Basic forms of capital
Debt and Equity
Debt
Financing supplied by lenders
Equity
Financing supplied by owners
How is capital allocated in a free market economy?
By price
How is the cost of debt capital measured?
By interest
Interest rate
Price paid by borrowers to obtain debt capital; price charged by lenders to provide debt financing
Short term debt
Less than 1 year, temporary cash needs
Long term debt
Greater than 1 year, permanent increases in needs such as inv., equipment, receivables, land, buildings
Trade-off Theory
Theory proposing that a business's optimal capital structure balances the costs and benefits associated with debt financing
Optimal Capital Structure
Balances the costs and benefits associated with debt financing; it is the mix of debt and equity financing that produces the lowest cost of capital for the business
Debt ratings
Interest rates should decline with higher investment grade; lower rating equals higher risk
CCC
the weighted average of the capital component costs, that is, the costs of debt and equity; provides a benchmark
Capital Investment Decisions
business decisions involving which long term assets to buy; also called capital budgeting decisions
Project Classifications
Projects are classified by purpose and size
Capital Investment Analysis
cash flow estimation, project risk assessment, cost of capital estimation, financial impact assessment
Payback Period
The number of years it takes to recover the cost of an investment
Major Deficiencies of Payback
Ignores all cash flows that occur after the payback period and ignores the time value of money
Opportunity Cost Rate
Applied to investment cash flows is the rate that could be earned on alternative investments with similar risk
How is ROI Measured?
Can be measured either in dollars (NPV) or a percentage (IRR)
NPV
Measures the dollar value of an investment on the basis of its opportunity cost of capital
IRR
Measures the expected rate (%) of a return on an investment. Discount rate that forces NPV to equal zero
Project Scoring
technique for incorporating both financial and non financial factors in capital investment decisions
Cash Flow Estimation
Most difficult yet most important step in evaluating capital investment proposals
Meaning of a NPV of 0
Project cash flows will be sufficient to recover the project cost and earn a return equal to the project's opportunity cost
Incremental Cash Flows
the firms cash flows in each period if the project is undertaken minus the firm's cash flows if the project is not undertaken
Financial Risk
Capital investments are risky because a project's cash flows are not known with certainty when the project is being analyzed
Sensitivity Analysis
The process of assessing how changes in one variable affect another variable; use in risk assessment is limited, still a valuable tool for identifying a project's critical component cash flows
Scenario Analysis
Risk assessment technique that overcomes the problems associated with sensitivity analysis; typically defines a projects best, worst and most likely scenario's
Project Cost of Capital
Discount rate that reflects the unique riskiness of the project being analyzed; typically found by adding or subtracting a specified number of percentage points from the CCC
Capital Budget
List of all projects expected to be undertaken during the next planning period
The predominant users of financial statements
stakeholders
Financial Accounting
Involves identifying, measuring, recording, and communicating the economic events and status of an organization
GAAP
The set of guidelines, which have evolved over time, that prescribes the content and format of financial statements
Cash Accounting
Economic events are defined by the transfer of cash; simpler method and closely mimics the data needed for income tax filing
Accrual Accounting
Economic events are defined by the creation of payment obligations; creates statements that better represent the financial status of the business; required by GAAP
Income Statements
reports the results from operations of a business over some period of time, often 1 year; revenues, expenses and profitability
Depreciation Expense
Amortizes the cost of a long lived asset over many years
Operating Income
Measures the profitability of a healthcare organization's core activities; the provision of patient services and those activities that are directly related
Imply that GAAP is not static
Subject to compromise, negotiation, and interpretations
Reporting Revenue
Discounts (not reported on inc. statement), charity care (not reported), Bad debt (reported but stripped)
Why is NI called the "bottom line
Because of its importance and its location on the income statement; measures profitability
NI vs Cash Flow
Businesses can go bankrupt even though its net income has been historically been positive
Balance Sheet
Reports the financial position of a business at a single point in time
Accounting Equation
Assets = Liabilities + OE
Balance Sheet order
Listed by liquidity
How much current assets should a business have?
Enough to cover for the business if it goes bankrupt
What is the first priority of a business if they go bankrupt?
To pay back their liabilities (workers, employees and most of all creditors*)
Accrued Expenses
Monies owed to various parties, such as to employees for services rendered; also includes interest owed to lenders and tax obligations (salaries, taxes, interest, debt, supplies)
Net Assets
term used to designate the equity on a NFP organization's balance sheet
Statement of Cash Flows
Reports where a business gets its cash and what it does with that cash
3 Major sections of cash flows
Operating activities, investing activities, financing activities
Financial Statement Analysis
Involves using financial statement data to make judgements about a business's financial condition; uses both historical and forecasted data
Cash Flow Op. Analysis
Are the businesses core operations profitable?
Cash Flow Inv. Analysis
How much capital did the business raise? How was it used?
Cash flow Financing analysis
What impact did op. and financing decisions have on the business's cash position?
Ratio Analysis
Technique that helps interpret the data contained in a business's financial statements as well as in other contexts
Ratio Basics
Know ratio basics
Du Pont Analysis
Provides an overview of a business's financial condition and helps managers and investors understand the relationships among several ratios
3 Advantages of ST Debt
Issuance cost, restrictive covenants, and generally have a lower IR
Stockholders Rights and Privilages
Claim to residual earnings, some percentage may be paid out as dividends, control of the firm (proxy), Preemptive right to purchase new shares of stock when they are issued
Financial Leverage
Comes with uncertainty; use of debt financing increases owner's risk, the greater the leverage the greater the risk
Permanent Assets
Buildings and equipment
Temporary Assets
Flu shots
Hurdle Rate
The minimum rate of return by an administrator for any project
Key to an effective project analysis
Correctly forecasting cash flows
Technique's Used for Ratio Analysis
Trend and Comparative