However, there are risks in the money market that any investor needs to be aware of, including the risk of default on securities such as commercial paper. (To learn more, read our Money Market Tutorial.)

Cash or Spot MarketInvesting in the cash or "spot" market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and

are delivered immediately. By the same token, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills.

Derivatives MarketsThe derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program. (To get to know derivatives, read The Barnyard Basics Of Derivatives.)

Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants. There are also many derivatives,structured products and collateralized

obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers use to varying degrees but that play an insignificant role in private investing.

Forex and the Interbank MarketThe interbank market is the financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks' own accounts.

The forex market is where currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world. The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market.

There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week and currencies are traded worldwide among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.

Until recently, forex trading in the currency market had largely been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average

investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts. (For further reading, see The Foreign Exchange Interbank Market.)

Primary Markets vs. Secondary MarketsA primary market issues new securities on an exchange. Companies, governments and other groups obtain financing through debt or equity based securities. Primary markets, also known as "new issue markets," are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors.

The primary markets are where investors have their first chance to participate in a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. (For more on the primary market, see our IPO Basics Tutorial.)

The secondary market is where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The Securities and Exchange Commission (SEC) registers securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.) 

The secondary market is where the bulk of exchange

trading occurs each day. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred. In the primary market, prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security.

Secondary markets exist for other securities as well, such as when funds, investment banks or entities such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash proceeds go to an investor rather than to the underlying company/entity directly. (To learn more about primary and secondary markets, read A Look at Primary and Secondary Markets.)

The OTC MarketThe over-the-counter (OTC) market is a type of secondary market also referred to as a dealer market. The term "over-the-counter" refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board(OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

Third and Fourth MarketsYou might also hear the terms "third" and "fourth

markets." These don't concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third and fourth market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

Financial institutions and financial markets help firms raise money. They can do this by taking out a loan from a bank and repaying it with interest, issuing bonds to borrow money from investors that will be repaid at a fixed interest rate, or offering investors partial ownership in the company and a claim on its residual cash flows in the form of stock.

Next: Introduction »

Five Chart Patterns you need to know… 

Taxes - Types Of Taxes

A business must pay a variety of taxes based on the company's physical location, ownership structure and nature of the business. Business taxes can have a huge impact on the profitability of businesses and the amount of business investment. Taxation is a very important factor in the financial investment decision-making process because a lower tax burden allows the company to lower prices or generate higher revenue, which can then be paid out in wages, salaries and/or dividends. Business may be required to remit the following types of taxes:

Federal Income Tax: A tax levied by a national government on annual income.

State and/or Local Income Tax: A tax levied by a state or local government on annual income. Not all states have implemented state level income taxes.

Payroll Tax: A tax an employer withholds and/or pays on behalf of their employees based on the wage or salary of the employee. In most countries, including the United States, both state and federal authorities collect some form of payroll tax. In the United States, Medicare and Social Security, also called FICA, make up the payroll tax.

Unemployment Tax: A federal tax that is allocated to state unemployment agencies to fund unemployment assistance for laid-off workers.

Sales Tax: A tax imposed by the government at the point of sale on retail goods and services. It is collected by the retailer and passed on to the state. Sales tax is based on a percentage of the selling prices of the goods and services and is set by the state. Technically, consumers pay sales taxes, but effectively, business pay them since the tax increases consumers costs and causes them to buy less.

Foreign Tax: Income taxes paid to a foreign government on income earned in that country.

Value-Added Tax: A national sales tax collected at each stage of production or consumption of a good. Depending on the political climate, the taxing authority often exempts certain necessary living items, such as food and medicine from the tax.Taxes - Types Of CreditsBusinesses can reduce their tax liability with deductions and credits. The IRS allows businesses to deduct

expenses that are considered ordinary and necessary for that line of business, and it provides credits to encourage specific business activities. Deductions reduce the amount of income on which a company must pay tax, while credits directly reduce a company's tax liability. In other words, a deduction might mean that a company pays tax on $750,000 instead of $1,000,000; a credit might mean that a company can subtract $50,000 from its $250,000 tax bill.

Some common business deductions and credits include the following:

Cost of Goods Sold: The amount spent to purchase inventory, including products purchased for resale, raw materials, freight, storage, labor and factory overhead. Indirect costs such as rent, interest and administrative costs must be capitalized.

Capital Expenses: Major expenses for ongoing business assets, including startup costs and improvements, must be capitalized. However, up to $5,000 in startup costs can be deducted in the year the business is opened.

Rent: The cost of leasing a place of business is tax deductible.

Interest: The cost of borrowing money for business activities can be deducted.

Employees' Pay: The salaries and wages paid to employees are tax deductible. So are retirement contributions for employees, directors and officers.

Taxes: Business taxes paid to state, local and foreign tax authorities are tax deductible.

Insurance: Premiums for business insurance such as property, casualty and liability insurance are tax deductible.

IRS Publication 535, Business Expenses, provides more detail about tax deductible business expenses.Capital Cost Allowance And Depreciation - Types Of DepreciationThe capital cost allowance (CCA) is a rate of depreciation used for income tax purposes only. This term primarily relates to Canadian taxation. The CCA rate that can be claimed depends on the asset itself; for example, computer software has a much higher CCA rate than buildings or furniture. The CCA is essentially a business tax deduction that helps Canadian businesses reduce

their taxes. 

Depreciation AccountingIn the United States, businesses can take a deduction for depreciation. Depreciation is the reduction in an asset's value caused by the passage of time due to use or abuse, wear and tear. Depreciation is a method of cost allocation. The cost allocation can be based on a number of factors, but it is always related to the estimated period of time the product can generate revenues for the company, also known as the asset's economic life. Depreciation expense is the amount of cost allocation within an accounting period. Only items that lose useful value over time can be depreciated. Depreciation can be calculated in more than one way.

Straight-line DepreciationThe simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can reasonably be expected to benefit the company (or its useful life).

Example: For $2 million, Company ABC purchased a

machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

Depreciation Expense= Total Acquisition Cost – Salvage Value / Useful Life

Straight-line depreciation produces a constant depreciation expense. At the end of the asset's useful life, the asset is accounted for in the balance sheet at its salvage value.

Unit-of-Production DepreciationThis method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense.

Depreciation Expense = Total Acquisition Cost - Salvage Value / Estimated Total Units

Estimated total units = the total units this machine can produce over its lifetimeDepreciation expense = depreciation per unit * number of units produced during an accounting period

Example:Company ABC purchased a machine for $2 million that can produce 300,000 products over its useful life. The company estimates that this machine has a salvage value of $200,000.

Unit-of-production depreciation produces a variable depreciation expense and is more reflective of production-to-cost (see matching principle).

At the end of its useful life, the asset's accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the

drawbacks of this method is that if the units of products decrease (due to slowing demand for the product, for example), the depreciation expense also decreases. This results in an overstatement of reported income and asset value.

Hours-of-Service DepreciationThis is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period.

Accelerated DepreciationAccelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement.

This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life if it becomes obsolete ( computers, for example).

Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (and therefore higher valuation).

The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and double-declining-balance method (DDB):

Sum-of-Year Method:Depreciation In Year i = ((n-i+1) / n!) * (total acquisition cost - salvage value) 

Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

n! = 1+2+3+4+5 = 15n = 5

The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.

Double-Declining-Balance MethodThe DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years.

DDB In year i = (2 / n) * (total acquisition cost - accumulated depreciation) n = number of years

Example For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.

The double-declining-balance method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage valueCapital Cost Allowance And Depreciation - Other Depreciation ConsiderationsChange in Useful life or Salvage ValueAll depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (due to new technology, for example), and its salvage value may also be affected. Once this happens there is asset impairment.

Companies can do two things:

1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time.

2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away. Changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. As a result, there is no need to restate past financial statements.

Sale, Exchange or Disposal of Depreciable AssetsCompanies that are in the business of exploring, extracting and/or transforming natural resources such as timber, gold, silver, oil and gas are known as "natural resource companies." The main assets these companies have are their inventory of natural resources. These assets must be reported at their carrying cost (or cost of carry). The carrying costs for natural resources include the cost of acquiring the lands or mines, the cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process.

When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large

premium because of what is contained in the plot of land. However, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion." That is why cost of carry is depleted over time. The depletion of these assets must be included in the income statement's accounting period. This is the only time land can be depleted.

The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method.

Example: A company acquired cutting rights for $1 million. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees.

Journal entries:

Certain types of assets are amortized rather than depreciated. Amortization describes the deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright.What is the difference between amortization and depreciation? Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally expensed based on the time period over which the asset was used. Depreciation and amortization (as well as depletion) methods are used to prorate the cost of a specific type of asset to the asset's life. Remember, these methods are calculated by subtracting the asset'ssalvage value from its original cost.

Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent with each portion being recorded as an expense on the company's income statement.

Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before changes in circumstances result in it being sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year.

Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the oil well.

It is important to note that in some countries, such as Canada, the terms amortization and depreciation are often used interchangeably to refer to both tangible and intangible assets.

Here is an example of how amortization works. Suppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that the patent on the equipment lasts 15 years. The business would record $2 million each year as an amortization expense.

While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets.

Amortization can be calculated easily using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.

To learn more about amortization and depreciation, read Financial Statements: Long-Lived Assets.Cash Flow And Relationships Between Financial Statement - The Relationship Between Financial StatementsThe income statement, balance sheet and cash flow statement are all interrelated. The income statement describes how the assets and liabilities were used in the stated accounting period. The cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount of cash the company has on hand, which is also reported in the balance sheet. By themselves, each financial statement only provides a portion of the story of a company's financial condition; together, they provide a more complete picture.

The Relationship Between the Financial Statements 

Stockholders and potential creditors analyze a company's financial statements and calculate a number of financial ratios with the data they contain to identify the company's financial strengths and weaknesses and determine whether the company is a good investment/credit risk. Managers use them to aid in decision making. (To learn more, check out Reading The Balance Sheet, Understanding The Income Statement and The Essentials Of Cash Flow.)

One important way the financial statements are used together is in the calculation of free cash flow (FCF). Smart investors love companies that produce plenty of free cash flow. It signals a company's ability to pay debt anddividends, buy back stock and facilitate the growth of business - all important undertakings from an investor's perspective. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery. (For background reading, see Analyzing Cash Flow The Easy Way.)

Cash Flow And Relationships Between Financial Statement - Free Cash FlowBy establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, make a beeline for the company's cash flow statement and balance sheet. There you will find the item cash flow from operations (also referred to as "operating cash"). From this number, subtract estimated capital expenditure required for current operations:

Cash Flow From Operations (Operating Cash)- Capital Expenditure---------------------------- = Free Cash Flow 

To do it another way, grab the income statement and balance sheet. Start withnet income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital,

which is done by subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):

Net income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure ---------------------------- = Free Cash Flow 

It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.

What Does Free Cash Flow Indicate?Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF - due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distributions or debt elimination - can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that

earnings and share value will soon be heading up.

By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.

Is Free Cash Flow Foolproof?Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand.

Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital, but the impacts are likely to be temporary.

The Trick of Hiding Receivables Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that has yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which is then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.

What happens when a company decides to record the revenue, even though the cash will not be received within a year? The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments." Revenue is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy an unjustified boost. Tricks like this one can be hard to catch. (For more insight, see 5 Tricks Companies Use During Earnings Season.)

Finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.Time Value Of Money - Introduction To The Time Value Of MoneyIn addition to being able to understand financial statements, it's important to be able to estimate the value of an investment in the present and in the future.

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity is called the time value of money. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Thus, at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

But why is this? A $100 bill now has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can

earn more intereston your money.

By receiving $10,000 today (Option A), you are poised to increase the future value of your money by investing and gaining interest over a period of time. If you receive the money three years down the line (Option B), you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you choose Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth compared to Option B? Let's take a look.

Future Value BasicsIf you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your

investment at the end of the first year is $10,450, which is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: 

Original equation: ($10,000 x 0.045) + $10,000 = $10,450

Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 Final equation: $10,000 x (0.045 + 1) =

$10,450

The manipulated equation above is simply a removal of the like-variable of $10,000 (the principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25

The above calculation is then equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation means that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Future Value And CompoundingThere are two ways to calculate Future Value (FV): 

1) For an asset with simple annual interest: = Original Investment x (1+(interest rate*number of years)) 

2) For an asset with interest compounded annually: = Original Investment x ((1+interest rate)^number of years) Consider the following examples: 

1) $1000 invested for five years with simple annual interest of 10% would have a future value of $1,500.00.

2) $1000 invested for five years at 10%, compounded annually has a future value of $1,610.51.

When planning investment strategy, it's useful to be able to predict what an investment is likely to be worth in the future, taking the impact of compound interest into

account. This formula allows you (or your calculator) to do just that:

Pn = P0(1+r)n

Pnis future value of P0

P0 is original amount investedr is the rate of interestn is the number of compounding periods (years, months, etc.)

Note in the example below that when you increase the frequency of compounding, you also increase the future value of your investment.

P0 = $10,000Pn is the future value of P0n = 10 yearsr = 9% 

Example 1- If interest is compounded annually, the future value (Pn) is $23,674.Pn = $10,000(1 + .09)10 = $23,674

Example 2 - If interest is compounded monthly, the future value (Pn) is $24,514.Pn = $10,000(1 + .09/12)120 = $24,514

To read more on this subject, see Continuously Compound Interest and Accelerating Returns With Continuous Compounding.Present Value And DiscountingPresent value, also called "discounted value," is the current worth of a future sum of money or stream of cash flow given a specified rate of return. Future cash flows

are discounted at the discount rate; the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations. If you received $10,000 today, the present value would be $10,000 because present value is what your investment gives you if you were to spend it today. If you received $10,000 in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P

variable with present value(PV) and manipulating the equation as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end of year two:

Note that if we were at the one-year mark today, the above $9,569.38 would be considered the future value of our investment one year from now.

At the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value

of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as the future value. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

The present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that

is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future PaymentLet's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. It is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.