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Macroeconomics theories measures economic input, employment, inflation and trade surplus (or deficits). It analyze spending of three segments: Individuals, businesses and government.  Level of activity measured by:

1. Nominal Gross Domestic Product (GDP): Defined as “the price of all goods and services produced by a domestic economy for a year, at current market prices”.
2. Real GDP: The price of all goods and services produced by a domestic economy at price level adjusted (constant) prices.
3. Potential GDP: The maximum amount of production that could take place in an economy without putting pressure on the general level of prices.
4. GDP Gap: The difference between potential GDP and Real GDP. A positive GDP gap indicates that are unemployed resources in the economy, and we could expect unemployment. A negative GDP gap, indicates that economy is running above normal capacity, and we can expect price increases.
5. Net Domestic Product (NDP): Calculated as GDP minus depreciation.
6. Gross National Product (GNP): The price of all product and services produced by labor and property supplied by the nation’s residents.

How to calculate GDP; 2 approaches:

1. The income approach: Add up all incomes earned in the production of final goods and services by household in the economy. I.e. income from wages, interest, rent, dividends etc.  National income, plus indirect taxes, plus compensation on fixed capital, plus payment of factor income to other countries = Gross domestic product.
2. The expenditure approach:  Add up all the economy’s expenditures to acquire final goods and services by households, businesses and the governments. It includes personal consumption expenditures, gross private investment in capital goods,  as well as the country’s net export. Gross domestic product = personal consumption expenditures, gross private domestic fixed investment (by businesses, government), plus government purchase (federal and local) plus net exports.

GDP and unemployment: There is a clear relationship between the change in employment and the economy’s GDP. High output growth will result in decrease in unemployment rate. A recession is a period of negative GDP growth (at least two consecutive quarters of negative GDP growth).

Debt Service Coverage Ratio (DSCR) definition: The ratio of cash available for debt servicing to interest, principal and lease payments. In corporate finance, DSCR refers to the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments. Most commercial banks require 1.15 – 1.35 times ratio to ensure cash flow sufficient to cover loan.

DSCR Formula: Net Operating Income / Total Debit Service

Fixed Charge Covenant definition: Use as a measured of debt ratio, the fixed charge coverage ratio indicate the company’s ability to satisfy fixed financing expenses, such as interest and leases. Commercial banks usually require businesses to maintain fixed charge coverage ratio of not less then 1.20 to 1.00. EBIT= Earning before interest and taxes; Net operating income Fixed charge = Expense+ Rent Exp+ current portion of LTD + Capital expenditure).Fixed Charge Covenant

Formula: (Net Operating Income + Fixed Charge) / (Interest + Fixed charge)

Liabilities to Net Worth Covenant: This ratio measure the company’s ability to cover its liabilities. It reflects the extent to which a company’s net worth (the value of its tangible assets) can offset the total liabilities. Formula: Total Liabilities / (Equity – Total Liabilities). In this ratio, we deduct intangible assets from the total assets.

The balance between debt and Equity: Capital structure refers to the relative proportions of a company’s different funding sources, which include debt, equity and hybrid instruments such as convertible bonds. A simple measure of capital structure is the ratio of long-term debt to total equity. Long term liabilities defined as loans that are given for a period greater then one year.
According to Harper (2009) since the cost of equity is not explicitly displayed on the income statement, whereas the cost of debt (interest expense) is itemized, it is easy to forget that debt is a cheaper source of funding for the company than equity. Debt is cheaper because 1. Creditors have a prior claim if the company goes bankrupt, debt is safer than equity and therefore warrants investors a lower return; for the company, this translates into an interest rate that is lower than the expected total shareholder return (TSR) on equity. 2. The interest paid is tax deductible, and therefore, lower tax bill would increase the net cash for the company.

By: Oren Gulasa

What is derivative? It refers to a financial instrument derived from another asset, or index. Derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset.

What is interest rate Swap? An interest rate Swap occurs when two parties exposed to opposite types of interest rate risk. It a derivative when one party exchanges a stream of interest payments for another’s party stream of cash flows. Interest rate swap often build upon the LIBRE + % (set interest rate).

The Swap agreement sample: A company would make fixed rate payments to the corporation based on a notional amount. The Corporation will pay the company an adjustable interest rate on the same notional amount.

According to the Green Interest Rate Swap Management, swap is a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is known as a fixed-for-floating interest rate swap. On the other hand, both series of cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Very popular money-market swap are the Libor and Commercial paper or Treasury Bills.

At the time the Swap being priced, the future stream of the floating rate is unknown. Never the less, while examining inflation to determine future interest rates trends, we could look at various relationships between interest rates and future period of time (i.e. yield curve).

The assets structure model help in finance decisions of how we get money, based on the capital structure of the company. The business assets provide us with Operating Cash Flow, which is primarily used to pay / finance one or portion of the following:

1. Debt: meet obligation for creditors; pay capital and interest on loans.
2. Taxes: meet tax obligations required by Federal Govt. and State Taxes.
3. Equity: Cash then used to pay dividends or re-invest in the company.

Capital structure and value of ownership: In the business world, every decision should be viewed as maximizing value for the firm’s owners. The company engaged in business first and foremost in order to make money. Increase value of ownership is the basis for business growth. The board of directors aims to increase profit for the shareholders/ business owners and maintain value of business. The board can take a decision not give dividend in a certain year (and re-invest all the profits) as long as in the long run, the value of the company increase, and thus the value of ownership.

Stockholders equity reflects the capital structure of the company. In a corporation’s capital structure there is a distinction between the money earned by the company, also known as retained earnings and the initial investment made by the corporation owners, known as common stock. Together, the retained earnings and common stock are parts of the stockholders equity section in the balance sheet.

Common stock: Refers to the main principle stock that is issued by companies to stockholders, which defines in monetary terms the ownership of investors in the company also known as preemptive rights and the share of dividends (% of total $ in the event of dividends distribution) according to Eisen Peter, (Accounting, 5^th Edition, 2007 p. 388). It has considerably greater number of shares authorized because it’s lower par-value (minimum $ value assigned by the company) makes it affordable to more investors.

The second class of stock is known as preferred stock which usually has higher price and thus, would give investors better conditions and protections. The main tow advantages of being preferred stock owner would be privilege of getting dividends first, before common stockholders, in the event of dividends distribution and an assets protection. Some preferred stock could include cumulative preferred stock rights which would grant stockholders dividend distribution for past years, if the company skipped one or more years in which dividend hasn’t been distributed, before distribution to common stockholders occurs.

Treasury stocks: a special act when company buys back its own stock. One of the reasons for reacquiring the company’s own stock would be the intention to increase earning per share (EPS). Simply because less stock in the market would drive stock price increases. Another reason is to reduce chance to takeover by other company / individual (who plan to buy stock). Since stock could be given as dividend (stock dividend) a company would buy its own stock and use it Increase value of ownership; mainly because it would be a tax efficient way to give cash to owners.  Lastly reacquiring the company’s own stock will keep the $ value of stock price, which owned by business owners/ directors etc.

 Notes from finance class with Dr. Cooper. C, J&W University, 2008; by Oren Gulasa