Corporate Finance Test 1

Test Information: 27 questions, 4 points each (108 points). 5 questions from Ch. 1, 5 from Ch. 2, and 17 questions from Ch. 3. 20 conceptual questions, 7 require computations
Statement of Cash Flows Gives details about the company’s cash at the beginning of the year and what is left at the end of the year, including some details about where cash was generated and where it was used during the course of the year.Helps determine whether the company 1) is generating enough cash from its operations to make new investments and pay dividends or 2) will need to generate cash by issuing new debt or selling its assets. Three categories of activities (operating, investing, and financing) generate or use the cash flow in a company.Actual cash collected = Net Sales – Increase in Accounts Receivable Operating – Investing + Financing = Net Increase in Cash(operating – investing + financing = difference between year one and year two)
Statement of Retained Earnings Reconciles 1) the amount of retained earnings recorded at the beginning of the reporting period, 2) changes during that period, and 3) the amount of retained earnings at the end of the reporting periodQuestion it could answer: does the firm generate enough internal funds to support anticipated investment, or does additional outside capital need to be raised?Shareholder’s Equity = Paid In Capital + Retained EarningsShareholders’ Equity = Total Assets – Total LiabilitiesDividends Paid = Net Income – (Ending Retained Earnings – Beginning Retained Earnings)
Annual Report Is published once a year and provides stockholders with details about the company’s performance and financial conditionVery important for investors because the information contained in the annual report: helps investors forecast expected earnings and dividends.
Free Cash Flow The amount of cash that could be withdrawn without harming a firm’s ability to operate and to produce future cash flows. FCF = [ EBIT(1-T) + Depreciation and amortization] – [Capital expenditures + Net Operating Working Capital]. EBIT(1-T) is often referred to as NOPAT, or net operating profit after taxes.Acquiring operating assets is not a use of free cash flow
(computation) Earnings Before Interest and Taxes (EBIT)
(computation) Free Cash Flow
(computation) Net Income (after taxes)
(computation) Economic Value Added (EVA)
(computation) Corporate Income Tax Liability
Ch.1 Info
Finance “the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities”.
Areas of Finance 1. Financial management2. capital markets3. investments
1. Financial Management (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.
2. 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. i.e. Federal Reserve System & Securities and Exchange Commission.
3. 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 reasonable heights in a speculative bubble or driven down to unreasonable lows in a fit or irrational pessimism.
Finance within an Organization The board of directors is generally the highest ranking individualThe CEO comes next, but note that the chairperson of the board also serves as the CEO. Below the CEO comes the Chief Operating Officer (COO), who is also designated as a firm’s president. The COO directs the firm’s operations, which include marketing, manufacturing, sales, and other operating departments. The Chief Financial Officer (CFO), who is generally a senior vice president and the third ranking officer, is in charge of accounting, finance, credit policy, decisions regarding asset acquisitions, and investor relations, which involves communications with stockholders and the press. The primary tasks of the CFO are (1) to make sure the accounting system provides “good” numbers for internal decision making and for investors, (2) to ensure that the firm is financed in the proper manner, (3) to evaluate the operating units to make sure they are performing in an optimal manner, and (4) to evaluate all proposed capital expenditures to make sure they will increase the firm’s value.
If the firm is publicly owned, the CEO and the CFO must both: Certify to the SEC that reports released to stockholders, and especially the annual report, are accurate. If inaccuracies later emerge, the CEO and the CFO could be fined or even jailed.
Sarbanes-Oxley Act (2002) Passed by Congress in the wake of a series of corporate scandals involving now-defunct companies such as Enron and WorldCom, where investors, workers, and suppliers lost billions of dollars due to false information released by those companies.
Finance versus Economics & Accounting Finance grew out of economics and accounting. Economists developed the notion that an asset’s value is based on the future cash flows the asset will provide, and accountants provided information regarding the likely size of those cash flows. People who work in finance need knowledge of both economics and accounting.
Forms of Business Organization 1) Proprietorship- unincorporated business owned by one individual. Advantages: easy/inexpensive, subject to few gov’t regulations, subject to lower income taxes than corporations. Limitations: unlimited personal liability for the business’ debts, the life of the business is limited to the life of the individual who created it, & have difficulty obtaining large sums of capital2) Partnerships- a legal arrangement between two or more people who have decided to do business together. Easy/inexpensive. Income is allocated on a pro rata basis to the partners and is taxed on individual basis. 3) Corporations- a legal entity created by a state, and it is separate from its owners and managers. It is this separation that limits stockholders’ losses to the amount they invested in the firm– the corporation can lose all of its money, but its owners can lose only the funds that they invested in the company. Have unlimited lives. Major drawback is taxes– most corporations are subject to double taxation. As an aid to small businesses, Congress created “S Corporations” which are taxed as if they were proprietorships or partnerships; thus they are exempt from the corporate income tax. Can have no more than 100 stockholders. “C Corporations” are larger corporations. 4) Limited Liability Partnerships (LLP’s)
Main Financial Goal: Creating Value for Investors Managers and employees work on behalf of the shareholders who own the business, and therefore they have an obligation to pursue policies that promote stockholder value. A company’s stockholders are not just an abstract group– they represent individuals and organizations who have chosen to invest in their hard-earned cash into the company and who are looking for a return on their investment in order to meet their long term financial goals, which might be saying for retirement, a new home, or a child’s education. This is why its important to create value for investors. Stockholders wealth is measured by stock price.
Determinants of Intrinsic Values and Stock Prices Managerial actions, combined with the economy, taxes, and political conditions influence the level and riskiness of the company’s future cash flows, which ultimately determine the company’s stock price. (investors like higher expected cash flows, they dislike risk; so the larger the expected cash flows and the lower the perceived risk, the higher the stock’s price).Next, you must differentiate “true” expected cash flows and “true” risk from “perceived” cash flows and “perceived” risk. True ,means the cash flows and risks that investors would expect if they had all the info that existed about a company. Perceived means what investors expect, given the limited info they have.Each stock has an intrinsic value (an estimate of the stock’s “true” value as calculated by competent analyst who has the best available data) & a market price (the actual market price based on perceived but possibly incorrect info as seen by the marginal investor. Not all investors agree so it is the marginal investor whose views determine the actual stock price).When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium. When equilibrium exists, there is not pressure for a change in the stock’s price. Market prices can- and do- differ from intrinsic values; but eventually, as the future unfolds, the two values tend to converge. Intrinsic value > Market price — undervaluedIntrinsic value < Market price — overvalued
Intrinsic Value Are estimates. Different analysts with different data and different views about the future form different estimates of a stock’s intrinsic value. It is a long run concept. Management’s goal should be to take actions designed to maximize the firm’s intrinsic value, not its current market price.Maximizing the intrinsic value will maximize the average price over the long run, but not necessarily the current price at each point in time. Management should provide info that helps investors make better estimates of the firm’s intrinsic value, which will keep the stock price closer to its equilibrium level.
Stockholder-Manager Conflicts Manager’s personal goals may compete with shareholder wealth maximization. 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.
Compensation Packages Must be consistent of time. 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 data. 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 data.
Manager’s Response Corporate Raiders: individuals who target corporations for takeover because they are undervalued. If the raid is successful, the target’s executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price. It’s bad for stockholders and managers when the intrinsic value is high but the actual price is low. In that situation, a raider may swoop in, buy the company at a bargain price, and fire the managers.
Stockholder-Debtholder Conflicts 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. Stockholders are typically more willing to take on risky projects.
Balancing Shareholder Interests and the Interests of Society Managers have an obligation to behave ethically, and they must follow the laws and other society-imposed constraints. *”B (benefit) Corporations”: are still focused on making a profit, they are committed to putting other stakeholders such as employees, customers, and their communities on an equal footing with shareholders.
Business Ethics a company’s attitude and conduct towards its employees, customers, community, and stockholders.A firm’s commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and selling practices, the use of confidential info for person gain, community involvement, and the use of legal payments to obtain business.
Consequences of Unethical Behavior Over the past few years, ethical lapses have led to a number of bankruptcies. Another consequence if a company avoids bankruptcy is a damaging blow to their reputation. The perception of widespread improper actions has caused many investors to lose faith in American business and to turn away from the stock market, which makes it difficult for firms to raise the capital they need to grow, create jobs, and stimulate the economy. So, unethical actions can have adverse consequences far beyond the companies that perpetrate them.Even if just a few employees are being unethical, the firm can still be deemed unethical because it fostered a climate where unethical behavior was permitted.
Chapter 2
The Capital Allocation Process Those with surplus funds expect to earn a return on their investments, while people and organizations that need capital understand that they must pay interest to those who provide that capital. In a well-functioning economy, capital flows efficiently from those with surplus capital to those who need it. The transfer can take place in three ways:1) Direct Transfers2) Indirect Transfers through Investment Bankers3) Indirect Transfers through a Financial Intermediary
1) Direct Transfers 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 (stocks or bonds) 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.
2) Indirect Transfers through Investment Bankers Transfers may go through an investment bank (iBank) such as Morgan Stanley, which underwrites the issue. An underwriter facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment bank. However, because the investment bank buys and holds the securities for a period of time, it is taking a risk– it may not be able to resell the securities to savers for as much as it paid. Because new securities are involved and the corporation receives the sale proceeds, this transaction is called a primary market transaction.
3) Indirect Transfers through a Financial Intermediary Transfers can also be made through a financial intermediary such as a bank, an insurance company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for its securities. The intermediary uses this money to buy and hold businesses’ securities.
Types of Financial Markets 1) Physical asset markets versus asset markets: -Physical asset markets (tangible or real asset markets): for products such as wheat, autos, real estate, computers, and machinery. -Financial asset markets: deal with stocks, bonds, notes, and mortgages. Also deal with derivative securities whose values are derived from changes in the prices of other assets. 2) Spot markets versus futures markets-Spot markets are markets in which assets are bought or sold for “on the spot” delivery. -Future markets are markets in which participants agree to buy or sell an asset at some future date. 3) Money markets versus capital markets-Money markets are the markets for short-term, highly liquid debt securities. -Capital markets are the markets for intermediate- or long term debt and corporate stocks. i.e. New York Stock Exchange 4) Primary markets versus secondary markets- Primary markets are the markets in which corporations raise new capital. – Secondary markets are markets in which existing, already outstanding securities are traded among investors. i.e. New York Stock Exchange because it deals in outstanding as opposed to newly issued stocks and bonds.5) Private markets versus public markets- Private markets: transactions are negotiated directly between two parties. i.e. bank loans and private debt placement with insurance companies- Public markets: standardized contracts are traded on organized exchanges. i.e. common stock and corporate bonds
Trends Globalization has exposed the need for greater cooperation among regulators at the international level, but the task is not easy. Factors that complicate coordination include 1) the different structures in nations’ banking and securities industries; 2) the trend toward financial services conglomerates, which obscures developments in various market segments; and 3) the reluctance of individual countries to give up control over their national monetary policies. Increased use of derivatives. The market for derivatives has grown faster than any other market in recent years, providing investors with new opportunities but also exposing them to new risks.
Financial Institutions Large businesses in developed economies generally find it more efficient to enlist the services of a financial institution when it comes time to raise capital. There are 10 major categories of financial institutions. With the exception of hedge funds and private equity companies, financial institutions are regulated to ensure the safety of these institutions and to protect investors. This has included: a prohibition on nationwide branch banking, restrictions on the types of assets the institutions could purchase, ceilings on the interest rates they could pay, and limitations on the types of services they could provide.
1) Investment Banks (underwriters) Help companies raise capital. They 1) help corporations design securities with features that are currently attractive to investors, 2) buy these securities from the corporation, and 3) resell them to savers.
2) Commercial Banks Bank of America, Citibank, Wells Fargo, and JP Morgan Chase.
3) Financial Services Corporations Large conglomerates that combine many different financial institutions within a single corportation.
4) Credit Unions Cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm. Members’ savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages.
5) Pension Funds Retirement plans funded by corporations or government agencies for their workers and administered primary by the trust departments of commercial banks or by life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.
6) Life Insurance Companies Take savings in the form of annual premiums; invest these funds in stocks, bonds, real estate, and mortgages; and make payments to the beneficiaries of the insured parties.
7) Mutual Funds Corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who prefer safety, stock funds for savers who are willing to accept significant risks in the hope of higher returns, and money market funds that are used as interest-bearing checking accounts.
8) Exchange Traded Funds (ETF’s) Similar to regular mutual funds and are often operated by mutual fund companies. ETF’s buy a portfolio of stocks of a certain type and then sell their own shares to the public.
9) Hedge Funds Also similar to mutual funds because they accept money from savers and use the funds to buy various securities, but there are some important differences. While mutual funds are registered and regulated by the Securities and Exchange Commission, hedge funds are largely unregulated. This difference in regulation stems from the fact that mutual funds typically target small investors, whereas hedge funds typically have large minimum investments (often exceeding $1 million) and are marketed primarily to institutions and individuals with high net worths.
10) Private Equity Companies Organizations that operate much like hedge funds; but rather than purchasing some of the stock of a firm, private equity players buy and then manage entire firms. Most of the money used to buy the target companies is borrowed.
Stock Market Where the prices of firms’ stocks are established. Two leading stock markets are the NYSE Euronext and NASDAQ. Stocks are traded using a variety of market procedures, but there are two basic types: 1) physical location exchanges (NYSE) and 2) electronic dealer based markets (NASDAQ).
Physical Location Stock Exchanges Tangible entities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body– its board of governors.
Over the Counter (OTC) and the NASDAQ Stock Markets
Types of Stock Market Transactions 1) Outstanding shares of established publicly owned companies that are traded: the secondary market. The company receives no new money when sales occur in this market2) Additional shares sold by established publicly owned companies: the primary market. 3) Initial public offerings made by privately held firms: the IPO market. Whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering (IPO) market. These deals however are often oversubscribed, which means that the demand for shares at the offering price exceeds the number of shares issued.
Stock Market Efficiency When markets are efficient, investors can buy and sell stocks and be confident that they are getting good prices. If markets are truly efficient, then each stock’s price should be close to intrinsic value. There is an “efficiency continuum” with the market for some companies’ stocks being highly efficient and the market for other stocks being highly inefficient.
Behavioral Finance Theory 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. 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. Although the logic behind the EMH is compelling, many events in the real world seem inconsistent with the hypothesis, which has spurred a growing field called behavioral finance. Rather than assuming that investors are rational, behavioral finance theorists borrow insights from psychology to better understand how irrational behavior can be sustained over time.
Chapter 3 Info
Annual Report Most Important report that corporations issue to stockholders. Contains two types of info. First there is a verbal section which describes the firms operating results during the past year and discusses new developments that will affect future operations. Second, the report provides these four basic financial statements: 1) balance sheet: shows what assets the company owns and who has claim on those assets; 2) income statement: sows the firm’s sales and costs during some period; 3) statement of cash flows: shows how much cash the firm began the year with, how much cash it ended up with, and what is did to increase or decrease the cash; 4) statement of stockholders; equity: shows the amount of equity the stockholders had at the start of the year, the items that increased or decreased equity, and the equity at the end of the year. Info in the annual report can be used to help forecast future earnings and dividends.
Balance Sheet Provides a quantitative summary of a company’s assets, liabilities, and net worth at a specific point in time. “snapshot” of a firm’s position at a specific point in time. Question it could answer: can the firm meet all its short-term obligations using its current assets?Left side of the statement shows the assets the company owns, and the right side shows the firm’s liabilities and stockholder’s equity, which are claims against the firm’s assets. The company’s debts are listed in the order in which they are to be repaid.Stockholders equity= paid in capital + retained earningsStockholders equity= Total assets – Total LiabilitiesNet Working Capital = Current Assets – Current LiabilitiesTotal Debt = Short Term debt + Long Term DebtTotal Liabilities = Total Debt + (Accounts payable + Accruals)
Book Values (computation) Accounting numbersTotal common equity/number of shares outstanding = book value
Market Values (computation) What the assets would sell for it they were offered for sale. Total market value of the business / the total number of shares outstanding
Net Operating Working Capital (computation) Net Operating Working Capital = Current Assets – (Current Liabilities – Notes Payable)
Income Statement Accounts for all revenues and expenses over an accounting period. “snapshot” of the financial performance of a company during a specified period of time. it reports a firm’s gross income, expenses, net income, and the income that is available for distribution to its preferred and common shareholdersNet sales are shown at the top of the statement; then operating costs, interest, and taxes are subtracted to obtain the new income available to common shareholders.Earnings per share is often the bottom line. The income statement is prepared using the generally accepted accounting principles (GAAP) that match the firm’s revenues and expenses to the period in which they were incurred, not necessarily when cash was received or paid.
Operating Income (EBIT) Sales revenues (net sales) – Operating Costs
Depreciation An annual charge against income that reflects the estimated dollar cost of the capital equipment and other tangible assets that were depleted in the production process.
Amortization Amounts to the same thing except that is represents the decline in value of intangible assets such as patents, copyrights, trademarks, and goodwill.

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