Corporate Finance Test #1

Annual Report Is Issued once a year by a corporation and contains basic financial statements and an analysis of past performance and future prospects.
Balance Sheet Provides a quantitative summary of a company’s assets, liabilities, and net worth at specific point in time.
Statement of Cash Flows Give details about the company cash at the beginning of the year and what is left at the end of the year, including some details about where the cash was generated and where was used during the course of the year.
Statement of Retained Earnings Detailed changes in the capital receipt from investors in exchange for stock (paid-in capital), donated capital, and retained earnings
Income Statement Is divided into two important parts: operating and non-operating sections; also known as the profit and loss statement
What financial statement shows how profitable a firm has been? Income Statement
What financial statement shows how how much of the firm earnings are left as balance after the firm pays out dividends to its shareholders? Statement of Retained Earning
If compensation for senior management is based on short-term performance of a firm, in the short run the firm is likely to: Overstate its earnings
How do you calculate the book value per share of common stock? Total Common Stockholder’s Equity / Number of Common Shares
Free cash flow (EBIT (1 – Tax rate) + Depreciation and amortization) – (Capital expenditures + Change in net operating working capital)
Market value added (MVA) Market value of common stock outstanding – Book value of common stockholders’ equity
Economic value added (EVA) (EBIT (1 – Tax rate)) – (Total invested capital X After-tax cost of capital)
If a firm has a lot of net cash flow, does that mean the firm’s balance sheet cash account musth be high? No
Operating Activity Operating activities are the functions of a business related to the provision of its offerings. These are the company’s core business activities, such as manufacturing, distributing, marketing and selling a product or service. Operating activities should generally provide the majority of a company’s cash flow and largely determine whether a company is profitable.
Investing Activity Cash flow from investing activities is an item on the cash flow statement that reports the aggregate change in a company’s cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries and changes resulting from amounts spent on investments in capital assets such as plant and equipment.
Financing Activity A category in a company’s cash flow statement that accounts for external activities that allow a firm to raise capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock. Cash flow from financing activities shows investors the company’s financial strength. A company that frequently turns to new debt or equity for cash, for example, could have problems if the capital markets become less liquid.
Financial Management Financial management, also called corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value. The same principles apply to both for-profit and not-for-profit organizations; and as the title suggests, much of this book is concerned with financial management.
Capital Market Capital markets relate to the markets where interest rates, along with stock and bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together “savers” who have money to invest and businesses, individuals, and other entities that need capital for various purposes. Governmental organizations such as the Federal Reserve System, which regulates banks and controls the supply of money, and the Securities and Exchange Commission (SEC), which regulates the trading of stocks and bonds in public markets, are also studied as part of capital markets.
Investment Investments relate to decisions concerning stocks and bonds and include a number of activities: (1) Security analysis deals with finding the proper values of individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to hold diversified portfolios in order to limit risks, so choosing a properly balanced portfolio is an important issue for any investor. (3) Market analysis deals with the issue of whether stock and bond markets at any given time are “too high,” “too low,” or “about right.” Included in market analysis is behavioral finance, where investor psychology is examined in an effort to determine whether stock prices have been bid up to unreasonable heights in a speculative bubble or driven down to unreasonable lows in a fit of irrational pessimism.
Market price Perceived investor cash flows, perceived risk
Intrinsic value True investor cash flows, true risk
Undervalued Intrinsic value > Market price
Overvalued Intrinsic value < Market price
Managers vs. stockholders – Compensation packages for managers should be sufficient to attract and retain able managers, but they should not go beyond what is needed. Compensation policies need to be consistent over time. Also, compensation should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so that managers have an incentive to keep the stock price high over time. When the intrinsic value can be measured in an objective and verifiable manner, performance pay can be based on changes in intrinsic value. However, because intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.- It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth than their stockholders’ wealth; therefore, managers might pay themselves excessive salaries.- Effective executive compensation plans motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages, (2) firing of managers who don’t perform well, and (3) the threat of hostile takeovers.
Stockholders vs. bondholders (creditors) Conflicts can also arise between stockholders and debt-holders. Debt-holders, which include the company’s bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two groups, to the extent that stockholders are typically more willing to take on risky projects.
Stockholders vs. society Higher level Pollution rates or Lay offs in order to raise stock price.
Difference between stakeholder and stockholder – Stakeholders are creditor’s- Stockholder can be stakeholder
Direct transfer Direct transfers of money and securities, as shown in the top section, occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who, in turn, give the firm the money it needs. This procedure is used mainly by small firms, and relatively little capital is raised by direct transfers.Not Common
Financial Markets People and organizations wanting to borrow money are brought together with those who have surplus funds in the financial markets. Note that markets is plural; there are many different financial markets in a developed economy such as that of the United States. We describe some of these markets and some trends in their development.
Physical asset vs. financial asset markets Physical asset markets versus financial asset markets. Physical asset markets (also called “tangible” or “real” asset markets) are for products such as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, and mortgages. Financial markets also deal with derivative securities whose values are derived from changes in the prices of other assets. A share of Ford stock is a “pure financial asset,” while an option to buy Ford shares is a derivative security whose value depends on the price of Ford stock.
Spot vs. futures markets Spot markets versus futures markets. Spot Markets are markets in which assets are bought or sold for “on-the-spot” delivery (literally, within a few days). Future Markets are markets in which participants agree today to buy or sell an asset at some future date. For example, a farmer may enter into a futures contract in which he agrees today to sell 5,000 bushels of soybeans 6 months from now at a price of $9.75 a bushel. To continue that example, a food processor that needs soybeans in the future may enter into a futures contract in which it agrees to buy soybeans 6 months from now. Such a transaction can reduce, or hedge, the risks faced by both the farmer and the food processor
Money vs. capital markets Money markets versus capital markets. Money Markets are the markets for short-term, highly liquid debt securities. The New York, London, and Tokyo money markets are among the world’s largest. Capital Markets are the markets for intermediate- or long-term debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard-and-fast rule, but in a description of debt markets, short-term generally means less than 1 year, intermediate-term means 1 to 10 years, and long-term means more than 10 years.
Primary vs. secondary markets Primary markets versus secondary markets. Primary Markets are the markets in which corporations raise new capital. If GE were to sell a new issue of common stock to raise capital, a primary market transaction would take place. The corporation selling the newly created stock, GE, receives the proceeds from the sale in a primary market transaction. Secondary Markets are markets in which existing, already outstanding securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of GE stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market because it deals in outstanding, as opposed to newly issued, stocks and bonds. Secondary markets also exist for mortgages, other types of loans, and other financial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and thus does not receive funds from such a sale.
Private vs. public markets Private markets versus public markets. Private Markets, where transactions are negotiated directly between two parties, are differentiated from Public Markets, where standardized contracts are traded on organized exchanges. Bank loans and private debt placements with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner to which the two parties agree. By contrast, securities that are traded in public markets (for example, common stock and corporate bonds) are held by a large number of individuals. These securities must have fairly standardized contractual features because public investors do not generally have the time and expertise to negotiate unique, non-standardized contracts. Broad ownership and standardization result in publicly traded securities being more liquid than tailor-made, uniquely negotiated securities.
Behavioral finance theory Behavioral finance has been studied in both the corporate finance and investments areas.
Efficient market hypotheses (EMH) The efficient markets hypothesis (EMH) remains one of the cornerstones of modern finance theory. It implies that, on average, asset prices are about equal to their intrinsic values. The logic behind the EMH is straightforward. If a stock’s price is “too low,” rational traders will quickly take advantage of this opportunity and buy the stock, pushing prices up to the proper level. Likewise, if prices are “too high,” rational traders will sell the stock, pushing the price down to its equilibrium level. Proponents of the EMH argue that these forces keep prices from being systematically wrong
Types of stock market transactions – Secondary market- Primary market- Initial public offering (IPO) market
Financial institutions 1. Investment banks (underwriters)2. Commercial banks3. Financial services corporations4. Credit unions5. Pension funds6. Life insurance companies7. Mutual funds8. Exchange traded funds9. Hedge funds10. Private equity companies
Net working capital Current Assets – Current Liabilities
Net Operating Working Capital (NOWC) Current assets – (Current liabilities – Notes payable)
Working capital Working Capital = Current assets
Stockholders Equity Paid-in Capital + Retained Earnings
Sales for Target Profit Total Fixed Expenses + Target EBT / Cont. Margin Percentage
Target EBT Target Net Income / (1 – Tax Rate)
Variable Cost Cost the change
Fixed Cost Cost that are fixed
Statement of cash flows – Operating activities- Investing activities- Financing activities- Non-cash investing and financing activities
Statement of stockholders’ equity – Common stock- Additional paid-in capital- Retained earnings- Treasury stock

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