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

2. 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

3. 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

4. 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

5. 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

6. 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

7. “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

8. 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