Capital Budgeting
The process of planning and managing a firm's long term investments
The financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire
Financial managers must be concerned with not only how much cash
Evaluating the time, size and risk of the cash flows is related to what finance decision?
Capital budgeting
Capital Structure
Ways in which the firm obtains and manages the long-term financing it needs to support its long term investments
The specific mixture of long-term debt and equity the firm uses to finance operations
What finance decision helps financial managers decide what percentage of the firm's cash flow goes to creditors and what percentage goes to shareholders?
Capital structure
Working Capital Management
Refers to a firm's short term assets (inventory) and short term liabilities ($ owed to suppliers)
The management of this ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions
This involves a number of act
These questions align with which finance decision?
- How much cash and inventory should we keep on hand?
- Should we sell on credit? If so, what terms will we offer, and to whom will we extend them?
- How will we obtain any needed short-term financing?
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Working capital management
Sole proprietorship
A business owned by one person
Simplest type of business to start and least regulated form of organization
Unlimited liability
This means that creditors can look beyond business assets to the proprietor's personal assets for payment
All business income is taxed as personal income
Limited to the owner's life span
Partnership
A business owned by two or more people
Limited liability
Investors who invest in a corporation are not liable for the debts or obligations of the firm
Primary disadvantages of sole proprietorships and partnerships are
- Unlimited liability for business debts on the part of owners
- Limited life of the business
- Difficulty of transferring ownership
Corporations
A legal "person", separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person.
They can borrow money and own property, can sue and be sued, and can enter into contracts.
Why are corporations superior for raising cash?
- Ease of transferring ownership
- Limited liability for business debts
- Unlimited life of the business
Double Taxation
Corporate profits are taxed twice; at the corporate level when they are earned and again at the personal level when they are paid out.
i.e.: Money paid out to stockholders in the form of dividends is taxed again as income to those stockholders.
Disadvantage to corporate forms
Double taxation
What is the goal of financial management?
To maximize shareholder wealth
Agency relationship
Relationship between stockholders and management
Exists whenever someone (shareholder/ the principal) hires another (manager/the agent) to represent his or her interests
Agency problem
Conflict between the principal (manager) and the agent (stockholder)
Agency cost
Refers to the costs of the conflict of interest between stockholders and management
Can be indirect (lost opportunity) or direct (benefits management but costs stakeholders or an expense that arises form the need to monitor management actions
The Securities Act of 1933
Firms must file a registration statement containing relevant information about securities being offered
Primary Markets
In this kind market transaction, the firm sells securities to investors and receives cash (initial public offering)
Public offerings
Securities sold to the general public
Mus tue registered with the Securities Exchange Commission (SEC) and requires the firm to disclose a lot of information before selling any securities
Private placements
Do not require registration with the SEC
Secondary Market
In this kind of market transaction, securities are traded between investors. The firm receives no cash
Provide the means for transferring ownership of corporate securities
i.e.: Involves one owner/creditor selling to another
Security
Document that certifies the bearer bearer has claim to funds in the future
Money Market
When firms want to raise cash for a short time, they issue these securities
Capital Market
When firms want to raise cash for a long period of time, they issue these securities
U.S. Givernemet Treasury Bills (T-Bills)
Short term IOU issued by the U.S. government
Essentially risk-free
Commercial Paper
Short-term IOU issued by a corporation
Negotiable Certificates of Deposit (CD)
Certificate representing a deposit in a bank that will be paid back, with interest, at a certain date
Common Stock
Conveys ownership in the firm
As owners, common shareholders have a claim on the earnings of the firm, after all other claims have been paid
Preferred Stock
Preferred stock holders are paid in dividend before common stock holders
Bonds
An IOU promising to pay a certain amount of money, at specified future dates
A firm (or government entity) issuing a bond is borrowing money from investors
Futures contract
An agreement to buy or sell an asset at specified date in the future, for an agreed upon price
Option contract
The right (but not obligation) to buy or sell an asset at specified date in the future, for an agreed upon price
Swaps contract
An agreement to exchange cash flows in the future according to an agreed upon formula
Commercial banks
Financial institutions that are in deposits and make loans, primarily to businesses, but also to individuals
Heavily regulated
What kind of bank makes money by charging a higher interest rate on loans they make than they pay on money they borrow from depositors?
Commercial banks
Federal Reserve System (Fed)
Regulates the money supply, makes loans to member banks and other financial institutions, and examines state-charted member banks
Federal Deposit Insurance Corporation (FDIC)
Provides deposit insurance to member institutions to member institutions. Almost all banks are members. They examine insured state-chartered banks that are non-members of the Fed system
Investment Banks
Financial institutions that help business and state & local governments sell securities
Underwriting
Investment banks purchase securities from the issuer and resell to investors
Best efforts
For riskier issuing firms, investment banks do not purchase the securities from the issuer but do their best to sell them to investors
Saving and Loans
Financial institutions that take in deposits and lend money, primarily mortgage loans (loans secured by real property)
Credit Unions
Member-owned financial institutions that make loans to members of the credit union
Finance Companies
Nonbank financial institutions that make loans to consumers and businesses
Mutual Fund
Investment vehicle using a pool of money from many investors that can be invested in stocks, bonds, money markets, etc
Exchange-Traded Fund (ETF)
A marketable security that tracks an index, a commodity, or a basket of assets
Trade like common stocks on a stock exchange
Hedge Fund
Similar to mutual funds, however, they are only able to take money from individuals with high net worth or income
Because of this, they face less regulation and can invest in a wider array of investments and take more risk than mutual funds
Balance sheet
A snapshot of the firm's accounting value at a specific point in time
Assets = Liabilities + Stockholders Equity
When analyzing a balance sheet, the Finance Manager should be aware of 3 concerns
- Liquidity
- Debt versus equity
- Value versus cost
Current Assets - Current Liabilities =
Net working capital
Debt versus Equity
- Creditors (those we owe money to) generally receive the 1st claiming the firm's has flow
- Shareholder's equity is the residual difference between assets and liabilities
Value versus Cost
- Under Generally accepted Accounting Principles (GAAP) audited financial statements of firms in the U.S. carry assets at a cost
- Market values is the price at which the assets, liabilities, and equity could actually be bought or sold, which is a complet
Income statment
Measures financial performance over a specific period of time
Revenue - Expenses =
Income
3 things to keep in mind when analyzing an income statement
- Generally Accepted Accounting Principles (GAAP)
- Non-Cash items
- Time and costs
GAAP
- Dictates that revenues be matched with expenses
- Thus, income is reported when it is earned, even though no cash flow may have occurred
Non-Cash Items
- Depreciation is the most apparent. No firm ever writes a check for "depreciation"
- Deferred taxes. Does not represent a crash flow
- Thus, net income is not cash
Time and Costs
- In the short run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials
- In the long run, all inputs of production and costs are variable
- Financial accountants do not disting
Marginal taxes
The percentage paid on the next dollar earned
Average taxes
The tax bill / taxable income
Free Cash Flow (FCF)
The cash flow available to the investors after the firm has made investments in fixed assets and working capital
A company's value depends on the about of _____ it can generate
Use of Free Cash Flow (FCF)
- Pay interest on debt
- Pay off debt
- Pay dividends
- Repurchase stock form shareholders
Operating Cash Flow - Investment in Fixed Assets - Investment in Net Working Capital =
Free (financial) Cash Flow (FCF)
Earnings before Interest and Tax (EBIT) + Depreciation - Tax =
Operating Cash Flow (OCF)
Future Value (FV)
Refers to the amount of money an investment will grow to over some period of time at some given interest rate
= Co x ( 1 + r )
Present Value (PV)
The current value of future cash flows
= C1/( 1 + r )
__________ is the reverse of compounding
Discounting
Annutiy
A stream of constant cash flows that lasts for a fixed number of periods
Ordinary Annuities
Have cash flows at the END of each period
Annuity Due
Have cash flows at the BEGINNING of each period
Deferred Annuity
When an annuity has payments beginning more than 1 year in the future (for example: payments begin 3 years after)
Growing Annuity
A growing stream of cash flows with a fixed maturity
Perpetuities
A constant stream of cash flows that lasts forever
Growing Perpetuities
A growing stream of cash flows that last forever