Finance 301 Exam 1

Finance involves the management of money-amount, time, risk
Three areas of Finance Corporate Finance- businessesInstitutions and Markets- financial marketsInvestments- investors
corporate finance The activities involved in managing money in a business environment.
institutions and markets Examines the structure of capital markets, the role of financial institutions, the process of financial intermediation and how money flows into the economy
investments focuses on the valuation techniques and how to value alternative investment opportunities that are provided primarily through financial markets and institutions
Capital Markets financial markets where issuers and investors buy and sell debt and equity securities
Companies Raise capital through… selling debt instruments selling stocks/ equity instruments
Debt obligation to repay borrowed money
Stock represents ownership in the company
Effect of Technology made cost of transactions lowermore transactions madecreation of new financial instrumentssophisticated hedging and investing practices
World’s capital markets include a wide variety of organized exchanged where financial claims are traded. Claim’s include… debt, equity, currencies, commodities, and other financial assets.
Economic health Gov-level of interest rates, relative currency values, and performance of the stock markets are a gauge of economic healthFirms- market value of stock is ultimate indicator of performance
International deregulation of past twenty years opened new sources of capital for companies throughout the world.markets tend to function most efficiently in deregulated environments.recent breakdowns in accounting and corporate governance at Enron, Worldcom, adelphia, and Bernie Madoff ponzi schemes, and the crippling effect of the collapse of the credit markets on the commercial and investment banking institutions has shown that regulation and oversight are necessary to reduce corruption, greed, and fraud.
Downside of free flow of capital volatility that may be associated with it.volatility in 2008 at unprecedented levels-stock markets moving 3 to 5 percent per day, extremes of 10 percent.
Three Sets of Decisions The investment decisionThe Financing decisionThe dividend decision
The Investment decision how corporate managers should allocate funds of the company to buy or build projects and investments that will be worth more than they cost
The Financing Decision how corporate managers should raise money from institutional and individual investors through the sale of debt and equity claims for the company to finance the investment projects of the firm
The Dividend Decision the percentage of the company’s profits and cash from operations that the company should reinvest in the business and how much should be returned to the company’s shareholders in the form of dividends
Net Present Value (NPV) is the value associated with investing in a project or venture.
Capital Budgeting valuation, planning, and managing of corporate investments for a firm
Cost of Capital the cost of raising debt and equity for the business
Capital Structure Decision minimizing the cost of capital by using the right mix of debt and equity -is an important role for the finance function of the company
Primary Markets The original sale of securities by governments and corporations
Direct finance A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange.
Secondary Markets Securities that are bought and sold after the original sale
Liquidity the speed and ease with which an owner of a security can sell an investment to another investor or trade it in the securities market
Indirect finance A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers).
Financial intermediation The process by financial institutions of acquiring funds and channeling them to users of funds
Secondary Securities savings and checkings accounts, annuities, insurance policies, pension plans, mutual funds
primary securities stocks, bonds, loans, mortgages, and other financial assets.
Financial Toolbox Financial statements and ratiosPresent value conceptsModel of risk and returnSpreadsheet modeling methods
Financial Statements and Ratio Analysis Investing and financing require projecting sales and expenses as well as fixed and working capital requirements. Current financial position is the base from which these projections are made. For forecasting purposes, financial ratios are commonly used to establish relationships between key financial variables
Present Value Concept Measurement of the time value of money.A dollar today is worth more than a dollar tomorrow
Models of Risk and Return Trade-off between return and risk- a safe dollar is worth more than a risky dollar.- an investor requires higher expected return to invest in riskier investments
Spreadsheet modeling methods spreadsheets programs have become an essential planning tool for modeling investment.
Market Efficiency The stock market is brutally efficient, current prices reflect publicly available information and prices react completely, correctly and instantaneously to incorporate the receipt of new information
Asset Allocation the process of spreading your money among several different types of investments to lessen risk
Diversification A risk management technique that mixes a wide variety of investments within a portfolio.
Risk The chance that an investments actual return will be different than expected. Usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Greater the risk, the greater the reward must be for an investor to invest in it.
Markets Where shares are issued and traded either through exchanges or over-the-counter markets. Also known as the equity markets
Remember to look in book for Questions at end of chapter
CHAPTER 2 Ten basic principles of finance
1. Return Versus Risk Higher Returns require taking more Risk-rational investors prefer to receive a higher rate of return on an investment to a lower return and would rather accept lower risk than more risk in earning that return.
-Rates of return on various assets compound annual return is the preferred measure of return return riskUs Treasury bills – 3.7 , 3.10us treasury bonds – 5.4 , 9.6corporate bonds – 5.9 8.3large company stock – 9.8 , 20.50small company stock- 11.9 , 32.80
-RISK MEANS UNCERTAINTY
-Reversion to the mean The tendency for a particular measure of performance, such as percentage rate of return, to revert to its historical average return.
2. Market Efficiency Efficient Capital Markets are tough to beat
-ECM ECM hypothesis states-the stock market is brutally efficient…
Random Walk hypothesis The theory that stock price movements are unpredictable and thus theres little way of knowing where future prices are headed
Capital Asset Pricing Model The equation of the SML showing the relationship between risk (Beta) and expected return for any given asset
Behavioral Finance models of financial markets that emphasize potential implications of psychological factors affecting investor behavior-challenge the assumptions underlying modern portfolio theory
3. Risk Preference Risk AverseRisk NeutralRisk Taker
Risk Averse investor prefers less risk to more risk.”a bird in the hand is worth two in the bus”
Risk-Neutral pain of losing a dollar is equal to the pleasure associated with winning a dollar
Risk-taker see page 25 investor who enjoys taking risk-the pleasure of winning a dollar exceeds the pain of losing a dollar
4. Supply and Demand the price of a stock is determined by the interaction of the supply curve of stock by potential sellers and the demand curve for stock by buyers
-stocks current price price x number of outstanding shares determines the market cap or total value of the cs of a company.
Market CAP = current stock price * amount shares outstanding
5. Corporate Finance and Governance Managers should make decisions hat maximize the shareholders value.-maximize CURRENT value of stock.
Capital Budgeting the process of planning and managing a firm’s long-term investments in projects and ventures. -must identify invested opportunities that are worth more than they cost to acquire or to fund, so that the present value of the future cash flows generated by an asset exceeds the cost of that asset.DEFINE THE COMPANY
goal of capital budgeting decision to maximize the NPV of the investments that are financed by the firm’s capital budget.-must be concerned with how much cash (amount) they expect from the investment, when (timing) they expect to receive it, and how likely (risk) they are to receive it.
Working Capital Management the managing of short-term assets and liabilities-mananging the structure and amount of the firm’s working capital is a day to day activity that should insure the firm has sufficient resources to continue its operations and to avoid costly financial interruptions.
Goal of the capital structure decision to minimize the weighted average cost of capital of the company
Goal of working capital management to minimize the cost of maintaining the net working capital position of the company
Capital Structure refers to a firm’s specific mixture of long-term debt and equity that uses to finance its operations and investments.
6. Minimizing the Cost of Investing Transaction Costs, Taxes, and Inflation are your enemies-greatly reduce the real returns on your investments.-include brokerage commissions, sales loads, 12b-1 fees, redemption fees when you purchase or sell a mutual fund; and yearly asset management fees paid to a mutual fund, stockbroker, or investment adviser.
-Taxes and cost of investing fed income tax rates of up to 35 percent-long term capital gains are taxed up to 20 percent.
-Tax advantage accounts IRAs, Rother IRAs, and 401 (k) all are tax free
IRA an investors annual contribution to an IRA is tax-deductible if the investors income does not exceed a certain level. Current maximum tax-deductible contribution to an IRA is 5000 dollars. Tax is deferred until the money is withdrawn and at current income.
Roth IRA not tax deductible but allows dividend, interest and capital gains on the investments to compound on a tax-exempt basis. If the investor is at least 591/2 and has invest for at least 5 years he may withdraw money on a tax-free basis.
401 (k) Allows tax-deferred investments to a retirement account. May be matched by employer.
7. Time Value of Money Time and the Value of Money are inversely related-spending money today and receiving cash payments in the future.
Compounding the process of going from today’s value, or pv, to some expected but unknown future value.-multiply by number greater than 1.0 over a number of time periods.
Future Value the amount of money that an investment will grow to at some future date by earning interest at a certain rate.FV= PV (1+r)^n
Discounting The process of finding present value; the inverse of compounding to find future value.DF = 1/ (1+r)^nPV= FV/(1+ r)^n
8. Asset Allocation Some investors maintain a fixed percentage of their funds in asset classes (20 percent cash, 30 percent bonds, 50 percent stocks). -should reflect beliefs about the anticipated risk and return of asset classes. IMPORTANT DECISION TO DETERMINE RANGE OF EXPECTED RETURNSStandard bench mark-10 cash, 35 bonds, 55 cs
9. Diversification Asset Diversification will reduce risk.-spread your wealth among a number of different investments and asset classes.-invest in a group of assets that provides you with the best return possible given a level of risk.
-Diversification tips dont invest in an industry in which you work-bad idea to invest in the stock of his employer-have enough liquid assets to finance six months of expenses and some unforeseen emergencies, and insurance to cover tragedies.
efficient frontier achieving the highest return for each level of risk is known as investing efficiently.-portfolios that are designed with he help of computer modeling and are beyond the scope of this book
Two Types of risk Systematicunsystematic
Systematic Risk the risk of the stock market-changes in stock prices are caused by changes in the economy, taxes, risk, and other market factors.-measured by beta
*Unsystematic Risk specific to a company-risk inherent to a particular stock due to decisions made by a corporation relative to the industry in which it operates-CAN BE REDUCED BY DIVERSIFICATION
Total Risk Total Risk= Systematic + Unsystematic Risk-20 to 25 stocks are sufficient enough to diversify a portfolio
10. Investment Valuation Value equals the sum of expected cash flows discounted for time and risk
Capital Asset Pricing Method a model that estimates the rate of return an investor should expect to receive on a risky asset.-determine discount rate to use when valuing an asset.expected return = risk free rate + risk premiumE(Ri) = Rf + Bi*(E(Rm)-Rf0
Market Risk Premium the difference between the expected return on a market portfolio and the risk-free rate.
Simple Average (interest) when an investment pays interest only on the original principal
Chapter 3
CFO Company officer responsible for managing a corporations finance function.-oversees a corporations working capital decision, the capital budgeting decision and the capital structure decision.
Controller Corporation officer who handles and monitors a corporations accounting and auditing activities.-oversees tax accounting, cost accounting, financing accounting, data collecting/ processing
Treasurer Officer responsible for managing a corporation’s finance function-small companies use term treasurer-large companies use term CFO
Shareholder Value Return that investors receive for their capital. This return is realized through dividend reimbursements, stock buy-backs, and capital gains on stock price increase.-sales, market share, ROE, Profits, Earnings growth, product Quality all effect shareholder value
Corporate Governance Interaction between shareholders and management inter to assure that management uses invested capital to maximize shareholder value-shareholders have limited say in day to day control over company-shareholders have voting rights
Sole Proprietorship (chart on page 56) Form of business organization where a business is owned by one person
Partnership Company formed by two or more individuals-can be general or limited-in general, each partner is liable for the debts of the partnership, shares in the profits and losses.-in limited, the liability to the amount of cash contributed by each partner-not taxed on their income-pay income tax on their share of the partnership.
Corporation Main characterisitcs-limited liability-corporate taxes in addition to personal income taxes-easily transferablesubject to double taxes
Limited/umlimited liability limited- owners are only liable for the amount of cash contributed by each investor.unlimited- owners are liable for an amount greater than their investment in the company
Dividends Earnings distributed to stockholders
Stock buy-back a corporation’s purchase of its own outstanding stock
Capital Gains The difference between a higher selling price and lower purchase price, resulting in financial gain for seller
Free Cash Flows Cash flow available for distrbution to shareholders after paying all corporate taxes
Return on Equity Net income ivied by equity. Ratio measures how efficiently firm utilizes shareholder’s investment dollars.
Stock Options A right- but not an obligation- to buy a stock from the company at a fixed price during a specified time period
Acquisition when one company purchases a majority interest in the acquired.
Divestiture The partial or full disposal of an investment or asset through sale, exchange, closure, or bankruptcy. Divestiture can be done slowly and systematically over a long period of time, or in large lots over a short time periodstrategy whereby a firm sells one or more of its business units
Agency Problem The possibility of conflict of interest between stockholders and management of a firm.-agency costs occur when management does not pursue strategies that maximize shareholder value, or when shareholders incur costs to monitor and realign management decisionsex: private jets, ski chalets, other perks
Stock Split A division of shares of a company into a larger number of shares. (A 2 for 1 split allows a shareholder to double the number of shares but worth one half of their previous value).
Corporate Raider an investor conducting a type of hostile corporate takeover against the wishes of the company
Hostile Takeover A takeover attempt that is strongly resisted by the target firm
Junk Bond a bond with high risk and potentially high yield-considered non investment grade by a major rating agency
Voting Rights Shareholder’s right to vote on the shareholder meeting-stockholders elect the directors of a corp-directors select the managers
Leveraged buy-out a going-private transaction in which a tender offer for all of a firm’s common stock, financed mostly by debt, is made by an investment group-done to beat out the bidder company by allowing management of a target company to buy out public shareholders at a stock price premium and continue to run the companyCAME BACK IN 2000s back much smaller buyouts
Staggered board Defense mechanism against unwanted takeovers-1/4 of the board members are elected each year and serve a four-year term.
Shark Repellent created in the 1980s to defend against hostile takeovers
White Knight company finds a friendly merger candidate
Pac-man Defense Company employs a counter-takeover bid for the raider
Greenmail target company purchases the acquirer’s shares at a premium over the market price to avoid a takeover- forces company to pay out to the acquirer
Golden Parachute Target company provides compensation to top-level executives in the event of a change of corporate control.
Self-tender offer target company agrees to purchase some of the current outstanding shares from its shareholders, usually at a price above what the acquiring company is offering-pay money specifically to current shareholders
Poison Pill Target Company gives current shareholders the right to purchase shares of the company at a bargain price, contingent on another firm acquiring control. Makes stock worth less
Crown Jewel Target company sells off its major assets to make self less appealing to takeover
Proxy Solicitations an attempt to gain control of a firm by soliciting a sufficient amount of votes to replace the existing management
Mutual Fund Most common type of investment company which holds large investment portfolio of assets that is divided up into small “shares” and sold to investors.
Insider Trading illegal practice of using special knowledge about a firm for profit or gain
Institutional Investors Includes commercial banks, investment banks, insurance companies, mutual funds, corporations, governments, and any other large pool of assets that invest in finical markets.
Shareholder Activism Active involvement of shareholder in corporate governance through influencing management decisions.
Command and Control Environment the finance function controlled financial information and was not accountable for overall business performance.-finance department was viewed as the corporate cop whose primary purpose was overseeing company spending and getting the books closed on a timely basis
New Model- competitive team new role involves finance personnel acting as business advocates who are assigned to, and very much a part of , individual business units.-generating and sharing of key financial info to asset in decision making.
Goal of Financial Management To maximize current value of the company’s stockor for non traded stockTo maximize the market value of the existing owner’s equity.
Stakeholders anyone who has a legitimate claim of any nature on a firm and therefore on its economic wellbeing-employees, creditors, customers, suppliers, the communities in which the company operates, and stockholders.
Stakeholders or Shareholders Some people argue that companies should care more about STAKEHOLDERS because they believe firms should be more socially responsible.-create value for SOCIETYhowever we know that shareholder value is the main goal, They own the firms-argument – shareholders are recipients of residual cash flow and stakeholders are protected by contracts
Tender offer an offer to buy shares in a corporation (usually above the market price) for cash or securities or both
Proxy Battle The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes.
Corporate Governance of the 1990s Shareholdings of investor institutions increased-these institutions are sophisticated shareholders who, in pursuit of good stock returns, used their large blocks of stock to influence management.
Securities and Exchange Commission (SEC) In 1992, there was a change in the SEC that relaxed the proxy solicitation rules regarding shareholder communications, which substantially reduced the costs to institutional shareholders of coordinating challenges against underperforming management. SEC required more detailed disclosure of top executives compensation and its relation to firm performance, particularly stock performance
Good Governance At the board level adds 11 percent on average, to the value of the firm.
2000s corporate governance Lack there of.-fraud, greed, ectEnron, Adelphia, Worldcom, Tyco, Xerox
Anglo-American Model – Fluid Capital Model minority shareholders with board, led to takeovers-us model-free of institutional constraints
Japan-Germany Dedicated Capital Model -captial owned by investors who will not trade or sell shares-viewed as long-term capital
Rest of World Majority owners (Governments, family, etc.)-oversees management-might have other motives besides creating investor value
Chapter 4 —-
Financial Accounting accounting information and analyses prepared for people outside the organization-language of numbers-conveys performance to investors, creditors, and public-used internally to establish performance goals
Four Accounting Statements Balance sheetIncome StatementStatement of Cash FlowStatement of retained earnings-all publicly traded companies are required to prepare periodic financial statements so that info is disclosed regular to investors-examined and AUDITED by independent organizations
Balance Sheet a financial statement that reports assets, liabilities, and owner’s equity on a specific date
Income Statement a financial document that shows how much money (revenues) came in and how much money (expenses) was paid out
Statement of Cash flows The financial statement that identifies a firm’s sources and uses of cash in a given accounting period
Statement of Retained Earnings summary of the changes in the retained earnings of a corporation during a specific period
GAAP Generally accepted accounting principles-broad guidelines and standards to make accounting information in financial statements relevant to the types of decisions that readers of the statements make
10-k the SEC required report – filed ANNUALLY within 90 days of a company’s fiscal year-end-includes all financial info, a discussion by the management of the company, and a summary of operations.
10-Q Not required to report-filed Quarterly -contains same info as 10-k but abbreviated
Annual Report fundamental document of communication between management of a corporation and its shareholders.-Three SectionsThe Letter to ShareholdersThe Business ReviewThe Financial Review
The Letter to Shareholders Gives a broad overview of the company’s business and financial performance
The Business Review Summarizes the company’s rent developments, trends, and business objectives
The Financial Review Presents a company’s business performance in financial terms, and includes audited financial statements, management discussion and analysis, and supplementary information
Assets economic resources owned by a firm that are measurable and are likely to produce future economic benefit
Liabilities probable future economic obligations of a firm
Equity A measure of ownership or the residual interest in the assets of a business entity. Equity is equal to assets minus liabilities
Cash Accounts records all cash payments and receipts for a specific time period
Accrual Accounting method of accounting in which income is recorded when earned and expenses are recorded when incurred.
Current Assets cash and other assets expected to be exchanged for cash or consumed within a year
Long-term assets assets with a lifespan of more than a year
Current Liabilities Liabilities due within a short time, usually within a year
Long-term liabilities liabilities owed for more than a year
Equity the owner’s residual interest in the firm.-cs, paid in capital excess par, stocks, treasury stocks, retained earnings
Off-Balance sheet activities Bank activities that involve trading financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets (223, 265).
Revenue Principle The principle prescribing that revenue is recognized when earned.
Matching Principle A GAAP principle that requires matching expenses incurred in an accounting period with the revenue earned in the same period
Revenues The income produced by selling goods and services
Expenses the costs of operating a business
Cost of Goods Sold The dollar amount a company pays to purchase a product for resale.
Gross Margin The difference between revenues and cost of goods sold during a particular accounting period
Selling Expenses expenses that are incurred directly in the selling of merchandise. -include marketing costs, cost of delivering goods, and overhead
General and Administrative Expenses related to personnel, accounting, and finance activities, the operating costs of organization overhead, and associated items
Other Operating Expenses general classification for all other expenses-R & D, depreciation, amortization
Non-operating Section income and expense items that are routine but not components of a company’s normal ongoing business operations.-interest income and expenses-dividend income
Income Tax Expense represents the portion of fed and state taxes applicable to the income recognized during the reported accounting period
Net Income the excess of revenues over outlays in a given period of time (including depreciation and other non-cash expenses)
Earnings per Share the net income after taxes/ amount of outstanding shares
Earnings per share dilution reflects the potential dilution of EPS that could occur if options are fulfilled
Operating Activities The activities of an organization directly related to its main line of business.
Investing Activities reflect cash provided by or used in buying and selling long-term assets
Financing Activities activities through which cash is obtained from and paid to lenders, owners, and investors.
Common size financial statements Financial statements that present each amount as a percentage of some sort of financial statement base.BS-percent of total assetIS-percent of sales
Current Ratio CA/CL
Quick Ratio (CA- Inv) / CL
Asset Turnover Sales/ TA
Inventory Turnover COGS/ Inventory
Days in Sale inventory 365/ Inventory Turnover
Receivables Turnover Sales/ AR
Days Sales Outstanding or Average Collection period 365/ Receivables Turnover
Payables Turnover COGS/ AP
Days payable outstanding 365/ Payables turnover
REASONS TO TAKE ON DEBT INSTEAD OF SELLING EQUITY 1. interest rate on debt is lower than the expected return on equity because it is more secure2. Interest expense on debt is tax deductible, dividends are not3. Debt poses constraints on management that minimizes the wasting of cash flows on non-value producing projectsCan be potentially costly to the shareholders of the firm-interest and principal payments are binding on the firm and may constrain operations.
Total Debt Ratio Total Assets- Shareholders Equity / Total Assets
Debt-to-Equity Long-term Debt / Equity
Financial Leverage (equity multiplier) Total Assets/ Equity
Times interest earned EBIT / Interest expenseEBIT- earnings before interest and taxes
debt covenant a provision in a loan agreement that require the firm to maintain a minimum financial ratio
Profit Margin Net Income/ Sales
Gross Margin Sales- COGS / Sales
Operating Margin EBIT/ Sales
Return on Asset Net Income / TA
REturn on Equity Net INcome/ Shareholders Equity
Price- Earnings Ratio Stock Price per share/ Earnings per share
ROA PM X AT = ROA = Net Income/ AssetsNet Income/ Sales X Sales/ Assets = Net Income/ Assets
ROE – Dupont formula ROA x Financial Leverage = ROENet income/ Sales x Assets/ Equity = Net income/ equity
Sarbanes – Oxley a comprehensive piece of legislation that resulted from corporate malfeasance, designed to improve integrity and accountability in reporting financial information.
Goodwill An intangible asset that provides a competitive advantage, such as a strong brand, reputation,etc.
Market Cap # of shares X stock price per share

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