Mutual Funds

• Open-end fund - An investment company that stands ready to buy and sell shares at any time
• Closed-end fund - An investment company with a fixed number of shares that are bought and sold only in the open stock market
• Net Asset Value (NAV) - The value of assets less liabilities held by a mutual fund, divided by the number of shares outstanding

To quantify as a regulated investment company, the fund must follow three basic rules:

1. It must in fact be an investment company holding almost all of its assets as investments in stocks, bonds, and other securities
2. Limits the funds to using no more than 5% of its assets when acquiring a particular security
3. The fund must pass through all realized investment income to fund shareholders

Types of Expenses and Fees

• Frond end load - A sales charge levied on purchases of shares in some mutual funds
• No-Load funds
• Offering Price = NAV + load
• Back-end load - Charges levied on redemptions

Money Market Mutual Fund - A mutual fund specialized in money market instruments. Their NAVs are always $1 per share. A money market fund simply sets the number of shares equal to the fund's assets. As the fund earns interest on its investments, the fund owners are simply given more shares.

Money Market Deposit Account - Banks offering MMMF and FDIC protection

Measuring Cash Flows

• Free cash flow to equity = Net income - (Capital expenditures - Depreciation) - Change in noncash working capital + (New debt raised - Debt repayment)

• Free cash flow to firm = Operating income (1 - Tax rate) - (Capital expenditures - Depreciation) - Change in noncash working capital

The expenses incurred by a firm can be categorized into three groups:

• Operating expenses - like labor and material, which are expected to generate benefits only in the current period
• Capital expenses - like land, building, and equipment, which are expected to generate benefits over multiple periods
• Financial expenses - such as interest expenses, which are associated with the use of nonequity financing

Misleading accounting measures of earnings:

1. The inclusion of capital expenses such as R&D in the operating expenses
2. Financial expenses such as operating leases expenses that are treated as operating expenses

Capitalized R&D Expenses:

• To capitalize and value research assets, we make an assumption about how long it takes for R&D to be converted, on average, into commercial products. This is called the amortizable life of these assets
• Once the amortizable life of R&D expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset

Value of the research asset =

=> Adjusted book value of equity = Book value of equity + Value of the research asset

=> Adjusted operating income = Operating income + R&D expenses - Amortization of research asset

=> Adjusted net income = Net income + R&D expenses - Amortization of research asset

Techniques for Managing Earnings

• Planning Ahead
• Revenue recognition
• Book revenues early
• Capitalize operating expenses
• Write-offs
• Use reserves
• Income from investments

Adjustments to Income

• One-time expenses or income that is truly one-time
• Expenses and income that do not occur every year but seem to recur at regular intervals
• Expenses and income that recur every year but with considerable volatility
• Items that recur every year that change signs - positive in some years and negative in others

Reinvestment Needs

• Two components go into estimating reinvestment:

1. Net capital expenditure
2. Investment in working capital

Net Capital Expenditure :-

• In estimating net capital expenditure, we generally deduct depreciation from capital expenditure
• The positive cash flows from depreciation pay for at least a portion of capital expenditures and it is only the excess that represents a drain on the firm's cash flow
• When estimating the capital expenditures to use for forecasting future cash flows, we should normalize capital expenditures

Method I: by averaging capital expenditures over a number of years

• Estimate the average capital expenditures over the last four or five years for a manufacturing firm and use that number rather than the capital expenditures from the most recent year
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