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85 Cards in this Set
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Forms of Business Organization

 Sole Proprietorship
 Partnership  Corporation  Income Trust 

Agency Problem

when managers do not always act in the shareholders best interests.


Financial Institutions

Indirect Finance: Funds Suppliers  Funds Intermediaries  Funds Demanders
Direct Finance: Funds Suppliers  Funds Demanders 

Money Markets

for short term debt instruments


Capital Markets

for long term debt and equity


Primary Market

original sale of securities by government and corporations via public offerings or private placements


Secondary Markets

Where securities are bought/sold after original sale. No new capital is raised. Two types:
1. Dealer Markets 2. Auction Markets 

Balance Sheet Analysis Concerns

1. Liquidity
2. Debt vs. Equity 3. Value vs. Cost 

Accounting Liquidity

refers to the ease with which assets can be converted to cash


Debt vs. Equity

Shareholders equity is the difference between assets and liabilities. When a firm borrows, it give the bondholders (shareholders) first claim on the firms cash flow.


Value vs. Cost

Under GAAP (generally accepted accounting principles) audited financial statements of firms in Canada carry assets at historical cost adjusted for depreciation.


Market Value

price at which willing buyers and sellers trade assets.


Income Statement

Measures performance over a specific period.


Income Statement  OPERATIONS

reports the firms revenues and expenses from principal operations


Income Statement  NONOPERATING Section

includes all financing costs, such as interest and expense.


Income Statement Analyzation

Keep in mind:
1. GAAP 2. Non Cash Items 3. Time and Costs 

Income Statement
GAAP Matching Principle 
When goods are sold, sales and profit are reported (whether cash or credit).


Income Statement
NonCash Items 
do not represent cash flow (i.e. depreciation)


Income Statement
Time and Costs 
financial accountants DO NOT distinguish between variable and fixed costs. These costs are generally fit into a classification that distinguishes product costs from period costs.


NWC

 is positive when current assets are greater than current liabilities.
 a firm can invest in NWC  called a change in NWC. This change is usually positive in a growing firm. 

NWC Formula

Total Current Assets  Total Current Liabilities


Current Ratio

Measure the firms ability to meet recurring financial obligations.
Total Current Assets / Total Current Liabilities *higher ratio indicated greater liquidity 

Quick Ratio

Determines firms ability to pay off current liabilities without relying on the sale of inventories.
(Current Assets  Inventories) / Total Current Liabilities 

Asset Turnover Ratio

Measures how effectively firm's assets are being managed.
Total Operating Revenues / Average Total Assets *retail/wholesale have high asset turnover compared to manufacturing. 

Receivables Turnover

Total Operating Revenues / Average Receivables


Average Collection Period

Days in Period (i.e. 365) / Receivables Turnover


Inventory Turnover

Cost of Good Sold / Average Inventory
*Measures how quickly inventory is produced. 

Days In Inventory

Days in Period (i.e. 365) / Inventory Turnover
*Measures how quickly inventory is produced. 

Debt Ratio

Total Debt / Total Assets


Interest Coverage

Earnings before Interest & Taxes (EBIT) / Interest Expense


Interest Coverage

Earnings before Interest & Taxes (EBIT) / Interest Expense


Net Profit Margin

Net Income / Total Operating Revenue
*trade firms = low service firms = high 

Price/Earnings Ratio

Market Price (Share) / Current Annual Earnings (Share)
* Show how much investors are willing to pay for $1 of earnings per share. Also reflects on investors' views of growth potential in different sectors. 

Market Clearing

When the borrower does not care whom he has to pay back, and if the lender does not care whose IOUs he is holding, an anonymous market will be formed.
Financial intermediaries will perform the anonymous market function by matching borrowers and lenders. In financial crisis, we do care who is holding the IOUs and matching buyers and sellers When the quantiy of money supplied by lenders equals the quantity demanded by borrowers, the market is clear at the equilibrium rate of interest. 

Borrowing/Lending/Investing

The rule is:
Investment opportunity is undertaken only with a better return than the financial market. That implies the financial market is a benchmark. This rule is quite important in investment society. Two issues should be considered in a sequence (step one first!!!). Step 1: Investment Decision  should the investment be taken. Step 2: Consumption Decision  how much can we consume if the investment project is taken? 

Separation Theorem

all investors will want to accept or
rreject the same investment projects by using the NPV rule, regardless of their personal preferences. 

Perpetuity

stream of constant cash flows that lasts FOREVER.


Growing Perpetuity

stream of cash flows that GROWS at a CONSTANT rate FOREVER.


Annuity

stream of cash flows that lasts for a fixed number of periods.


Growing Annuity

stream of cash flows that grows at a constant rate for a fixed number of periods.


Growing Annuity Special Cases

1. When r = g
2. When r = g and CF starts at t0. 

Annual Compounding Periods

52


SemiAnnually Compounding Periods

2


Weekly Compounding Periods

52


Quarterly Compounding Periods

4


Daily Compounding Periods

365


BiWeekly Compounding Periods

26


r

Stated Annual Interest Rate


EPR

Effective Period Interest Rate


EAR

Effective Annual Interest Rate


Mortgage Question Default

quoted annual interest compounded semiannually (although interest is compounded every month).


Capital Budgeting

process of planning and managing a firms longterm investments.
Management identifies investment opportunities worth more to the firm than they cost to acquire. 

Monthly Exclusive Projects

 Ranking Criteria
 only ONE of several potential projects can be chosen. ex. Marriage 

Independent Projects

 Minimum Acceptance Criteria
 accepting or rejecting one project does not affect the decision of the other projects. ex. Dating 

Accepting Positive NPV Projects  benefits to shareholders

 uses Cash Flows
 uses ALL Cash Flows in project  discounts ALL Cash Flows properly 

NPV

total PV of future CF's (benefit)  Initial Investment (Cost)


NPV Reinvestment Assumption

the NPV rule assumes that all cash flows can be reinvested at the discount rate.


Payback Period Rule

 how long does it take the project to "pay back" it's initial investment.
Payback period = # of years to recover initial costs. Minimum acceptance criteria  set by management Ranking criteria  set by management 

Discounted Payback Period Rule

How long does it take the Decision Rule: accept project if it pays back on discounted basis within specified time.
 project to "pay back" the initial investment taking the time value of money into account? 

ARR

Average Accounting Return Rule:
= Average income from project / Average book value of the asset 

Calculating AAR

1. Calculate the average net income.
2. Calculate average book value of the investment 3. Divide Total from Step 1 / Total Step 2. *mistakes are common on step 2. 

AAR Advantages

 Very easy to calculate (just need accounting info)
 Needed info is usually available 

AAR Disadvantages

 Time value of money is ignored.
 Based on accounting (book values), not cash flows. 

IRR

Internal Rate of Return Rule:
 does NOT depend on the market interest rate. Depends only on the CFs of a particular investment.  it is the discount rate that sets NPV to 0. MAC  Accept if IRR > required return RC  Select alternative with the highest IRR 

IRR = NPV Conditions

1. Projects CF must be conventional, meaning the initial investment (first CF) must be negative and the rest are all positive.
2. Projects must be independant (not mutually exclusive). 

IRR Cash Flow...investment or financing project?

CF at time 0:
 if negative = investment project  if positive = financing project 

IRR Advantages

 Closely related to the NPV rule, generally leading to identical decision
 in most cases NPV & IRR will give the same answer.  Easy to understand and communicate  will give you $ amount. IRR rules are easy  just pick a number (i.e. 5% return), if you get 8% return you will take project 

IRR Disadvantages

 It does not distinguish between investing and financing projects.
 Investing, CF at time 0 will be negative  Financing, CF at time 0 will be positive  IRR may not exist or there may be multiple IRRs  Problems with mutually exclusive projects. a  b or b  a...want CF at time 0 to be negative!!! 

PI Rule

Profitability Index:
= PV of CFs subsequent to initial investment / Initial investment MAC  accept if PI > 1 RC  select alternative with highest PI 

PI Advantages

 May be useful when available investment funds are limited
 Easy to understand and communicate  easy because you compare with benchmark number (i.e. 1)  Correct decision when evaluating independent projects 

PI Disadvantages

Problems with mutually exclusive investments (similar scale problem as IRR)


Taxes & Net Operating CFs

Tax is a cash outflow.
 must include in capital budgeting analysis. 

CCA

Capital Cost Allowance:
 depreciation  used to determine taxable income  not the same as depreciation under GAAP  begins by putting assets into predefined class. *Special Case = half year rule 

Real Interest Rate

Interest rate in terms of goods. Tells us how many goods one has to repay in exchange for one good today.


Nominal Interest Rate

Interest rate in terms of the dollars. It tells us how many dollars one has to repay in the future in exchange for one dollar today.


Inflation

A sustained rise in the general level of prices
*can affect the amount of CFs and the discount rate. 

Dollar Returns

 sum of the cash received and the change in value of the asset, in $.
= Dividends + End of Period Price  Beginning of Period Price 

Percentage Returns

 sum of the cash received and the change in value of the asset divided by the original investment (%).
= Dollar Return / Beginning of Period Price = (Dividends + End of period price / Beginning of period price)  1 

Holding Period Returns

 the return that an investor would get when holding an investment over a period of n years when the return during year T is given as RT;
HPT = (1+R1)(1+R2)(1+RT)1 

Arithmetic Average

 return earned in an average period over multiple periods


Geometric Average

 average compound return per period over multiple periods
* will be less than the arithmetic average unless all returns are equal.  overly pessimistic for short horizons. 

Standard Deviation

Measure of Risk:
 the standard statistical measure of the spread of a sample and it will be the measure used most of the time. 

Risk Premium

 the additional return (over and above the riskfree rate) resulting from bearing risk.


Normal Distribution

Bell Curve


Stock/Bond Significant Observation

 long run excess of security return over the riskfree return.
