Financial Market Theory Tuesday, August 29, 2017 Professor Edwin T Burton

Readings, So Far (Available on Collab) You should have already read Malkiel, “A Random Walk Down Wall Street” During last week, you should have read Chapters One and Two This week, you should read Chapters Three and Four August, 29, 2017

Debt and Equity – What Do These Terms Mean? Balance Sheet As of August 29, 2017 Assets Liabilities (Debt) Net Worth (Equity) Assets = Liabilities + Net Worth = Debt + Equity August, 29, 2017

Debt is the simpler concept Debt is what you owe: bank debt, outstanding bonds, payables (things that you owe but have not paid for yet Typically has a “fixed” return – interest payments, principal payments Usually non-participating in any profit stream, other than the “contractual” payments If payments aren’t received, then a “default” occurs, leading to bankruptcy proceedings. Bankruptcy usually means the holders of debt take over and those who own equity lose everything August, 29, 2017

Equity is what is left over after payments to debtors Could be negative Could be anything (unlimited upside) Public company limits losses to amount of equity owned Partnership may mean unlimited liability – even for activities of “other” partners Public company means that shares are issued and sold to the public. Buyer and seller of “public” equity usually don’t know one another (anonymous trading for the most part). A company that is not a public company is usually a sole proprietorship or a partnership Some private companies have limited liability like public companies (Subchapter S Corporation (S Corp), Limited Liability Partnership (LLC), Limited Liability Company (LLC) August, 29, 2017

Public Equity “Public Equity” values the equity on the balance sheet. The balance sheet numbers are “accounting” entries. Public values change every second Public equity comes in the form of: shares of stock and a price per share of stock (these stocks are called “common stock”) These shares trade every day, usually on “stock exchanges” like the NYSE (the New York Stock Exchange) Book versus Market (usually these are quoted on a per share basis Book is total equity on the balance sheet divided by the number of shares of stock outstanding Market is price per share Total Market value is outstanding shares times price per share “Enterprise Value” is Total Market Value plus value of outstanding debt (total liabilities) August, 29, 2017

“Return” to Equity is a “Residual” Return “Residual” means what is left after paying making interest and principal payments Return to public stocks = Capital Gain (or loss) Plus Dividends Capital Gain = Price at End of Period Minus Price at Beginning of Period If the above is negative, then the gain is actually a Capital Loss August, 29, 2017

Bankruptcy Usually a change in ownership Equity owners lose everything Debt holders take over At a later time, the new owners (the previous debt holders) may create new equity and new debt in exchange for outstanding debt. This creates a new balance sheet with new equity and new debt Reduces interest payments that the company would have to pay Could permit the company to “emerge from bankruptcy” Bankruptcy process over seen by the courts August, 29, 2017