Download net consumer surplus - Warrington College of Business

DEMAND
1
1.
At a price of $0.040, how many kilowatt-hours (kwh) will be purchased?
2.
At a price of $0.055, how many kilowatt-hours will be purchased?
3.
At a price of $0.060, how many kilowatt-hours will be purchased?
4.
At a price of $0.045, how many kilowatt-hours will be purchased?
5.
At approximately what price will 300 million kilowatt-hours be purchased?
6.
At about what price will 600 million kilowatt-hours be purchased?
7.
What trend do you observe on the Demand Curve?
8.
Would you expect the Demand Curve for all products to look the same? Why or
why not? Give examples to support your position.
2
CHANGES IN DEMAND
Assume that electricity has a price of $0.045/kwh.
How would the demand or quantity demanded for electricity change if:
a.
the price of electricity dropped by $0.010/kwh?
b.
the price of gas (a substitute) decreased?
c.
a recession hits the country and people’s incomes decrease?
d.
the electricity distribution grid expands into a new region?
3
NET CONSUMER SURPLUS
Net consumer surplus measures how much value consumers receive from consuming the
good beyond what they paid for it. In general, economists look for regulatory policies
that improve net consumer surplus.
A SIMPLE EXAMPLE:
I am extremely thirsty and I see a soda machine that sells sodas for $0.75/can. I
would pay $3 for the soda, but I only have to pay $0.75 for it. Thus, my net
consumer surplus from buying the soda is $2.25 (= $3.00 - $0.75).
We can apply this concept to all the consumers of a good.
This chart shows the net consumer surplus when the price is $0.050/kwh.
a. Draw the new net consumer surplus if the price of electricity falls to $0.004/kwh.
b. Identify the change in net consumer surplus from this price decrease.
c. How would your answer to (b) change if the price initially was $0.040/kwh and
rose to $0.045/kwh?
4
Price Elasticity of Demand
You have already learned that when price rises, the quantity demanded falls and when price falls, the
quantity demanded rises. While it is useful to know the direction of movement of quantity as price changes,
it is also important to know the magnitude of the change. A firm may decide to increase the price of a
product if customers consume only slightly less at a higher price, but not to increase the price if customers
consume much less at the higher price. This magnitude of change in quantity demanded with change in
price is known as price elasticity of demand. A good or service has an elastic demand when the quantity
demanded is extremely responsive to changes in price. A good or service has an inelastic demand when the
quantity demanded responds little to changes in price.
To ascertain whether or not a good or service has an elastic or inelastic demand curve, we examine several
determinants. Items that are considered necessities tend to have very inelastic demand schedules. Even
when the price of a necessity increases, people are unable to easily consume less of the product. For
example, in the United States, gasoline is considered a necessity. When the price of gasoline rises, the
quantity consumed does not significantly decrease. Luxury items often have very elastic demand curves. As
the price of these items rise, consumers tend to purchase much less of them. Goods and services with very
close substitutes have elastic demand because as the price of these goods rises, consumers will purchase
goods that function as their substitutes. For example, if customers consider hot dogs and hamburgers
reasonable substitutes, then if the price of hot dogs increases significantly customers will purchase much
fewer hot dogs and more hamburgers.
Instructions: Try to determine whether the demand for the following items is price elastic or inelastic. Try
to justify your answer with a reason in the space provided.
1.
Water
2.
New watch
3.
Popcorn
4.
Vacation to Florida
5.
Insulin
6.
Pizza from Pizza Hut in Gainesville
5
Elasticity of Demand and Changes in Total Revenue
One of the ways economists use the elasticity of demand is to predict what will happen to total revenue if
we change the price. (Recall total revenue is simply the price we charge multiplied by the number of units
we sell.)
Specifically,
If we increase the price: ● if demand is inelastic, total revenue will increase
● if demand is elastic, total revenue will decrease
If we decrease the price: ● if demand is inelastic, total revenue will decrease
● if demand is elastic, total revenue will increase
Directions: For each problem, calculate the initial total revenue, the new total revenue, indicate the
direction of the change in price and total revenue (, , or no change) and write whether the demand for the
item is elastic or inelastic.
Ex: Price rises from $5 to $6. Quantity demanded decreases from 15 to 10.
Old total revenue: $5 X 15 = 75
New total revenue: $6 X 10 = 60
P 
TR 
elastic
.
1.
Price falls from $10 to $9. Quantity demanded increases from 100 to 110.
Old total revenue:
$___ X ____ = _____
New total revenue: $___ X ____ = _____
P ____
TR ____
___________
2. Price rises from $6 to $9. Quantity demanded decreases from 60 to 50.
Old total revenue:
$___ X ____ = _____
New total revenue: $___ X ____ = _____
P ____
3.
TR ____
___________
Price falls from $6.50 to $6.00. Quantity demanded increases from 100 to 200.
Old total revenue:
$___ X ____ = _____
New total revenue: $___ X ____ = _____
P ____
4.
TR ____
___________
Price falls from $4.00 to $3.75. Quantity demanded increases from 300 to 340.
Old total revenue:
$___ X ____ = _____
New total revenue: $___ X ____ = _____
P ____
5.
TR ____
___________
Why do price and total revenue go in opposite directions when the demand for the good is elastic and
in the same direction when the demand is inelastic?
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APPLYING ELASTICITY TO THE REAL WORLD
INSTRUCTIONS: Each of the following stories contains an assumption about elasticity
of demand. For each story:
a
State whether you believe the assumption made about the elasticity of
demand is correct or wrong.
b
Justify your answer.
1.
I. M. Politico, a candidate for the parliament, is proposing a large increase in the
tax on cigarettes and liquor. He says, “I’m not proposing these taxes to raise
revenue but to discourage reckless drinking and the filthy smoking habit. If the
prices of cigarettes and booze go up, most people will quit using them. After all,
no one needs to drink or smoke.”
2.
U.R. Kool, also a candidate for parliament, proposes freezing the price of
electricity. “There is no substitute for electricity,” he says. “People have to light
their houses and run their machinery. Economists who say higher prices will
discourage people from buying as much electricity as before don’t live in the real
world.”
3.
Domestic Services Minister Vic Acqua opposed a price increase for water during
a recent drought. He claimed that there is no substitute for water, and that
therefore the demand for water is inelastic. He believes an increase in the price of
water (water taxes) will result in the same quantity of water used as before the
price went up.
4.
Sky King, world traveler, says if the airlines want to attract more passengers, they
should lower fares for business travelers as well as for vacationers. Both groups
should respond equally to a price decrease.
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HOW COMPETITION AFFECTS ELASTICITY OF DEMAND
As we saw above, one of the main determinants of the price elasticity of demand is the extent to which
substitutes are available. For example, one of the reasons why the demand for insulin is very inelastic is
that there are no substitute goods available for those who have diabetes. If there were a substitute available
for insulin, one would imagine the demand for insulin would be more elastic (although it could still be
inelastic on whole).
Competition by many producers has a similar effect. Until recently, BellSouth was the only provider of
local phone service for Gainesville and consumers consider local phone service to be essential. In the days
before cellular phone service, there were very few substitutes for BellSouth local phone service. Therefore,
the demand for BellSouth local phone service was inelastic. However, now there are other companies that
provide local phone service and furthermore cellular phones are available and reasonably priced. In effect,
there are now substitutes available to BellSouth’s local phone service. As a result, the demand for
BellSouth’s local phone service is more elastic even though the market demand for local phone service in
general (wireline plus wireless) remains inelastic.
Generally, we expect competition to increase the elasticity of demand. Competition generates substitutes
for a firm’s product and therefore tends to make the demand for it more elastic. We will see later that this is
one of the beneficial aspects of competition.
8
SUPPLY
9
1. How many kwhs will generators want to supply at the following prices?
a. $0.045
b. $0.055
c. $0.035
2. What price is necessary to make generators willing to supply at least 400 million
kwh/month?
3. What happens to the Supply chart if:
a.
The price of fuel used for generation decreases?
b.
Labor wages increase?
c.
New environmental restrictions are imposed on the generating company?
d.
Interest rates decrease?
10
NET PRODUCER SURPLUS
The net producer surplus measures how much firms are receiving for the good beyond
what it cost them to make it. (If you think this sounds very much like profits, you’re right.
We’ll make the connection later.)
This chart shows the net producer surplus when the price is $0.050/kwh.
a. Now assume that the price of electricity falls to $0.040/kwh. Draw the new
net producer surplus.
b. Identify the change in net producer surplus from the decrease in price.
c. How would your answer to (b) change if the price was initially $0.040/kwh
and rose to $0.045/kwh?
11
COMBINING SUPPLY
AND DEMAND
12
1.
Identify the equilibrium price and quantity.
2.
A surplus is shown on the graph at a point _______ the equilibrium.
a. below
c. at the right of
b. above
d. at the left of
3.
A shortage is shown on the graph at a point ______ the equilibrium.
a. below
c. at the right of
b. above
d. at the left of
4.
In what direction will the surplus force prices?
5.
In what direction will the shortage cause prices to move?
What happens to the equilibrium price if:
a.
The price of fuel used for generation decreases?
b.
Labor wages for the electricity operator increase?
c.
A recession hits the country and people’s incomes decrease?
d.
The price of gas ( a substitute) decreases?
13
NET CONSUMER AND PRODUCER SURPLUS
We can also now combine net consumer surplus and net producer surplus on the same
graph.
Net
Consumer
Surplus
Net
Producer
Surplus
14
COST CONCEPTS
15
Cost Concepts
Definitions of cost and methods of relating prices and costs
total cost -- Generally refers to the value of all the inputs consumed by the company, but
is sometimes used to refer to only an enterprise, service, or increment of output for the
company.
 When the term is used for something less than the whole company, there should be a
modifier attached, such as “the total cost of producing an additional megawatt of
electricity.”
 Total cost may be defined in accounting terms or economic terms. This is explained
next.
embedded cost -- the money actually expended by the company; also called original cost,
historical cost, or accounting cost in some contexts.
 Embedded costs are generally found in the company’s accounting records.
 Embedded costs are the foundation of the accounting approach to costing.
current or forward looking cost -- the money that would be expended if the inputs were
purchased in the current time period, or some future time period. This is also often
referred to as economic cost. Economic cost is the foundation for the economic approach
to costing.
 Economic costs are opportunity costs. Opportunity costs are money that a company
or person gives up, whether they ever physically had the money or not. Opportunity
costs include explicit costs plus, for example, money a company could have made by
producing services that have higher value.
profit
 Accountant definition -- In normal business usage, profit is revenues minus explicit
costs. Explicit costs are out-of-pocket costs such as wages, utility expenses, interest,
and rent.
 Economist definition -- Profits over and above a normal earnings level. Also called
economic rents.
Basic approaches to pricing
fully distributed cost (FDC) -- The allocation and assignment of costs by account to
service categories.
 Assignments are generally restricted to direct costs. Allocations are based on
allocators that are believed to be related to cost causation, or are reasonable.
direct cost -- Generally used in the context of accounting costs, but some people are
starting to use this term when referring to economic costs. Refers to the cost of inputs
that are only needed to provide a specific service or set of services. Generally is limited
to resources that have their own identity for accounting purposes; i.e., their own account
or subaccount.
16
common costs
 accounting definition -- the cost of inputs that are shared by more than one output;
e.g., a telecommunications central office switch
 economic definition -- costs that are not avoided by some difference1 in output; does
not include joint costs
joint costs -- The cost of inputs that, once placed into production, necessarily produce
more than one product in fixed proportions. There are very few joint costs.
shared costs -- joint and common costs. There are two major types:
 shared incremental costs -- shared costs that are specific to only some services. For
example, some consumer services may have shared costs in consumer billing, but
these costs are not shared with business services.
 overhead shared costs -- shared costs that are shared by all services. These are costs
that do not change or go away unless the company goes out of business. The classic
example is the president's desk, but it's not a perfect example because the desk's cost
tends to grow with the company.
Shared costs result from economies of scope. Economy of scope is one of four forms of
production economies.
 A company has economies of scope if it is less expensive for a single company to
produce two or more products than for 2 or more companies to produce them.
 A company has economies of scale if increases in production create decreases in
average cost.
 A company has economies of vertical integration if it is less expensive for the
company to produce both the input and the final product than to produce either: (1)
the input only and sell the input to another company; or (2) the final product only,
purchasing the input from another source.
 Economies of scope and economies of vertical integration are two forms of
economies of joint production.
 Economies of density exist when customers are sufficiently close to each other (such
as in the case of urban customers) to make their marginal costs lower than the
marginal cost of the average customer.
Understanding these economies of production is important for regulating prices that
affect which companies will be in which markets and each company’s market share.
incremental cost pricing -- prices that are equal to incremental cost. When prices are
equal to short-run marginal cost, also called first-best pricing or marginal cost pricing.
 incremental costs -- Costs that can be avoided with some difference in output. That is
to say, the extra cost of doing something versus not doing it. The term has little
1
The term "difference" is used rather than "change" to ensure that the focus is on the burden an increment
places on the resources of the firm. If a cost could be avoided, it is part of the incremental cost for purposes of
regulatory costing.
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
meaning without a modifier saying what that something is. Generally it is meant to
describe the extra cost of providing a service versus not providing it.
A related concept is avoided cost -- the costs that are avoided, or can be avoided, by
changing the business in some way. Avoided cost is generally applied to a change in
the service -- for example, for estimating the costs avoided because of IPP power.
Avoided cost is often used to establish differences between wholesale and retail
prices, establish USO costs, and set prices for IPP power.
Long run versus short run
Economists differentiate between cost measures by differentiating between long-run costs
and short-run costs.
 long run means that everything about the company can be changed. For example, in
the long run, new fiber optic cables and all associated facilities can be added in
response to increased sales of local loops. So a cost measure that assumes that the
company can optimize all of these facilities is a long-run cost.
 short run means that something about the company is fixed -- i.e., it cannot be
changed by the company to lower its costs. What this something is must be defined
for the term short run to have a precise meaning.
 total service long run incremental cost (TSLRIC) -- the costs that would not be
incurred were the firm not offering the service or services in question. TSLRIC is the
same as the economist definition of direct cost.
 TSLRIC is the sum of the usage sensitive costs caused by the service and servicespecific fixed costs. This is also called long run service incremental cost (LRSIC),
total service incremental cost (TSIC), long run incremental cost-total service (LRICTS) or direct incremental cost.
volume sensitive costs or usage costs -- costs that vary with output.
fixed costs -- costs that do not vary with output. Fixed costs are higher in the short run
than in the long run because more costs can be varied in the short run. Long-run fixed
costs are sometimes called getting started costs or first unit costs. Service-specific fixed
costs are fixed costs that are caused by only one service.
sunk costs -- costs that cannot be avoided. Sometimes used to describe embedded costs
because these are monies already spent. Other times used to describe monies that have
not been spent, but that will be even if the company goes out of business. An example
would be termination clauses on contracts.
service-specific fixed costs -- fixed costs are costs that do not vary with output. Servicespecific fixed costs are fixed costs that are caused by only one service.
The FCC in the USA has developed the term total element long run incremental cost
(TELRIC) to describe the TSLRIC of a network component.
stand-alone cost -- The total cost of a specialized company producing only the service or
services in question.
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

For example, the stand-alone cost of providing water to residential customers would
be the total cost of a company that provided only sufficient pumping, processing,
distribution, etc., to serve residential customers and produced nothing else.
Stand-alone costs include all of the usage costs and service-specific fixed costs for the
service or services in question, the shared costs that are needed only by the service or
services in question, and the shared costs that are needed by the service or services in
question plus those that may be shared with other services not included in the standalone cost estimate. In other words, if we were estimating the stand-alone cost of
services A and B, and companies also tend to offer service C, then the stand-alone
cost of A and B is:
Usage costs of A
Usage costs of B
Fixed costs of A
Fixed costs of B
Costs shared by A & B, but not C
+ Costs shared by A or B with C
Stand-alone cost of A & B
19
Part B. Marginal Cost Problem.
Fill in the blanks.
Output, Total Cost, and Marginal Cost
Output
Total Cost (TC)
0
55
1
85
2
110
3
130
4
160
5
210
Marginal Cost (MC)
Part C. Graphing Problem.
Graph these marginal costs on the graph Plotting Marginal Cost of Mobile Phones. MC is
on the vertical axis, and output of mobile phones is on the horizontal axis. Plot MC
between output levels.
Plotting Marginal Cost of Mobile Phones
Cost
60
55
50
45
40
35
30
25
20
15
10
5
0 1
2
3
4
5
6
Output of Mobile Phones
1. What is the relationship between MC and output as shown on your graph?
2. Explain why MC falls and then rises as output increases.
20
Part D. Charting and Graphing Costs.
Complete the chart Fixed and Variable Costs of Mobile Phones. Assume that the firm
has a total fixed cost (FC) of $60 and total variable costs (VC) as shown below. Part of
the chart has been completed for you.
Fixed and Variable Costs of Mobile Phones
Total
Product
FC
VC
TC
0
$60
$0
$60
1
$60
$45
2
$60
$85
3
$120
4
$150
5
$185
6
$225
7
$270
8
$325
9
$390
10
$465
MC
AFC
AVC
ATC
$105
$45
$60.00
$45.00
$105.00
$145
$40
$30.00
$42.50
$72.50
1. Graph FC, VC, and TC on the graph Total Fixed, Total Variable, and Total Costs.
Graph all three cost curves on one graph. Cost is on the vertical axis, and output of
mobile phones is on the horizontal axis. Label each curve.
a. What is the difference between fixed and total costs?
b. Why does VC rise as output increases?
c. Why is FC a horizontal line?
d. Why does the TC curve have the same slope as the VC curve?
21
FINANCIAL VALUATION
22
Basic Steps in Valuation:
1. Estimate future cash flows.
2. Determine appropriate risk-adjusted discount rate.
3. Find value by discounting expected CFs.
Value =
k=
CFn
CF1
CF2

...
1
2
(1  k ) (1  k ) (1  k ) n
investor’s required return.
Depends on risk, general level of interest rates, etc.
An Example: Privatization

Government is contemplating the privatization of utility services.

Bidding firms will receive cash flows that are based on the strength of
the market, the firm’s operating strength, and the regulatory climate.

These elements also affect the timing and risk of the cash flows.
23
Valuing 3 Projects @ 10% (Illustrating Timing Differences)
Project
1
2
3
CF1
100
150
50
CF2
100
100
100
CF3
100
39.51
160.51
PV
248.69
248.69
248.69
Assessing the 3 Projects

While the three projects have the same present value, different
stakeholders may view these payoffs very differently:
-differences in perceived cash flows
-differences in perceived risk
-differences in horizon
24
APPENDIX
25
Appendix 1
DEFINITIONS
Pure/Perfect Price Competition. This is an idealized market with so many buyers and sellers that no one
buyer or seller can have a noticeable influence on the
market. All firms make or produce the same product (the same quality) and the only reason to buy one
product over another is the price. Each buyer and seller is
so small in the total picture that no one acting alone can create any noticeable change in total supply or
demand. Pure or perfect competition seldom exists. It is
difficult to find producers who sell exactly the same standard product to a large number of buyers at a
standard price. Certain agricultural products are examples of
pure price competition. In a pure-competition market, suppliers can only decide the best quantity to offer at
the market-determined price.
Monopolistic Competition. There are a large number of firms of different sizes offering very similar
products (or services). This term—combining monopoly with
competition—means there are many firms, yet they seek to offer their products for sale by appeals so
unique or special that consumers will buy only their brand.
Monopolistic competitors have some price control (depending upon their ability to differentiate or
distinguish their product), yet they must operate in a market where
there are many others eager to duplicate or improve these product qualities. With monopolistic
competition, there is both price and nonprice competition. By
nonprice competition we mean service, convenience, trading stamps, attractive facilities, improved quality,
etc.
Oligopoly. This is where a few large firms produce most—or all—of the output of an industry. (An
example is the aluminum industry.) A large percentage of a
commodity or service of a total industry is produced by a few large firms. In the aluminum industry in the
United States, for example, 100% of the aluminum is
produced by four firms. This kind of concentration causes each firm to react to what rival firms do.
Oligopolies often try to avoid competing on the basis of price,
but rely on nonprice competition or cartel agreements.
Monopoly. A monopoly exists where there is only one active seller in a market. Some firms are called
“natural monopolies”. The reasoning behind this concept is
that one single, larger company may provide better service at a lower cost to the public than multiple,
smaller companies.
26
Appendix 2
Characteristics of the Four Basic Market Models
CHARACTERISTICS
PURE
MONOPOLY
OLIGOPOLY
MONOPOLISTIC
COMPETITION
Number of Firms
One
Few
Many
Type of Product
Unique, no close
substitutes
Control over Price
Considerable
Ease of Entry
Blocked
Non-price
Competition
Mostly Public
Relations
Advertising
Degree of Regulation
May be regulated
by
the government
Competition Law
Very little
Very little
Examples
Electricity
Distribution
Steel, shipping,
aluminum,
chemicals
Retail trade,
automobiles,
appliances, and fast
food
Agriculture
Standardized or
Differentiated
Differentiated
Mutual
Some, within narrow
Interdependence
limits
Significane
Relatively Easy
obstacles
Large amount, with
Considerable emphasis
product
on advertising, brand
differentiation
names, etc.
paramount
27
PERFECT
COMPETITION
A Very Large
Number
Standardized
None
Very easy, no
obstacles
None
Appendix 3
Calculating the Rate of Return on Investments
Let's say you invest $100 in stock, which is called your capital. One year later, your
investment yields $110. What is the rate of return of your investment? We calculate it by
using the following formula:
((Return - Capital) / Capital) × 100% = Rate of Return
Therefore,
(($110 - $100) / $100) × 100% = 10%
Your rate of return is 10%.
There are two ways to measure the rate of return on an investment.


Average annual rate of return (also known as average annual arithmetic return)
Compound rate of return (also called average annual geometric return)
A simple example below will show what these two yardsticks measure.
You initially invest $100. One year later, your investment grows to $200 in value. The
year after that, the investment drops back to $100. The rate of return after the first year is
((Return - Capital) / Capital) × 100% = Rate of Return
(($200 - $100) / $100) × 100% = 100%
The rate of return after the second year is
(($100 - $200) / $200) × 100% = -50%
28
By using the formulas for calculating the average annual rate of return, we get a
percentage that measures gains accurately over only a short period. Whereas, the
geometric or compound rate of return is a better yardstick to measure your investment
over the long run. The arithmetic mean or average return should be used to calculate
return on investment only in the short-term.


Average annual return (arithmetic mean) = (Rate of Return for Year 1 + Rate of
Return for Year 2) / 2 = (100% + (-50%)) / 2 = 25% (Arithmetic return = 25%)
Compound return (geometric mean) = (capital / return) ^ (1 / n) - 1 where n =
number of years. The formula is (100 / 100) ^ .5 - 1 = 0%. (Geometric return =
0%)
Note : Mutual fund managers report the average annual rate of return (arithmetic) on the
investments they manage. As shown in the above example, the arithmetic return of the
investment is 25%, even though the value of the investment is the same as it was two
years ago. Thus, mutual fund reports are somewhat deceptive.
29
GLOSSARY OF FINANCE TERMS
A
annual report:
The write-ups and financial statements given every year to investors and
inquiring members of the public concerning a corporation's business
asset:
A resource of money value, including cash, accounts receivable, inventory,
real estate, machinery, collectibles, and securities
B
balance sheet:
A firm's financial statement that provides a picture of its assets, debts, and net
worth at a specific time
bankruptcy:
A term that describes the legal process governed by the U.S. bankruptcy
code for companies unable to meet financial obligations
beta:
The indicator used by Value Line to measure a stock's risk relative to the
market, in this case the NYSE Index. The market's beta is always 1.0 (Based
on past statistical records, a beta higher than 1.0 indicates that when the
market rises, the stock will rise to a greater extent than that of the market;
likewise, when the market falls, the stock will fall to a greater extent. A beta
lower than 1.0 indicates that the stock will usually change to a lesser extent
than that of the market. The higher the beta, the greater the investment risk.)
bid price:
The price one is willing to pay for a security
book value per share:
The accounting value of a share of common stock, determined by dividing the
company's net worth by the number of shares that are circulating
buy-and-hold:
A strategy in which the stock portion of one's portfolio is fully invested,
including dividends reinvestments, at all times.
buy and sell orders:
An intent to buy or sell a security
C
call option:
The right given a buyer to buy stock at a specified price within a certain time
period
callable bond:
A bond that can be officially repaid by the issuer prior to its maturity date
(Out of courtesy, a premium is usually paid when the bond is repaid.)
capital gain:
An increase from the purchase price to the selling price of common stock or
any other capital asset; profit from the sale of investments or property (A
capital gain that persists for one year or less is called a short-term capital
gain. Likewise, one that persists for more than one year is called a long-term
capital gain.)
capital loss:
A decrease from the purchase price to the selling price of common stock or
any other capital asset; a loss from the sale of investments or property
cash flow per share:
30
Earnings after taxes and depreciation, divided by the number of a firm's
shares
certificate of deposit (CD):
An interest-bearing bank receipt for a specified amount of money (CD's
usually mature between three months and three years. The interest rate
depends on the amount of money and length of time of the deposit.)
commission:
A broker's fee is given for assisting in buying or selling securities
common stock:
Shares in a company that represent part ownership of that company
compounding:
The paying of interest on the accrued interest as well as on the principal
corporation:
An association of individuals, under authority of law, whose powers and
liabilities are distinct from those of its individual members
current assets:
Assets that can be converted to cash within a year
current liabilities:
Liabilities that must be paid within a year
current ratio:
The worth of a company (contained as current assets, including cash,
accounts receivable and inventory,) divided by current financial liabilities,
including all short-term debts (This ratio roughly measures a company's
financial risk: logically, the more the financial liabilities, the riskier the
company. Thus, small current ratios indicate high risk.)
current yield:
The amount produced by dividing the annual income, both from interest and
dividends, by the current price of the security (Stocks do not gain interest; the
current yield for stocks is equal to the dividend yield.)
cyclical industry:
An industry whose success is closely linked to the rise and fall of the general
economy (The auto industry is a cyclical industry.)
D
debt-to-equity ratio:
The ratio found by dividing long-term debt by the equity (all assets minus
debts) held in stock (This is a measure of financial risk.)
default:
A term that denotes the failure to pay the principal or interest on a financial
obligation (such as a bond).
default risk:
The risk that a company will default, or fail to meet its financial obligations,
i.e., fail to pay the interest or principal on its bonds
depreciation:
The decrease in value due to wear and tear, decay, decline in price, e.g., a
new car purchased at $20,000 depreciates to $5,000 in five years
discount bond:
A bond whose value is less than its face amount
discount broker:
A stockbroker who charges a smaller commission than other brokers, but
provides no counsel in investment
diversification:
The process of buying securities in different investment types, industry types,
risk levels, and companies in order to reduce the loss from a possible
company-local or industry-local loss of business (Diversification is illustrated
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by a famous saying, "Don't put all your eggs in one basket.")
dividend payout ratio:
The ratio found by dividing the annual dividends per share by the annual
earnings per share.
dividend yield:
The yield found by dividing the annual dividends per share by the price per
share (This yield is an indication of the income from a share of stock. Since
return on a stock is comprised of capital gain plus dividends, the total return
is comprised of dividend yield plus the capital gains percentage for stock.)
dividend:
A sum of money, determined by a company's directors, paid to shareholders
of a corporation out of earnings
dollar cost averaging (DCA):
A system of buying securities at regular intervals, using a fixed amount of cash
over a considerable period of time regardless of the prevailing prices of the
securities (DCA protects against the risk of losing a sum of money invested
all at once at an inopportune time, e.g., right before a price drop.)
Dow Jones industrial average (DJIA):
An indicator showing generally how well the market is going, found by
averaging the prices of 30 industrial blue-chip stocks trading in the New
York Stock Exchange
E
earnings per share:
Earnings found by dividing the net income of the company by the number of
shares of common outstanding stock
earnings yield:
Yield found by dividing the earnings per share for the last 12 months by the
market price per share
equity:
(1) Value determined by subtracting debts from assets
(2) An alternate term for stock or similar securities which denote a partial
ownership
F
face value:
The value printed on the face of a stock, bond, or other financial instrument
or document
financial strength:
A company's financial condition as seen by its analysts (Value Line rates
financial strength on a scale from A++ to C.)
financial planner:
An investment professional who helps with financial plans for specific goals
and assists in the coordination of financial concerns
fixed assets:
Any long-term asset, such as a building, tract of land, or patent that will not
be converted to cash within a year
fundamental analysis:
An analysis of stocks based on fundamental factors, such as company
earnings, growth potential, etc., to determine a company's worth, strength,
and potential for growth
G
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going public:
An expression used to describe the first public selling of shares of an
institution that previously sold shares privately
gross domestic product (GDP):
The total value of goods and services produced by a nation. In the U.S. it is
calculated by the Commerce Department, and it is the main measure of U.S.
economic output (In other countries, the GDP is called the gross national
product (GNP).)
H
holding period return/yield:
The yield calculated by dividing the income plus price appreciation during a
specified time period by the cost of the investment
I
income statement:
The financial statement of a firm that presents both revenues and expenses
during a specified time period
index:
A quantity whose variation represents market fluctuation (The Standard &
Poor's 500 index measures the overall change in the value of 500 stocks of
the largest firms in the US.)
industry rank:
Value Line's ranking of a company within its own industry
inflation risk:
The uncertainty of the future real (after-inflation and -tax) value of an
investment
investment adviser:
A professional who, for a fee, manages an investment portfolio
issuer:
One who under writes (issues) and distributes a company's securities
J
junk bond:
A weak bond, rated BB or lower, that has a high default risk, and thus
carries a high interest rate
K
L
liabilities:
The claims of those who have loaned to a company; debts
limit order:
An order to buy stock once the price has dropped below the price limit
liquidity:
The ability or ease with which assets can be converted into cash; also the
degree to which one can obtain the full cash value of an investment
long-term debt:
A debt owed over a relatively long period of time
M
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market capitalization:
The value found by multiplying the number of outstanding common stock
shares by the share price; indicates firm size and total value held in stock
market order:
An order to purchase or sell stock at a current price
market risk:
The movement of a stock price relative to the overall market; indicated by
beta
market timing:
The selecting of the best time for leaving or reentering the market in order to
achieve the maximum result
maturity:
The time a note or bill of exchange becomes due
money-market fund:
A type of mutual fund that invests in short-term securities such as Certificates
of Deposits and Treasury Bills
N
National Association of Securities Dealers Automated Quotations System
(NASDAQ):
A "virtual stock exchange"--that is, a stock market without a trading floor
whose orders are made through a computer network (Usually, high-tech
stocks are listed here.)
net income:
Profit after taxes
net profit margin:
A measure of a company's profitability and efficiency, calculated by dividing a
measure of net profits (operating profit minus depreciation and income taxes)
by sales
net sales:
Amount of sales found by subtracting returns and allowances from money
collected for goods and services
net worth:
Value found by subtracting all liabilities from all assets
New York Stock Exchange (NYSE):
The largest stock exchange in the U.S. located in New York City (Also
known as "Wall Street," this stock exchange carries stocks of
well-established companies on its trading floor.)
New York Stock Exchange index:
A market-value-weighted measure that indicates stock market changes for all
NYSE stocks
O
odd lot:
A lot that is less than 100 shares, or less than a round lot
over-the-counter market:
A communications network, supervised by the National Association of
Securities Dealers (NASD), which trades bonds, non-listed stocks, and other
securities
operating costs and expenses:
The costs and expenses necessary to operate a company; includes
manufacturing, marketing, research and development operating costs
operating income:
The income derived after subtracting operating costs and expenses from net
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sales
operating margin:
A measure of a company's profitability and efficiency, calculated by dividing a
measure of operating profit (sales minus cost of producing goods and
operating expenses) by sales
P
par value (bond):
The face value of a bond, usually $1,000 for corporate bonds, and generally
higher denominations for many government bonds
payout ratio:
The ratio found by dividing the dividends per share by earnings per share
(Shows how well earnings support dividends, or how secure the dividend is.
The lower the ratio, the more secure the dividend.)
portfolio:
The securities an investor holds
premium bond:
A bond whose value is greater than its face value
preferred stock:
Stock whose holders have precedence over common stock in claiming
dividends and assets
present value:
The amount invested at a certain interest rate
price-earnings ratio (P/E):
The ratio found by dividing market price per share by earnings per share
(This ratio indicates what investors think of the firm's earnings' growth and
risk prospects.)
price-earnings ratio to earnings per share growth (P/E to EPS growth):
The ratio found by dividing a stock's price-earnings ratio by its earnings per
share growth rate, indicating the company's profits relative to investors'
expectations
price-earnings relative:
The relative amount found by dividing a stock's price-earnings ratio by that of
the market as given by a widespread market yardstick such as the S&P 500
or the Value Line index (This relative suggests to the investor whether his
investment's price is reasonable compared to the market. Also can be used
for historical comparison with P/E relatives of recent years.)
price-to-book ratio:
The ratio found by dividing a stock's market price per share by its book value
(defined as being assets minus all liabilities) per share (This ratio measures the
stock's value relative to its net assets. A high ratio, for instance, might suggest
that a stock is overvalued.)
price-to-cash-flow ratio:
The ratio found by dividing a stock's price per share by its cash flow per
share (This ratio, similar in type to the price-earnings ratio, serves as a
measure of investors' expectations on a firm's future financial success.)
principal:
The amount owed, invested, or the face value of a debt
private corporation:
A corporation which does not offer stock for public sale (Private
corporations are not required by law to provide information about their
financial conditions.)
public corporation:
A corporation which offers stock for public sale (Public corporations are
required by law to provide information about their financial condition,
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operations, and such.)
profit margin:
The margin found by dividing a firm's post-tax net earnings by sales (Profit
margin measures how well a firm can earn money from sales relative to
others.)
prospectus:
The written statement disclosing the terms of a mutual fund or the offering of
securities
put option:
The right given a buyer to sell stock at a specified price within a specified
period of time
Q
R
real rate of return:
The percentage of return on an investment over one year after adjustments
for inflation or deflation
retention ratio:
The percent of a firm's earnings kept for investment purposes
return:
The sum of the income plus capital gains
return on equity (ROE):
The value found by dividing the company's net income by its net assets (ROE
measures the amount a company earns on investments).
revenue bond:
A municipal bond (muni) backed by the revenue gained from a specific
project such as the building of a stadium
risk/return trade-off:
The compromise made between high- and low-risk investments (High-risk
investments generally generate more earnings, while low-risk ones generate a
lower rate of return.)
risk:
The chance that an original investment might lose value
round lot:
Generally 100 shares, the basic trading unit for stock
S
safety:
Value Line's measure of stock volatility (magnitude of beta), measured from
1 to 5, 5 being most volatile
securities:
A financial that indicated the holder owns a share or shares of a company
(stock) or has loaned money to a company or government organization
(bond)
Securities and Exchange Commission (SEC):
The federal agency that regulates the sale of securities
security analyst:
A person who specializes in evaluating information regarding stocks and
bonds
shareholder:
See stockholder
shareholders' equity:
The sum of preferred and common stock equity held by shareholders
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Standard & Poor's 500 index (S&P 500):
A well-known, value-rated index of 500 major US companies: 400 industrial
firms, 20 transportation firms, 40 utilities firms, and 40 financial firms
stock dividend:
A dividend paid in shares of stock as a substitute for cash (Stock dividends
allow dividends to make money on themselves.)
stock split:
The splitting or dividing of shares to reduce the price needed for the
formation of a round lot (To illustrate, in a 2-for-1 split, when 1 shares splits
into 2, an investor would receive one additional share for each he formerly
owned.)
stockbroker:
A broker who buys and sells stocks and other securities for his customers,
charging commission
stockholder:
A holder or owner of shares of stock; also referred to as shareholder
stop-limit order:
An order placed with a stockbroker to buy or sell at a certain price or better
during a limited period of time
stop-loss order:
An order placed with a stockbroker to buy or sell a designated stock once a
designated price has been reached (This order limits the amount an investor
can lose on that investment.)
T
technical analysis:
The analysis of historical trends of price, volume, and other related market
indicators to aid in predicting future trends; commonly includes tables and
graphs
timeliness:
Value Line's measure of a stock's price performance for the upcoming year
total assets:
The sum found by adding property, plant, and equipment asset values to
current asset values
total debt to total assets:
The ratio found by dividing short- and long-term debts by the total assets of
the firm (This ratio measures a company's financial risk, showing how much
of the firm's property has been financed by debt.)
total liabilities:
The liabilities found by adding current liabilities to long-term debts
trading range:
The range of prices within which a stock is normally traded
transaction costs:
The costs that are brought about by the buying or selling of securities,
including broker commissions and the difference between dealer buying and
selling price (called a dealers' spread)
Treasury bill (T-bill):
A certificate representing a short-term loan to the federal government for
periods not exceeding one year
Treasury bond (T-bond):
A certificate representing a long-term loan to the federal government for
periods exceeding ten years
Treasury note (T-note):
A certificate representing a median-term loan to the federal government for a
duration of between two and ten years
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U
V
valuation:
The process of determining the current value of stock or other assets
Value Line index:
An index representing 1700 equally-weighted companies from the NYSE,
AMEX, and the over-the-counter markets
W
Wilshire 5000 equity index:
A stock market index composed of approximately 7000 securities, including
most issues from NYSE, AMEX, and the over-the-counter markets (This
index formerly consisted of only 5000 securities.)
X
Y
yield to maturity:
The return expected on a bond held until the maturity date
yield:
The value found by dividing the amount of interest paid on a bond by the
price, thus measuring the income from a bond (The term also refers to the
dividend from stock divided by its price. Yield, however, is not a measure of
total return since it does not include capital gains or losses.)
Z
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