Goal of the financial manager
maximize shareholder wealth, (maximize the company's stock price)
purpose of the balance sheet
represents a summary statement of the firm's financial position at a given point in time (snapshot of the company's financial position at a point in time)
format of the balance sheet
Left side: assets
Right side: liabilities and stockholders equity
Balance sheet Identity
assets = liabilities + SE
purpose of income statement
financial statement summarizing a firm's performance over a period of time
format of income statement
revenue-expenses=net income
future value
the value of a present amount at a future date found by applying compound interest over a specified time
interest rates increase as time to maturity increases
present value
the presents value of a dollar decreases as interest rates go up and decrease as time to maturity increases. calculations discount all future cash flows back to the present
annuity
a stream of equal cash flows paid out at regular intervals - these cash flows can be inflows of cash (monthly pension check) or outflows of cash (monthly mortgage payment)
ordinary annuity
payments occur at the END of the period
annuity due
payments occur at the BEGINNING of the period
perpetuity
an annuity with an infinite life - FOREVER
value of any financial asset
PV of the cash flows you expect to receive from that asset
bond
long-term debt instrument by which the borrower agrees to pay back the principal and interest on specific dates to the bond holders - purpose of obtaining large sums of money
coupon interest rate
if the par value of a bond is equal to the price, then the yield to maturity is the same as the coupon rate
maturity date
you can sell a potable bond back before its maturity date
premium
(r < coupon rate; Value of bond > par value)
discount
(r > coupon rate; Value of bond < par value)
yield to maturity
the yield an individual would receive if the individual purchased the bond today and held the bond to the end of its life
what are two determinants of stock
risk & return
risk
variability of returns
standard deviation
measures the total risk of asset. The higher the standard deviation, the higher the variability of returns = higher risk.
coefficient of variation
measures relative risk - risk per unit of return
risk/return tradeoff
historically its been proven that higher returns are accompanied by higher risk
diversification
the spreading of wealth over a variety of investment opportunities so as to eliminate some risk.
effect of diversification on a portfolio's risk
the standard deviation of a portfolio is less than the weighted average of the standard deviation of the assets in that portfolio
Correlation of asset's effect on diversification and reducing risk
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diversifiable/unsystematic risk
the part of the risk associated with random events - lawsuits, strikes, loss of key accounts, etc. (events that are unique to a particular firm and can be eliminated by having a diversified portfolio.
market/systematic risk
the risk that stems from factors that affect all firms -war, inflation, high interest rates. Most stocks are negatively affected by these events
cannot be eliminated by diversification
Capital Asset Pricing Model (CAPM)
is the basic theory that links together market/systematic risk and return for all assets.
beta coefficient
is used to measure market/systematic risk. It examines the asset's historical returns relative to the market returns (return on market portfolio of all traded securities).
average beta for market
1
Beta < 1.0
less risky than the market e.g. utility stocks
Beta > 1.0
more risky than the market e.g. high-tech stocks
Beta = 0
independent of the market e.g. T-bill
capital budgeting
the process of deciding which long-term investments or projects a firm will acquire using the long-term funds it has available.
reason for investing capital projects
to maximize the value of the stock
payback period
the length of time it will take an investment to recover the initial investment
decision criteria for payback method
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mutually exclusive projects
projects that compete with each other. If you choose one project, that automatically means that you will reject the other one (e.g. comparing models when you are planning to buy a new car). You rank mutually exclusive projects according to the capital bud
independent projects
projects whose cash flows are independent of each other. The projects do not compete. Accepting one project does not necessarily mean that you will reject another project. Each project is evaluated on its own merit with regard to accept or reject criteria
net present value (NPV)
nets all of the cash flows associated with a project back to time 0 (present value) using an appropriate discount rate (the company's cost of capital). The unit for NPV is currency ($ and cents).
decision criteria for NPV method
if the number you get is positive you should accept the project
profitability index (PI)
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decision criteria for PI
If PI is greater than 1 you should accept the project
internal rate of return (IRR)
the discount rate which forces the sum of all the discounted cash flows from a project to equal 0
decision criteria for IRR method
IRR > cost of capital -> NPV > 0 -> Accept project
The IRR is measured as a percent while the NPV is measured in dollars.
reason that NPV and IRR sometimes give conflicting rankings for projects
They always give the same accept/reject decisions
NPV method assumes that all intermediate cash flows are
reinvested at the firm's cost of capital. IRR method assumes that all intermediate cash flows are reinvested at the project's IRR
cost of capital
the rate of return that a firm must earn on it's project investments to maintain the market value of its stock.
-If risk is held constant, taking on projects with a rate of return ABOVE the cost of capital will INCREASE the value of the firm, while taking
4 basic sources of long term capital
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reason for using weighted average cost of capital
interrelatedness of financing activities
cost of debt (after tax bc of interest deductibility
is the rate that firms have to pay when they borrow money from banks, finance companies, and other lenders, including issuing bonds. Because of the tax-deductibility of interest expense, debt is always the least expensive source of long-term funds.
cost of preferred stock
some companies have preferred stock and other do not
common stock equity
common stock and retained earnings
cost of retained earnings
the money left over after the fir's other obligations have been paid belong to the common stock holder
cost of issuing new common stock
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reason that cost of issuing new CS is higher than the cost of RE
because of floatation cost associated with the issue of common stock
Order of cost of individual components from lowest to highest
Debt, Preferred Stock, retained earnings, and issuing new common stock
weighted average cost of capital
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retained earnings breaking point
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