Principles of Business Finance Exam 1

Flashcard maker : Lily Taylor
3 Functions of Corporate Finance
1) Capital budgeting
2) Capital structure
3) Short-term cash flow managements
Capital budgeting
-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
Capital structure
-How do we finance those investments?
-The mix of debt and equity describing how the firm is financed.
-Selling of stocks and bonds
Short-term cash flow managements
-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
What is the goal of the firm?
-To maximize shareholder wealth (by increasing price of existing shares of stock)
Sole proprietorship
-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
Pros of a sole proprietorship
-Easy start up
-Taxed as personal income
Cons of a sole proprietorship
-Unlimited liability
-Life limited to that of the owner
-Equity limited to owner’s wealth
-Difficulty in transferring ownership
-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.
Pros of a partnership
-Easy start up
-Taxed as personal income
Cons of a partnership
-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
-A business created as a distinct legal entity composed of one or more individuals or entities.
Separation of ownership and control w/in a corporation
-Shareholders: own corporation
-Directors: elected by shareholders
-Managers: picked by directors to make decisions
2 things you have to do when starting a corporation
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
Pros of a corporation
-Limited liability
-Easy transfer of ownership
-Unlimited life
-Equity is not limited
Cons of a corporation
-Difficult to start up
-Double taxation of earnings: income and dividends are both taxed
Agency conflicts
-Possibility of conflict of interest between the stockholders (principal) and management (agent) of a firm
Agency costs
-The costs of the conflict of interest between the stockholders and management
Direct agency costs
-Wasteful spending (ex: expensive vacations)
-Monitoring and auditing: makes sure owners are doing what they are supposed to be doing
Indirect agency costs
-Missed opportunities
How do we control agency conflicts?
-Managerial compensation: based more on performance than strict salaries
-Control of the firm:
-Proxy fights: internal takeover
-Takeovers: external, from competition
Primary market
-Deals directly w/company
-IPO: initial public offering (deals directly w/company)
Secondary market
-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
-Promise to repay
-Gets everything else
-Stock: dividends not guaranteed
Balance sheet
-“Snapshot” of the firm
-Assets = Liabilities + Stockholders’ equity
-The speed and ease w/which an asset can be converted to cash
-Assets normally listed on balance sheet in order of decreasing liquidity
Pros of liquid assets
-Financial security
Cons of liquid assets
-Could possibly be better invested elsewhere
Market value vs. book value
-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
Income statement
-“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
Issues w/the income statement
-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
Statement of cash flows
-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
Sources and uses of funds
-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
These things aren’t cash flows:
-Net income
Financial statements:
-Are backward, not forward, looking
Marginal tax rate
-Tax rate on next dollar earned
-As financial managers, we care about marginal tax rate more than average, because marginal is forward looking
Financial statement analysis
-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
Classification of Financial Ratios
-Short-term solvency (liquidity) ratios
-Long term solvency (financial leverage) ratios
-Asset management (turnover) ratios
-Profitability ratios
-Market value ratios
Short-term solvency (liquidity) ratios
-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)
Long term solvency (financial leverage) ratios
-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
Asset management (turnover) ratios
-Describe how efficiently or intensively a firm uses its assets to generate sales -Want numbers to be high, except for days ratios
Profitability ratios
-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
Market value ratios
-DON’T come from financial statements
-Can be calculated directly only for publicly traded companies
DuPont identity
-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
Limitations to financial statements
-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
Simple interest
-Interest only earned on principal (original) payment amount
Compound interest
-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
Present value
-Current value of future cash flows discounted at the appropriate discount rate
-Calculate the present value of some future amount
Discount rate
-Rate used to calculate the present value of future cash flows
-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
-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
-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
10-yr bond
In the Dupont identity, Profit margin measures:
In the Dupont identity, total asset turnover measures:
-Asset utilization efficiency
In the dupont identity, equity multiplier measures:
-financial leverage

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