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ACADEMY OF AMERICAN AND INTERNATIONAL LAW

An Introduction to Accounting and Finance for Lawyers Prof. Stanley Siegel, NYU Law School

Copyright 2015, Stanley Siegel

Note on source materials and their use in this outline This is a slightly abbreviated outline of a full course on Law & Accounting that is offered annually at NYU Law School. The first part of the outline is based – as a “case study” – on the Annual Report on Form 10K of Hewlett-Packard Company for the fiscal year 2014, which is available to you in your course materials. A further source of financial and corporate data concerning Hewlett-Packard is its 2014 proxy statement, which also available to you. An overview discussion of each course topic appears in a recent short course text, C.H. Meyer, Accounting and Finance for Lawyers (5th ed., West Nutshell Series). You might find that text a handy outline for later reference. At the beginning of each discussion unit, there appear one or more citations to the Financial Accounting Standards Board Accounting Standards CodificationTM [hereinafter "FASB ASC" or the "Codification"], a codification and complete replacement of all official pronouncements of Generally Accepted Accounting Principles ["GAAP"], effective for all periods ending after September 15, 2009. You will have academic access to the Codification during the Academy through use of the following website sponsored by the American Accounting Association, which is password-protected: http://aaahq.org/FASB-GASB Please use the following user-name and password for access to the codification: User ID: AAA52756 Password: FF3tG6a PLEASE NOTE: I have obtained an academic site license for access to this database. Sharing of the password or using it for non-academic purposes is forbidden, and would result in loss of access to the Codification for me and for all of my students. Please honor this limitation.

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Part I – Overview and Basic Principles

Unit 1: Introduction – Accounting Principles and Auditing Standards Sources: FASB ASC Topic 105 [Generally Accepted Accounting Principles]. FASB ASC, Notice to Constituents (v. 4.0), About the Codification. Text: Meyer, Chapter 3, Generally Accepted Accounting Principles. Meyer, pp. 477-483, Accounting Rules in Other Countries. I. The Importance of Understanding Financial Accounting: A. A preliminary note on financial and tax accounting: 1. Financial accounting and tax accounting are different. 2. What is the basis for the differences? 3. To what extent is financial accounting relevant to tax issues? B. The fundamental importance of understanding financial accounting and auditing: 1. GAAP-based financial statements are the principal source of data. 2. GAAS is the fundamental method of assurance of reliability. 3. Most of what is relevant – for all financial, analytical, tax and regulatory purposes – can be found in the statements, notes or supplementary data. 4. Accounting culture and practice are the keys to understanding the content of the financial statements. II. The Legal Framework: A. State law: 1. Regulation of licensing of accountants. 2. General absence of accounting and reporting requirements.

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B. Federal law: 1. The regulatory power of the Securities & Exchange Commission:

• Regulatory power over auditing and accounting. • The history of SEC regulation: the SEC as gadfly. • The core accounting regulations: S-K, S-X. • Continued expansion of SEC regulation.

2. Increased federal accounting regulation under Sarbanes-Oxley. 3. Potential political intervention into accounting standards setting. 4. Accounting and the Internal Revenue Service.

• Absence of an IRS body of accounting principles. • Why tax and financial accounting should be similar. • Why tax and financial accounting must sometimes differ.

C. The legal basis for accounting principles and auditing standards: 1. Accounting and auditing outside the United States:

• Treaty-based legal rules on accounting and auditing. • Statutory principles of accounting and auditing.

2. The unique United States structure: • Auditing standards developed by the profession. • Accounting principles by the profession and independent

bodies. III. Generally Accepted Accounting Principles (GAAP) – a Work in Progress: A. The history of the development of definitive GAAP – original sources: 1. Accounting Research Bulletins (ARB’s). 2. Opinions of the Accounting Principles Board (APB’s). 3. Statements of Financial Accounting Standards (FAS’s). B. Problems with the early standards: 1. Erratic, problem-based development. 2. Conflicting and overlapping standards; absence of a hierarchy. 3. The contrast with International Financial Reporting Standards (IFRS). 4. The movement toward international harmonization and "principle- based" standards.

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IV. The FASB Accounting Standards Codification: A. The new hierarchy – FASB ASC Topic 105: 1. All definitive GAAP included; all other sources non-definitive. 2. In theory, at least, no substantive changes in the codification. 3. Inclusion of SEC definitive statements, with limitations. B. The new structure – FASB ASC, Notice to Constituents: 1. At core, an on-line based, near-real-time standards compilation. 2. Searchability by topic, by words, by aggregation of topics and sections. 3. The concept of codification: parallels to legal codes. 4. Citation form. C. Implications of the Codification: 1. Simplification; avoidance of inconsistency and overlap. 2. Completing the body of standards: gaps in coverage revealed. 3. Movement toward principles-based standards. 4. Harmonization with IFRS: is this an attempt to maintain the primacy of U.S. GAAP? V. Generally Accepted Auditing Standards (GAAS): A. The nature of audit and audit regulation: 1. The profession: licensing, regulation, review. 2. Definitive GAAS for nonpublic companies: the Auditing Standards Board of the AICPA. 3. Standards applicable to registered companies: the Auditing Standards of the PCAOB. B. The standards of Generally Accepted Auditing Standards: 1. General standards, including competence, supervision, independence. 2. Field work standards, including internal control, evidentiary matter. 3. Reporting standards.

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Unit 2: The Financial Statements: Balance Sheet and Statement of Income Sources: Hewlett-Packard Company Form 10-K (2014), pages 84 - 86. FASB ASC Subtopics 210-10 [Balance Sheet – overall], 225-10 [Income Statement – overall]. Text: Meyer, Chapter 1, The Basic Financial Statements. I. Introduction: A. The principal financial statements. 1. Balance sheet, or statement of financial position. 2. Statement of income. 3. Statement of cash flows. 4. Statement of stockholders’ equity. B. Some general observations: 1. Multiple years disclosed and audited:

• Two years of balance sheets. • Three years of income statements and cash flows. • Comparative data as an analytical tool.

2. Consolidated financial statements. 3. Notes are an integral part of the financial statements. 4. Balance sheet and income statement are “articulated.” C. Realization and recognition in financial accounting: 1. The realization concept.

• Transaction-based recording and reporting. 2. Items that do not appear on the financial statements:

• Non-purchased assets, e.g., self-generated inventions. • Gain contingencies. • Contract rights and obligations not yet “realized.”

3. An alert to recent developments that alter these core concepts: • “Fair value” in recent accounting principles. • The call for greater disclosure of self-generated assets.

D. For whom are the financial statements prepared: 1. The US view: investors and creditors. 2. The IAS view: multiple users. 3. Which view is more sound?

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II. The Balance Sheet: A. The left and right sides: 1. Assets. 2. Liabilities. 3. Net Worth. B. Current assets: 1. Cash and cash equivalents. 2. Short-term investments. 3. Accounts receivable and estimated uncollectibles. 4. Inventories, cost basis, and lower-of-cost-or-market. C. Property, plant and equipment: 1. Cost basis. 2. Depreciation and amortization; impairment. D. Other assets: 1. Long-term investments. 2. Intangibles. 3. Goodwill. E. Liabilities: 1. Current liabilities, and current portion of long-term debt. 2. Analytical tools: the current ratio. 3. Long-term debt. 4. Deferred taxes. F. Stockholders’ equity: 1. Common and preferred stock. 2. Additional paid-in capital. 3. Retained earnings. III. The Statement of Income: A. Gross profit or gross margin: 1. Revenues. 2. Cost of sales. 3. Analysis of gross profit. B. Earnings from operations: 1. Operating expenses. 2. Research and development expenses. 3. Analysis of earnings from operations.

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C. Net earnings: 1. Financial expenses and income: interest, investments, etc. 2. Provision for income taxes. 3. Extraordinary items. D. Earnings per share: 1. The complexity of calculation. 2. Variations: dilution, extraordinary items.

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Unit 3: The Financial Statements: The Statement of Cash Flows Sources: Hewlett-Packard Company Form 10-K, page 87. FASB ASC Subtopic 230-10 [Statement of Cash Flows – overall]. I. Net Income vs. Cash Flow – The Differences and Their Consequences: A. Net income: 1. Realization, recognition and periodic allocation. 2. Matching of costs against related revenues. 3. Timing of cash flows usually – but not always – ignored. 4. Effects of choice of differing accounting principles. 5. Effects of judgment differences in applying accounting principles. 6. Current criticisms of variability in accounting principles & judgments. B. Cash flow: 1. Apparently simple concept: cash in, cash out. 2. Direct and indirect measurement of cash flow. 3. Major difference: non-cash allocations and charges. 4. The operational relevance of cash-flow. 5. Does cash flow avoid the criticisms/defects of net income? II. The Statement of Cash Flows: A. Direct and indirect cash flow calculations. B. Categories of cash flow and their relevance: 1. From operating activities – reconciliation with net earnings. 2. From investing activities. 3. From financing activities. C. Cash flow as a test of real earnings and earning power: 1. Net loss companies with positive cash flows. 2. Net losses combined with negative cash flow; e.g., e-commerce. III. Other Cash Flow Concepts: A. Cash flow as a test of asset impairment. B. Discounted cash flow as an asset/enterprise valuation method.

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Units 4-5: Other Disclosures: Audit Report; Notes to the Financial Statements; MD&A Sources: Hewlett-Packard Company Form 10-K, pages 81 - 83 (audit reports), 89 - 169 (notes); 42 - 77 (MD&A); Exhibits 31, 32 (certifications). FASB ASC Subtopic 235-10 [Footnotes – overall]. Text: Meyer, Appendix A, The Sarbanes-Oxley Act of 2002. I. The Report of Independent Auditors: A. “We have audited . . .”: 1. Audit report speaks as of the date it is signed. 2. Audit is of the listed financial statements. 3. Company management is responsible for the statements. 4. Auditor’s responsibility is to express an opinion. B. Auditing standards of the PCAOB: 1. Reasonable assurance of absence of material misstatements. 2. Examination of evidence on a test basis. 3. The implications of sampling. C. Opinion of auditors: 1. Financial statements present fairly. 2. In all material respects. 3. In conformity with generally accepted accounting principles. D. Qualification of opinion: 1. Scope limitations. 2. Disclosure and GAAP questions. 3. “Going concern” qualification. 4. Negative opinion or denial of opinion. II. The Notes to the Financial Statements: A. Notes are an integral part of financial statements: 1. Notes are audited. 2. Disclosures under GAAP may be in statements or notes. 3. Contrast notes with MD&A, commentary, etc. B. Note 1: summary of significant accounting policies: 1. Provides detail on which GAAP were applied, and how. 2. Some – but not all – judgments are explained. C. Earnings per share calculation.

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D. Financial details on material transactions: 1. Investment gains and losses. 2. Discontinued operations. 3. Acquisitions and divestitures. E. Detailed disclosures on components of the financial statements: 1. Balance sheet: inventory, fixed assets, long-term investments. 2. Financial instruments, including derivatives. 3. Leases and financing receivables. 4. Borrowings. 5. Income taxes. 6. Capital structure. F. Supplementary financial disclosures: 1. Comprehensive income. 2. Cash flow details. 3. Retirement and post-retirement benefits. 4. Litigation and contingencies. 5. Material post financial-statement events. G. Segment information. III. Management’s Discussion and Analysis of Financial Condition and Results of Operations (the “MD&A”): A. Introduction: 1. MD&A is not required by GAAP, but by SEC regulation. 2. Therefore, MD&A is generally available only from public companies. 3. MD&A is not audited, but is subject to “review.” 4. MD&A is not addressed in the Codification. B. Results of operations. 1. Detailed review by category of revenue and expense. 2. Detailed segment information. C. Risk disclosures: 1. Liquidity and capital resources. 2. Factors that could affect future results: risk factors.

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Part II – Selected Current Issues

Unit 6: Inventory Accounting: Sources: Siegel, Inventory Cost Calculator (Excel Spreadsheet) FASB ASC Subtopic 330-10 [Inventories – overall]. Text: Meyer, Chapter 6, Accounting for Inventories. I. Inventories – Determination of Cost: A. Manufacturing inventories – components of cost: 1. Direct materials. 2. Direct labor. 3. Overhead. 4. Allocation methods and cost accounting. B. Merchandising inventories – inventory flow conventions: 1. FIFO – first-in, first-out. 2. LIFO – last-in, first-out. 3. Weighted average. 4. Why does GAAP allow variations in inventory principles? II. Inventories – Balance Sheet Value: A. Lower-of-cost-or-market: 1. Calculation of the cost of inventory: see above. 2. Market: replacement cost presumed. 3. Market: not to exceed net realizable value. 4. Market: no less than net realizable value less normal profit margin. 5. Criticisms of lower-of-cost-or-market. B. Change of inventory method or other accounting principles: 1. No restatement of earlier financial statements. 2. Disclosure of change and its effect on net income and balance sheet. 3. The problem of consistency.

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Units 7 – 8: Accounting for Fixed Assets – Depreciation and Asset Impairment: Sources: Siegel, Depreciation Calculator (Excel Spreadsheet). FASB ASC Subtopic 360-10 [Property, Plant, and Equipment – overall]. Text: Meyer, Chapter 7, Property, Plant, and Equipment and Depreciation. I. Fixed Assets – Determination of Cost: A. Initial acquisition cost: 1. Cost basis – upward revaluation prohibited. 2. Purchase price; donations of assets; assets acquired for stock. 3. Installation costs, training, interest expense, etc. B. Depreciation – allocation of cost to expense over time [FASB ASC ¶¶ 360-10- 35-1 to 360-10-35-14]: 1. Estimates of useful life and residual value. 2. Straight-line depreciation – by time, units or other measures. 3. Accelerated depreciation, primarily double-declining-balance. 4. Change of depreciation method. 5. Depreciation for tax purposes. 6. Change of depreciation methods. 7. Non-depreciable assets: land. C. Other similar cost-allocation concepts: 1. Depletion. 2. Amortization. D. Repairs and capital improvements: 1. Income effects of expensing vs. capitalization. 2. Criterion: extension of utility or useful life. 3. Depreciation recalculated for current and future years. E. Balance sheet disclosure of fixed assets: 1. Original cost. 2. Accumulated depreciation. 3. General information on depreciation methods and useful lives.

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II. Impairment of Long-Lived Assets [FASB ASC ¶¶ 360-10-35-15 to 360-10-35-49]: A. The original rules (before 1995 and original SFAS 121): 1. Long-lived assets reflected at cost less depreciation/amortization. 2. When useful life or utility declined, depreciation schedule was changed. 3. Write-down of fixed assets was extremely rare. B. The genesis of the new rules: 1. Major business and bank failures following the real-estate boom of the 1980’s. 2. Non-performing real estate (and other leased assets), secured by non- recourse debt. 3. Little or no disclosure of impairment of assets or associated debt. C. The new rules: 1. Impairment defined: carrying value of an asset exceeds its fair value. 2. Recognition required when carrying amount is not recoverable and exceeds the fair value of the asset. 3. The test: does the sum of the undiscounted cash flows expected from the asset exceed its carrying value? 4. When is testing for impairment appropriate: significant decrease in market value, operating or cash flow losses, adverse change in legal factors, etc. 5. New cost basis: fair value. 6. Discounted present value of cash flows is often the best available technique for revaluation of impaired assets. 7. After impaired assets are written down, they may not be revalued up. D. The moral of the story: 1. Accounting is still a work in progress. 2. Major accounting reform usually follows financial disasters.

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Unit 9: Leases and Off-Balance-Sheet Financing Sources: FASB ASC Subtopics 840-10 [Leases – overall], 840-20 [Operating Leases], 840-30 [Capital Leases]. Text: Meyer, Chapter 11, Accounting for Leases. I. Financial Objectives of Off-Balance-Sheet Financing: A. Keep assets – and related liabilities – off the financial statements: 1. Avoid disclosure of significant liabilities. 2. Favorable effect on financial statement ratios. 3. Avoid potential violation of loan and other covenants. B. Obtain full use of the assets through effective financing: 1. Long-term use may be equivalent to ownership. 2. Financing terms equal to – or better than – direct borrowing. C. From the lessor’s viewpoint: 1. Spread out recognition of gain or loss on effective sale. 2. Obtain desirable contract with possibly non credit-worthy buyer/lessee. 3. Maintain legal title, with superior rights to secured creditor. II. GAAP Lease Rules – Substance Governs Over Form: A. Operating vs. capital leases – distinctions for lessor and lessee. B. When is a lease capital – the four criteria: 1. Transfer of title at the end of the lease term. 2. Bargain purchase option at end of the lease term. 3. Lease term at equal to 75% or more of asset useful life at inception. 4. Discounted present value of minimum lease payments at least 90% of fair market value of property at inception.

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III. Accounting for an Operating Lease: A. Accounting by the lessee: 1. Lease payments recorded as rental expense when accrued/paid. 2. No other reporting on the financial statements. B. Accounting by the lessor: 1. Lease receipts recorded as rental revenue when accrued/received. 2. Property remains on books of lessor. 3. Depreciation expense recorded periodically on property. IV. Accounting for a Capital Lease: A. Accounting by the lessee: 1. Property recorded as purchased: asset shown on balance sheet. 2. Liability recorded equal to discounted present value of lease payments. 3. Periodic lease payments recorded as payments on a level-payment loan, including interest. 4. Depreciation expense recorded periodically on the property. B. Accounting by the lessor: 1. Treatment not necessarily parallel with lessee’s accounting treatment. 2. Lease must first be characterized:

• Sale-type lease • Direct-financing lease • Leveraged lease

3. Transaction treated as a sale of the asset with long-term, level-payment financing. 4. Periodic lease receipts treated as payments on the loan plus interest. V. Additional Disclosures: A. Notes to the financial statements disclose both capital and operating leases. B. Lessee discloses commitments on operating leases.

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Unit 10: Accounting for Investments Sources: FASB ASC Subtopic 320-10 [Investments – overall]. FASB ASC Subtopics 323-10 [Equity Method and Joint Ventures – overall], 323.30 [Partnerships, Joint Ventures, and Limited Liability Entities]. FASB ASC Subtopic 820-10 [Fair Value Measurements and Disclosures – overall]. FASB ASC Subtopic 810-10 [Consolidation – overall]. Text: Meyer, Chapter 9, Accounting for Investments. I. The Categories of Equity Investments: A. Portfolio investments – generally less than 20% of the stock of a company. B. Equity method investments – generally between 20% and control. C. Controlling investments – application of consolidated accounting required. II. The Equity Method: A. Investments entered at original cost. B. Adjustment of investment carrying value and net income for proportionate share of income and loss. C. Dividends and other distributions reflected as reduction of investment. III. Consolidated Accounting: A. Financial statements combined, item-for-item. B. Difficulties with foreign exchange translation. C. Elimination of inter-company accounts. D. Accounting for minority interests in consolidated subsidiaries. E. The problem of creditors and investors in consolidated subsidiaries. IV. The New Accounting for Investments in Debt and Equity Securities: A. The Original Rules, prior to 1993: 1. Debt generally held at amortized cost. 2. Equity securities valued at aggregate: lower of cost-or-market, with write-up permitted back to original cost, but no higher. B. The Genesis of the New Rules: 1. The same circumstances as impairment of long-lived assets. 2. But the FASB opened Pandora’s infamous box. 3. What they found was – for accounting – revolutionary.

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C. The New Rules: 1. The three methods of accounting for investments: (i) Current investments – FASB ASC Subtopic 320-10. (ii) The equity method – FASB ASC Subtopics 323-10, 323-30. (iii) Consolidated statements – FASB ASC Subtopic 810-10. 2. Three categories of investment, determined largely by intent: (i) Held to maturity (debt only) (ii) Available for sale. (iii) Trading securities. 3. Held to maturity to be valued at amortized cost, subject to impairment test. 3. Available for sale and trading securities subject to new rules: (i) Carried on the balance sheet at fair value. (ii) Gains and losses reflected on the financial statements. (iii) For trading securities gains and losses are recognized directly in the income statement. (iv) For available for sale securities, gains and losses are reflected in a separate category of comprehensive income. D. What is revolutionary: 1. Application of fair value and mark-to-market:

• There was precedent, but only for downward revaluation, e.g., inventory.

• No clear guidance as to how to pick market values in a volatile exchange market.

2. New concept of “comprehensive income” for certain gains and losses. 3. Intent-based characterization of assets and accounting for them. E. What comes next: 1. Fair valuation of derivatives and financial instruments. 2. Problems of volatility: FASB chose the most volatile assets to subject to the mark-to-market rule. 3. Will other assets and liabilities ultimately be subject to similar rules?

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Units 11 - 12: Business Combinations and Intangible Assets Sources: Siegel, Illustrative Problem & Spreadsheet on Acquisition Accounting. FASB ASC Subtopics 805-10 [Business Combinations – overall], 805-20 [Identifiable Assets and Liabilities], 805-30 [Goodwill or Gain From Bargain Purchase]. FASB ASC Subtopics 350-10 [Intangibles – overall], 350-20 [Goodwill]. Text: Meyer, Chapter 15, Accounting for Business Combinations; Chapter 8, Intangible Assets. I. Background: Old Accounting and the Purchase vs. Pooling Distinction: A. Accounting Principles Board Opinion No. 16: 1. The effects of pooling of interests: -- Carry-over of old asset basis. -- Combination of earnings history and retained earnings. -- Avoidance of creation of goodwill on acquisition. 2. The desirability of pooling of interests: -- Avoiding significant additional charge against net income. -- Goodwill as an ephemeral and undesirable asset. B. The effects of purchase accounting: 1. Assets valued at purchase price. 2. Step-up in values of tangible assets. 3. Recording of acquired intangible assets. 4. Increased financial statement values not necessarily matched by tax deductibility. C. Substantive effects of the accounting distinction: 1. Transactions structured to maximize the likelihood of pooling treatment. 2. Pooling treatment became a “deal breaking” issue. 3. International differences in accounting. II. New Rules on Business Combinations: A. Rules apply to business combinations irrespective of form: 1. The combining entities may be of any form. 2. The business combination may take any form.

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B. Purchase accounting is mandatory: 1. Acquiring entity applies purchase accounting to acquired entity. 2. Assets recorded at cost, equal to the fair value of consideration transferred. 3. Aggregate cost is allocated among acquired assets, including tangible assets and intangibles other than goodwill. 4. Basic rule of cost allocation: all assets valued at fair value. 5. Goodwill is recorded:

• Aggregate cost of acquired assets, less • Aggregate amount assigned to other assets.

C. These rules are comparable to International Accounting Standards. III. Goodwill and Other Intangibles: A. The old rules: 1. Intangibles with determinable useful life amortized over useful life. 2. Intangibles with indefinite useful life – including goodwill – amortized over a period not to exceed 40 years. 3. Intangible amortization included in calculating net income from operations. B. The new rules: 1. Intangibles – other than goodwill – are recognized if they:

• Arise from contractual or other legal rights, or • Are separable.

2. Intangibles are valued initially at cost, or at fair value in an aggregate acquisition. C. Amortization of non-goodwill intangibles: 1. Amortization over useful life, normally straight-line. 2. Useful life may be indefinite – resulting in non-amortization – but there is a high presumption against indefinite life. 3. Intangibles to be reviewed for impairment.

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D. Amortization of goodwill: 1. Presumption of non-amortization of goodwill. 2. Write-off – in whole or in part – based only on impairment of the “reporting unit.” 3. Any impairment loss reduces net income from operations, unless the loss is based on discontinued operations. E. What happened – why were these unusual rules adopted? 1. Compare international accounting standards: mandatory amortization of goodwill, generally over a maximum 20 year period. 2. American industry strongly opposed mandatory purchase accounting, because of the corresponding mandate to amortize goodwill. 3. Eventually, industry got its way: mandatory purchase, but no mandatory amortization. 4. The effect: goodwill write-off may be indefinitely deferred, until impairment. 5. But the piper has to be paid: look at goodwill – and other intangible – impairment write-offs in the last two years.

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Part III -- Elements of Contemporary Corporate Finance Unit13: Key Concepts of Corporate Finance -- Cash Flow, Risk and Return I. The Importance of Contemporary Financial Theory: A. At the theoretical and societal level, we seek to understand how the "invisible hand" of Adam Smith governs the markets. Our reason: to help us determine what legal structures are essential, or desirable, to regulating those markets. B. A key insight: totally free -- i.e., unregulated -- market is unworkable. C. At the individual level, we seek tools to help our clients evaluate investment and other decisions. Contemporary financial theory offers a variety of methods for determining values. II. The Core Concept -- Valuation by Cash-Flow Analysis: A. The difference between finance and accounting: valuation based on projection of future performance contrasted with reporting on past performance. B. How cash flow differs from net income, and the relevance of the difference. C. The cash flow diagram: timing, amounts and risks of future cash flows. Discounting of cash flows. Are we missing anything when we use the discounted cash flow analysis? D. How are future cash flows predicted? How do we account for risk or variability of future cash flows? How do we address the problem that cash flows cannot be predicted into the indefinite future? III. The Problem of Determining the Discount Rate: A. The historical data establish a clear relationship between risk and return in the capital markets: higher risk carries higher return. Early models -- e.g., Dewing -- applied this relationship (very roughly) in valuing investments.

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B. The Capital Asset Pricing Model (CAPM) assumes that there is a straight- line (linear) relationship between the relative riskiness of an investment and the expected return of that investment. It quantifies the relationship between risk and return based on three factors: 1. The market risky return rate, or rm. 2. The risk-free return rate, or rrf. 3. A standardized measure of risk, or β (beta). 4. The formula: re = rrf + β (rm - rrf). C. The CAPM remains the most widely used method for determining risk- based discount rates, and therefore for determining project/investment value. However, empirical research raises questions of its precision and accuracy in practice. D. Within the past decade, there has been increasing application of any of several multi-factor formulas for determining return rate. These formulas -- known collectively as the Arbitrage Pricing Theories (APT) -- usually apply three or four factors to determine a risk-adjusted return rate. Among the factors: expected inflation, expected growth in the gross national product, and variations between long-term and short-term interest rates. E. These methodologies are -- of course -- not perfect. But they represent the state-of-the-art in determining valuation under conditions of uncertainty, and are widely used and respected. Moreover, empirical testing of them has confirmed, to some degree at least, our conceptions of how the market actually works.

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Unit 14: Key Concepts -- Market Efficiency I. Market Efficiency Defined: A. The basic argument of market efficiency: the financial market rapidly adjusts for ("impounds") information that is relevant to the price of stock, bonds and other financial instruments. The implications -- which are often disputed -- of this theory are that market prices should be trusted, and that no advantage can be gained by studying the information that has affected the market, since the prices already include that information. B. The three major arguments -- or "forms" -- of the Efficient Market Hypothesis: 1. Weak Form: the market rapidly incorporates all past price movements in the present price. Therefore future movements are not affected by the past, and so-called "technical analysis" of price movements is worthless in predicting the future. This argument is supported by many empirical studies. 2. Semi-Strong Form: the market rapidly incorporates all public information in the present price. Therefore, nothing can be gained by so-called "fundamental analysis' -- i.e., study of the financial statements -- since the price already reflects all relevant data therein. There are many empirical studies supporting aspects of this argument, but it is not beyond dispute. 3. Strong Form: argues that the market rapidly incorporates all relevant information -- public or not -- into the prices of stocks, bonds and other financial instruments. The empirical data rejects this argument definitively. II. Questions About Market Efficiency: A. How efficient is "efficient"? How quickly does the market move in response to various inputs? B. Is market movement always rational? How does market efficiency explain -- or account for -- bubbles and busts? Herein of the new literature on behavioral finance. B. There are many demonstrations -- and they have spawned a collection of complex trading strategies -- that the market is not efficient below a threshold of about 15 minutes. This, interestingly, gives us some strong insight into how the market becomes efficient.

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C. Market efficiency, and the conditions required to make it effective, affects significantly the nature of the required and desirable regulation of capital markets.

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Unit 15: Options and Other Derivative Financial Instruments I. The Building Blocks of Finance: A. Four building blocks are the "atomic particles" of all financial instruments: S pure stock B pure discount bond C call on a share of stock S P put on a share of stock S These building blocks each have a unique "payoff" curve, which makes each one different in substance from the others. Thus, a call option on a share of stock is fundamentally different from the share of stock (the "underlying" asset) on which it is written. B. It can be demonstrated -- both in theory and in practice -- that the price (or value at any given time) of a call option will be affected by five factors: 1. The price of the underlying stock. 2. The strike price of the option. 3. The term of the option 4. The risk-free market interest rate. 5. The total risk (both systemic and idiosyncratic) of the underlying stock. One immensely important insight concerns factor 5: As the risk of the stock increases, the price of a call option on the stock increases. This fact has important implications for corporate governance. C. Key to an understanding of derivatives is that they are risk-shifting arrangements, in which one party "buys" risk, and the other "sells" (or avoids or minimizes) risk. D. Contemporary financial theory has developed several option pricing models, which have proved highly accurate in practice. These include not only the famous Black-Scholes Option Pricing Model, but also the more general Binomial Option Pricing Models