Finance 301 Exam 1

Finance

involves the management of money
-amount, time, risk

Three areas of Finance

Corporate Finance- businesses
Institutions and Markets- financial markets
Investments- investors

corporate finance

The activities involved in managing money in a business environment.

institutions and markets

Examines the structure of capital markets, the role of financial institutions, the process of financial intermediation and how money flows into the economy

investments

focuses on the valuation techniques and how to value alternative investment opportunities that are provided primarily through financial markets and institutions

Capital Markets

financial markets where issuers and investors buy and sell debt and equity securities

Companies Raise capital through...

selling debt instruments
selling stocks/ equity instruments

Debt

obligation to repay borrowed money

Stock

represents ownership in the company

Effect of Technology

made cost of transactions lower
more transactions made
creation of new financial instruments
sophisticated hedging and investing practices

World's capital markets include a wide variety of organized exchanged where financial claims are traded. Claim's include...

debt, equity, currencies, commodities, and other financial assets.

Economic health

Gov
-level of interest rates, relative currency values, and performance of the stock markets are a gauge of economic health
Firms
- market value of stock is ultimate indicator of performance

International deregulation of past twenty years

opened new sources of capital for companies throughout the world.
markets tend to function most efficiently in deregulated environments.
recent breakdowns in accounting and corporate governance at Enron, Worldcom, adelphia, and Bernie Madoff ponzi schemes

Downside of free flow of capital

volatility that may be associated with it.
volatility in 2008 at unprecedented levels
-stock markets moving 3 to 5 percent per day, extremes of 10 percent.

Three Sets of Decisions

The investment decision
The Financing decision
The dividend decision

The Investment decision

how corporate managers should allocate funds of the company to buy or build projects and investments that will be worth more than they cost

The Financing Decision

how corporate managers should raise money from institutional and individual investors through the sale of debt and equity claims for the company to finance the investment projects of the firm

The Dividend Decision

the percentage of the company's profits and cash from operations that the company should reinvest in the business and how much should be returned to the company's shareholders in the form of dividends

Net Present Value (NPV)

is the value associated with investing in a project or venture.

Capital Budgeting

valuation, planning, and managing of corporate investments for a firm

Cost of Capital

the cost of raising debt and equity for the business

Capital Structure Decision

minimizing the cost of capital by using the right mix of debt and equity
-is an important role for the finance function of the company

Primary Markets

The original sale of securities by governments and corporations

Direct finance

A flow of funds from savers to firms through financial markets, such as the New York Stock Exchange.

Secondary Markets

Securities that are bought and sold after the original sale

Liquidity

the speed and ease with which an owner of a security can sell an investment to another investor or trade it in the securities market

Indirect finance

A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers).

Financial intermediation

The process by financial institutions of acquiring funds and channeling them to users of funds

Secondary Securities

savings and checkings accounts, annuities, insurance policies, pension plans, mutual funds

primary securities

stocks, bonds, loans, mortgages, and other financial assets.

Financial Toolbox

Financial statements and ratios
Present value concepts
Model of risk and return
Spreadsheet modeling methods

Financial Statements and Ratio Analysis

Investing and financing require projecting sales and expenses as well as fixed and working capital requirements. Current financial position is the base from which these projections are made. For forecasting purposes, financial ratios are commonly used to

Present Value Concept

Measurement of the time value of money.
A dollar today is worth more than a dollar tomorrow

Models of Risk and Return

Trade-off between return and risk
- a safe dollar is worth more than a risky dollar.
- an investor requires higher expected return to invest in riskier investments

Spreadsheet modeling methods

spreadsheets programs have become an essential planning tool for modeling investment.

Market Efficiency

The stock market is brutally efficient, current prices reflect publicly available information and prices react completely, correctly and instantaneously to incorporate the receipt of new information

Asset Allocation

the process of spreading your money among several different types of investments to lessen risk

Diversification

A risk management technique that mixes a wide variety of investments within a portfolio.

Risk

The chance that an investments actual return will be different than expected. Usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Greater the risk, the greater the reward must be fo

Markets

Where shares are issued and traded either through exchanges or over-the-counter markets. Also known as the equity markets

Remember to look in book for Questions

at end of chapter

CHAPTER 2 Ten basic principles of finance

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1. Return Versus Risk

Higher Returns require taking more Risk
-rational investors prefer to receive a higher rate of return on an investment to a lower return and would rather accept lower risk than more risk in earning that return.

-Rates of return on various assets

compound annual return is the preferred measure of return
return risk
Us Treasury bills - 3.7 , 3.10
us treasury bonds - 5.4 , 9.6
corporate bonds - 5.9 8.3
large company stock - 9.8 , 20.50
small company stock- 11.9 , 32.80

-RISK

MEANS UNCERTAINTY

-Reversion to the mean

The tendency for a particular measure of performance, such as percentage rate of return, to revert to its historical average return.

2. Market Efficiency

Efficient Capital Markets are tough to beat

-ECM

ECM hypothesis states
-the stock market is brutally efficient...

Random Walk hypothesis

The theory that stock price movements are unpredictable and thus theres little way of knowing where future prices are headed

Capital Asset Pricing Model

The equation of the SML showing the relationship between risk (Beta) and expected return for any given asset

Behavioral Finance

models of financial markets that emphasize potential implications of psychological factors affecting investor behavior
-challenge the assumptions underlying modern portfolio theory

3. Risk Preference

Risk Averse
Risk Neutral
Risk Taker

Risk Averse

investor prefers less risk to more risk.
"a bird in the hand is worth two in the bus

Risk-Neutral

pain of losing a dollar is equal to the pleasure associated with winning a dollar

Risk-taker see page 25

investor who enjoys taking risk
-the pleasure of winning a dollar exceeds the pain of losing a dollar

4. Supply and Demand

the price of a stock is determined by the interaction of the supply curve of stock by potential sellers and the demand curve for stock by buyers

-stocks current price

price x number of outstanding shares determines the market cap or total value of the cs of a company.

Market CAP

#NAME?

5. Corporate Finance and Governance

Managers should make decisions hat maximize the shareholders value.
-maximize CURRENT value of stock.

Capital Budgeting

the process of planning and managing a firm's long-term investments in projects and ventures.
-must identify invested opportunities that are worth more than they cost to acquire or to fund, so that the present value of the future cash flows generated by a

goal of capital budgeting decision

to maximize the NPV of the investments that are financed by the firm's capital budget.
-must be concerned with how much cash (amount) they expect from the investment, when (timing) they expect to receive it, and how likely (risk) they are to receive it.

Working Capital Management

the managing of short-term assets and liabilities
-mananging the structure and amount of the firm's working capital is a day to day activity that should insure the firm has sufficient resources to continue its operations and to avoid costly financial inte

Goal of the capital structure decision

to minimize the weighted average cost of capital of the company

Goal of working capital management

to minimize the cost of maintaining the net working capital position of the company

Capital Structure

refers to a firm's specific mixture of long-term debt and equity that uses to finance its operations and investments.

6. Minimizing the Cost of Investing

Transaction Costs, Taxes, and Inflation are your enemies
-greatly reduce the real returns on your investments.
-include brokerage commissions, sales loads, 12b-1 fees, redemption fees when you purchase or sell a mutual fund; and yearly asset management fe

-Taxes and cost of investing

fed income tax rates of up to 35 percent
-long term capital gains are taxed up to 20 percent.

-Tax advantage accounts

IRAs, Rother IRAs, and 401 (k) all are tax free

IRA

an investors annual contribution to an IRA is tax-deductible if the investors income does not exceed a certain level. Current maximum tax-deductible contribution to an IRA is 5000 dollars. Tax is deferred until the money is withdrawn and at current income

Roth IRA

not tax deductible but allows dividend, interest and capital gains on the investments to compound on a tax-exempt basis. If the investor is at least 591/2 and has invest for at least 5 years he may withdraw money on a tax-free basis.

401 (k)

Allows tax-deferred investments to a retirement account. May be matched by employer.

7. Time Value of Money

Time and the Value of Money are inversely related
-spending money today and receiving cash payments in the future.

Compounding

the process of going from today's value, or pv, to some expected but unknown future value.
-multiply by number greater than 1.0 over a number of time periods.

Future Value

the amount of money that an investment will grow to at some future date by earning interest at a certain rate.
FV= PV (1+r)^n

Discounting

The process of finding present value; the inverse of compounding to find future value.
DF = 1/ (1+r)^n
PV= FV/(1+ r)^n

8. Asset Allocation

Some investors maintain a fixed percentage of their funds in asset classes (20 percent cash, 30 percent bonds, 50 percent stocks).
-should reflect beliefs about the anticipated risk and return of asset classes. IMPORTANT DECISION TO DETERMINE RANGE OF EXP

9. Diversification

Asset Diversification will reduce risk.
-spread your wealth among a number of different investments and asset classes.
-invest in a group of assets that provides you with the best return possible given a level of risk.

-Diversification tips

dont invest in an industry in which you work
-bad idea to invest in the stock of his employer
-have enough liquid assets to finance six months of expenses and some unforeseen emergencies, and insurance to cover tragedies.

efficient frontier

achieving the highest return for each level of risk is known as investing efficiently.
-portfolios that are designed with he help of computer modeling and are beyond the scope of this book

Two Types of risk

Systematic
unsystematic

Systematic Risk

the risk of the stock market
-changes in stock prices are caused by changes in the economy, taxes, risk, and other market factors.
-measured by beta

*Unsystematic Risk

specific to a company
-risk inherent to a particular stock due to decisions made by a corporation relative to the industry in which it operates
-CAN BE REDUCED BY DIVERSIFICATION

Total Risk

Total Risk= Systematic + Unsystematic Risk
-20 to 25 stocks are sufficient enough to diversify a portfolio

10. Investment Valuation

Value equals the sum of expected cash flows discounted for time and risk

Capital Asset Pricing Method

a model that estimates the rate of return an investor should expect to receive on a risky asset.
-determine discount rate to use when valuing an asset.
expected return = risk free rate + risk premium
E(Ri) = Rf + Bi*(E(Rm)-Rf0

Market Risk Premium

the difference between the expected return on a market portfolio and the risk-free rate.

Simple Average (interest)

when an investment pays interest only on the original principal

Chapter 3

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CFO

Company officer responsible for managing a corporations finance function.
-oversees a corporations working capital decision, the capital budgeting decision and the capital structure decision.

Controller

Corporation officer who handles and monitors a corporations accounting and auditing activities.
-oversees tax accounting, cost accounting, financing accounting, data collecting/ processing

Treasurer

Officer responsible for managing a corporation's finance function
-small companies use term treasurer
-large companies use term CFO

Shareholder Value

Return that investors receive for their capital. This return is realized through dividend reimbursements, stock buy-backs, and capital gains on stock price increase.
-sales, market share, ROE, Profits, Earnings growth, product Quality all effect sharehold

Corporate Governance

Interaction between shareholders and management inter to assure that management uses invested capital to maximize shareholder value
-shareholders have limited say in day to day control over company
-shareholders have voting rights

Sole Proprietorship (chart on page 56)

Form of business organization where a business is owned by one person

Partnership

Company formed by two or more individuals
-can be general or limited
-in general, each partner is liable for the debts of the partnership, shares in the profits and losses.
-in limited, the liability to the amount of cash contributed by each partner
-not

Corporation

Main characterisitcs
-limited liability
-corporate taxes in addition to personal income taxes
-easily transferable
subject to double taxes

Limited/umlimited liability

limited- owners are only liable for the amount of cash contributed by each investor.
unlimited- owners are liable for an amount greater than their investment in the company

Dividends

Earnings distributed to stockholders

Stock buy-back

a corporation's purchase of its own outstanding stock

Capital Gains

The difference between a higher selling price and lower purchase price, resulting in financial gain for seller

Free Cash Flows

Cash flow available for distrbution to shareholders after paying all corporate taxes

Return on Equity

Net income ivied by equity. Ratio measures how efficiently firm utilizes shareholder's investment dollars.

Stock Options

A right- but not an obligation- to buy a stock from the company at a fixed price during a specified time period

Acquisition

when one company purchases a majority interest in the acquired.

Divestiture

The partial or full disposal of an investment or asset through sale, exchange, closure, or bankruptcy. Divestiture can be done slowly and systematically over a long period of time, or in large lots over a short time period
strategy whereby a firm sells on

Agency Problem

The possibility of conflict of interest between stockholders and management of a firm.
-agency costs occur when management does not pursue strategies that maximize shareholder value, or when shareholders incur costs to monitor and realign management decis

Stock Split

A division of shares of a company into a larger number of shares. (A 2 for 1 split allows a shareholder to double the number of shares but worth one half of their previous value).

Corporate Raider

an investor conducting a type of hostile corporate takeover against the wishes of the company

Hostile Takeover

A takeover attempt that is strongly resisted by the target firm

Junk Bond

a bond with high risk and potentially high yield
-considered non investment grade by a major rating agency

Voting Rights

Shareholder's right to vote on the shareholder meeting
-stockholders elect the directors of a corp
-directors select the managers

Leveraged buy-out

a going-private transaction in which a tender offer for all of a firm's common stock, financed mostly by debt, is made by an investment group
-done to beat out the bidder company by allowing management of a target company to buy out public shareholders at

Staggered board

Defense mechanism against unwanted takeovers
-1/4 of the board members are elected each year and serve a four-year term.

Shark Repellent

created in the 1980s to defend against hostile takeovers

White Knight

company finds a friendly merger candidate

Pac-man Defense

Company employs a counter-takeover bid for the raider

Greenmail

target company purchases the acquirer's shares at a premium over the market price to avoid a takeover
- forces company to pay out to the acquirer

Golden Parachute

Target company provides compensation to top-level executives in the event of a change of corporate control.

Self-tender offer

target company agrees to purchase some of the current outstanding shares from its shareholders, usually at a price above what the acquiring company is offering
-pay money specifically to current shareholders

Poison Pill

Target Company gives current shareholders the right to purchase shares of the company at a bargain price, contingent on another firm acquiring control. Makes stock worth less

Crown Jewel

Target company sells off its major assets to make self less appealing to takeover

Proxy Solicitations

an attempt to gain control of a firm by soliciting a sufficient amount of votes to replace the existing management

Mutual Fund

Most common type of investment company which holds large investment portfolio of assets that is divided up into small "shares" and sold to investors.

Insider Trading

illegal practice of using special knowledge about a firm for profit or gain

Institutional Investors

Includes commercial banks, investment banks, insurance companies, mutual funds, corporations, governments, and any other large pool of assets that invest in finical markets.

Shareholder Activism

Active involvement of shareholder in corporate governance through influencing management decisions.

Command and Control Environment

the finance function controlled financial information and was not accountable for overall business performance.
-finance department was viewed as the corporate cop whose primary purpose was overseeing company spending and getting the books closed on a tim

New Model- competitive team

new role involves finance personnel acting as business advocates who are assigned to, and very much a part of , individual business units.
-generating and sharing of key financial info to asset in decision making.

Goal of Financial Management

To maximize current value of the company's stock
or for non traded stock
To maximize the market value of the existing owner's equity.

Stakeholders

anyone who has a legitimate claim of any nature on a firm and therefore on its economic wellbeing
-employees, creditors, customers, suppliers, the communities in which the company operates, and stockholders.

Stakeholders or Shareholders

Some people argue that companies should care more about STAKEHOLDERS because they believe firms should be more socially responsible.
-create value for SOCIETY
however we know that shareholder value is the main goal, They own the firms
-argument - sharehol

Tender offer

an offer to buy shares in a corporation (usually above the market price) for cash or securities or both

Proxy Battle

The attempt by a nonmanagement group to gain control of the management of a firm by soliciting a sufficient number of proxy votes.

Corporate Governance of the 1990s

Shareholdings of investor institutions increased
-these institutions are sophisticated shareholders who, in pursuit of good stock returns, used their large blocks of stock to influence management.

Securities and Exchange Commission (SEC)

In 1992, there was a change in the SEC that relaxed the proxy solicitation rules regarding shareholder communications, which substantially reduced the costs to institutional shareholders of coordinating challenges against underperforming management.
SEC r

Good Governance

At the board level adds 11 percent on average, to the value of the firm.

2000s corporate governance

Lack there of.
-fraud, greed, ect
Enron, Adelphia, Worldcom, Tyco, Xerox

Anglo-American Model - Fluid Capital Model

minority shareholders with board, led to takeovers
-us model
-free of institutional constraints

Japan-Germany Dedicated Capital Model

-captial owned by investors who will not trade or sell shares
-viewed as long-term capital

Rest of World

Majority owners (Governments, family, etc.)
-oversees management
-might have other motives besides creating investor value

Chapter 4

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Financial Accounting

accounting information and analyses prepared for people outside the organization
-language of numbers
-conveys performance to investors, creditors, and public
-used internally to establish performance goals

Four Accounting Statements

Balance sheet
Income Statement
Statement of Cash Flow
Statement of retained earnings
-all publicly traded companies are required to prepare periodic financial statements so that info is disclosed regular to investors
-examined and AUDITED by independent o

Balance Sheet

a financial statement that reports assets, liabilities, and owner's equity on a specific date

Income Statement

a financial document that shows how much money (revenues) came in and how much money (expenses) was paid out

Statement of Cash flows

The financial statement that identifies a firm's sources and uses of cash in a given accounting period

Statement of Retained Earnings

summary of the changes in the retained earnings of a corporation during a specific period

GAAP

Generally accepted accounting principles
-broad guidelines and standards to make accounting information in financial statements relevant to the types of decisions that readers of the statements make

10-k

the SEC required report
- filed ANNUALLY within 90 days of a company's fiscal year-end
-includes all financial info, a discussion by the management of the company, and a summary of operations.

10-Q

Not required to report
-filed Quarterly
-contains same info as 10-k but abbreviated

Annual Report

fundamental document of communication between management of a corporation and its shareholders.
-Three Sections
The Letter to Shareholders
The Business Review
The Financial Review

The Letter to Shareholders

Gives a broad overview of the company's business and financial performance

The Business Review

Summarizes the company's rent developments, trends, and business objectives

The Financial Review

Presents a company's business performance in financial terms, and includes audited financial statements, management discussion and analysis, and supplementary information

Assets

economic resources owned by a firm that are measurable and are likely to produce future economic benefit

Liabilities

probable future economic obligations of a firm

Equity

A measure of ownership or the residual interest in the assets of a business entity. Equity is equal to assets minus liabilities

Cash Accounts

records all cash payments and receipts for a specific time period

Accrual Accounting

method of accounting in which income is recorded when earned and expenses are recorded when incurred.

Current Assets

cash and other assets expected to be exchanged for cash or consumed within a year

Long-term assets

assets with a lifespan of more than a year

Current Liabilities

Liabilities due within a short time, usually within a year

Long-term liabilities

liabilities owed for more than a year

Equity

the owner's residual interest in the firm.
-cs, paid in capital excess par, stocks, treasury stocks, retained earnings

Off-Balance sheet activities

Bank activities that involve trading financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets (223, 265).

Revenue Principle

The principle prescribing that revenue is recognized when earned.

Matching Principle

A GAAP principle that requires matching expenses incurred in an accounting period with the revenue earned in the same period

Revenues

The income produced by selling goods and services

Expenses

the costs of operating a business

Cost of Goods Sold

The dollar amount a company pays to purchase a product for resale.

Gross Margin

The difference between revenues and cost of goods sold during a particular accounting period

Selling Expenses

expenses that are incurred directly in the selling of merchandise.
-include marketing costs, cost of delivering goods, and overhead

General and Administrative Expenses

related to personnel, accounting, and finance activities, the operating costs of organization overhead, and associated items

Other Operating Expenses

general classification for all other expenses
-R & D, depreciation, amortization

Non-operating Section

income and expense items that are routine but not components of a company's normal ongoing business operations.
-interest income and expenses
-dividend income

Income Tax Expense

represents the portion of fed and state taxes applicable to the income recognized during the reported accounting period

Net Income

the excess of revenues over outlays in a given period of time (including depreciation and other non-cash expenses)

Earnings per Share

the net income after taxes/ amount of outstanding shares

Earnings per share dilution

reflects the potential dilution of EPS that could occur if options are fulfilled

Operating Activities

The activities of an organization directly related to its main line of business.

Investing Activities

reflect cash provided by or used in buying and selling long-term assets

Financing Activities

activities through which cash is obtained from and paid to lenders, owners, and investors.

Common size financial statements

Financial statements that present each amount as a percentage of some sort of financial statement base.
BS
-percent of total asset
IS
-percent of sales

Current Ratio

CA/CL

Quick Ratio

(CA- Inv) / CL

Asset Turnover

Sales/ TA

Inventory Turnover

COGS/ Inventory

Days in Sale inventory

365/ Inventory Turnover

Receivables Turnover

Sales/ AR

Days Sales Outstanding or Average Collection period

365/ Receivables Turnover

Payables Turnover

COGS/ AP

Days payable outstanding

365/ Payables turnover

REASONS TO TAKE ON DEBT INSTEAD OF SELLING EQUITY

1. interest rate on debt is lower than the expected return on equity because it is more secure
2. Interest expense on debt is tax deductible, dividends are not
3. Debt poses constraints on management that minimizes the wasting of cash flows on non-value p

Total Debt Ratio

Total Assets- Shareholders Equity / Total Assets

Debt-to-Equity

Long-term Debt / Equity

Financial Leverage (equity multiplier)

Total Assets/ Equity

Times interest earned

EBIT / Interest expense
EBIT- earnings before interest and taxes

debt covenant

a provision in a loan agreement that require the firm to maintain a minimum financial ratio

Profit Margin

Net Income/ Sales

Gross Margin

Sales- COGS / Sales

Operating Margin

EBIT/ Sales

Return on Asset

Net Income / TA

REturn on Equity

Net INcome/ Shareholders Equity

Price- Earnings Ratio

Stock Price per share/ Earnings per share

ROA

PM X AT = ROA = Net Income/ Assets
Net Income/ Sales X Sales/ Assets = Net Income/ Assets

ROE - Dupont formula

ROA x Financial Leverage = ROE
Net income/ Sales x Assets/ Equity = Net income/ equity

Sarbanes - Oxley

a comprehensive piece of legislation that resulted from corporate malfeasance, designed to improve integrity and accountability in reporting financial information.

Goodwill

An intangible asset that provides a competitive advantage, such as a strong brand, reputation,etc.

Market Cap

# of shares X stock price per share