Principles of Business Finance Exam 1 – Flashcards
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3 Functions of Corporate Finance
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1) Capital budgeting 2) Capital structure 3) Short-term cash flow managements
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Capital budgeting
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-What should we invest in? -The process of planning and managing the firm's long term investments. -How do we do it? 1) Estimate cash flows 2) Estimate cost of those cash flows 3) Discount cash flows
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Capital structure
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-How do we finance those investments? -The mix of debt and equity describing how the firm is financed. -Selling of stocks and bonds
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Short-term cash flow managements
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-How do we manage the day-to-day operations of the firm? -Short term: focuses on current assets and liabilities (NWC = CA - CL) -Cash management: -Pros: stability -Cons: money isn't doing anything for you -Credit management: -Pros: everyone uses cards -Cons: you pay fees on credit & it takes longer to get paid
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What is the goal of the firm?
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-To maximize shareholder wealth (by increasing price of existing shares of stock)
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Sole proprietorship
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-Business owned by one person -Simplest type of business to start -Least regulated form of organization -More of these than any other type of business
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Pros of a sole proprietorship
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-Easy start up -Taxed as personal income
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Cons of a sole proprietorship
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-Unlimited liability -Life limited to that of the owner -Equity limited to owner's wealth -Difficulty in transferring ownership
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Partnership
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-Two kinds: 1) General: all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share 2) Limited: one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership.
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Pros of a partnership
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-Easy start up -Taxed as personal income
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Cons of a partnership
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-Unlimited liability -Life limited to that of the owner: spouse takes over if one partner dies -Equity limited to owner's combined wealth -Difficulty in transferring ownership
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Corporation
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-A business created as a distinct legal entity composed of one or more individuals or entities.
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Separation of ownership and control w/in a corporation
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-Shareholders: own corporation -Directors: elected by shareholders -Managers: picked by directors to make decisions
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2 things you have to do when starting a corporation
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1) Articles of incorporation: a charter containing the corporation's name, intended life, business purpose, and # of shares issuable 2) Bi-laws: rules describing how the corporation regulates existence
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Pros of a corporation
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-Limited liability -Easy transfer of ownership -Unlimited life -Equity is not limited
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Cons of a corporation
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-Difficult to start up -Double taxation of earnings: income and dividends are both taxed
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Agency conflicts
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-Possibility of conflict of interest between the stockholders (principal) and management (agent) of a firm
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Agency costs
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-The costs of the conflict of interest between the stockholders and management
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Direct agency costs
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-Wasteful spending (ex: expensive vacations) -Monitoring and auditing: makes sure owners are doing what they are supposed to be doing
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Indirect agency costs
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-Missed opportunities
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How do we control agency conflicts?
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-Managerial compensation: based more on performance than strict salaries -Control of the firm: -Proxy fights: internal takeover -Takeovers: external, from competition
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Primary market
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-Deals directly w/company -IPO: initial public offering (deals directly w/company)
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Secondary market
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-Company isn't involved -No cash flow goes to firm -Bigger than primary market -Company cares heavily about secondary market, because they want to know demand for their stock
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Debt
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-Bonds -Promise to repay
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Equity
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-Gets everything else -Stock: dividends not guaranteed
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Balance sheet
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-"Snapshot" of the firm -Assets = Liabilities + Stockholders' equity
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Liquidity
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-The speed and ease w/which an asset can be converted to cash -Assets normally listed on balance sheet in order of decreasing liquidity
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Pros of liquid assets
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-Financial security
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Cons of liquid assets
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-Could possibly be better invested elsewhere
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Market value vs. book value
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-Financial statements are book values -Balance sheet is a book value -Book values: historic costs -Market value: what can I get for an asset today? -Market values is what financial managers care about -True (market) value of the firm can be found by looking at the stockholders' equity value -True value of the firm: Market capitalization: # shares outstanding x share price
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Income statement
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-"Video" (as opposed to a snap shot, which is what the BS is referred to as) -Revenues - Expenses = Income -Bottom line: -Net income or EPS (earnings per share) -EPS = NI / # shares outstanding
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Issues w/the income statement
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-Often times in accounting the cash isn't followed...we want to follow cash! -Income statement contains non-cash items -Depreciation: we add it back in because we don't technically lose money from it
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Statement of cash flows
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-Cash flow from these types of activities: 1) Operating: how we spend cash in day-to-day business 2) Investing: long term fixed assets 3) Financing: Stocks and bonds
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Sources and uses of funds
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-Changes in CA: think inventory -Changes in CL: think borrowing money -Source: cash inflow -CA decrease, CL increase -Use: cash outflow -CA increase, CL decrease
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These things aren't cash flows:
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-Depreciation -Net income
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Financial statements:
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-Are backward, not forward, looking
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Marginal tax rate
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-Tax rate on next dollar earned -As financial managers, we care about marginal tax rate more than average, because marginal is forward looking
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Financial statement analysis
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-Common size financial statements -Balance sheet items as a percentage of total assets -Income statement items as a percentage of total sales -Use of rations helps alleviate "big vs. small" issues, moves away from simply working w/numbers (work with percentages instead) -Can find numbers for each category of ratios, except market value ratios, from financial statements -other sources are used to find market value ratios
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Classification of Financial Ratios
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-Short-term solvency (liquidity) ratios -Long term solvency (financial leverage) ratios -Asset management (turnover) ratios -Profitability ratios -Market value ratios
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Short-term solvency (liquidity) ratios
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-Intended to provide information about a firm's liquidity -Financial strength in short term -These ratios focus on CA and CL -Particularly interesting to short-term creditors -Want to be at least greater than 1, but not too high (too high may indicate inefficient use of cash & other short term assets)
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Long term solvency (financial leverage) ratios
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-Intended to address the firm's long term ability to meet its obligations, or, more generally, its financial leverage -Financial "leverage"- debt isn't necessarily a bad thing
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Asset management (turnover) ratios
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-Describe how efficiently or intensively a firm uses its assets to generate sales -Want numbers to be high, except for days ratios
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Profitability ratios
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-Best known and most widely used of all financial ratios -Measure how efficiently a firm uses its assets to manage its operations -Focus is on bottom line, net income -Because benefiting shareholders is our goal, ROE is the true bottom line measure of performance (most important) -All percentages
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Market value ratios
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-DON'T come from financial statements -Can be calculated directly only for publicly traded companies
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DuPont identity
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-helps break down ROE and identify more specifically where problems might lie -Splits ROE into: -profit margin: measures profitability -total asset turnover: measures asset use efficiency -equity multiplier: measures financial leverage
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Limitations to financial statements
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-Benchmarking: are any two firms exactly the same? who do we compare to? -Effects of inflation: never taken into account on financial statements -Seasonal factors: what are companies fiscal years? companies that are seasonal in business. -Window dressing: there are ways to manipulate financial statements -Differing operating and accounting practices: LIFO vs. FIFO -The big picture: financial statements do a poor job of showing us this
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Simple interest
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-Interest only earned on principal (original) payment amount
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Compound interest
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-Interest is earned on both the principal payment as well as the reinvested interest after each period -Compounding: process of accumulating interest on an investment over time to earn more interest
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Present value
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-Current value of future cash flows discounted at the appropriate discount rate
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Discount
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-Calculate the present value of some future amount
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Discount rate
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-Rate used to calculate the present value of future cash flows
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IRA
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-Individual retirement account (separate from anything at work) -Have to be 59.5 years old to touch money or you receive a 10% penalty and have to pay taxes on the penalty -exceptions: you die, become disabled, down payment on primary residence, education -$5,000 is the most you can put in yearly, unless your 55, then you can put in $5,500 -Traditional: -acts like your 401k at work -get tax deduction initially, but have to pay taxes on money once you take it out of the account reaching retirement age -gov't makes you start taking out money at 70.5 -Roth: -no tax deduction initially, but it is tax free at retirement -income limitations -if you're single, you can't make more than $90,000 -if married, combined salary can't exceed $167,0000 -only tax free investment in the US
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S&P
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1,433.56
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Nasdaq
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3,104.53
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Dow
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13,323.36
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Oil
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98.900002
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10-yr bond
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1.695
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EUR/USD
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1.2866
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Gold
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1,738.70
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In the Dupont identity, Profit margin measures:
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-Profitability
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In the Dupont identity, total asset turnover measures:
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-Asset utilization efficiency
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In the dupont identity, equity multiplier measures:
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-financial leverage
