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85 Cards in this Set
- Front
- Back
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Forms of Business Organization
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- Sole Proprietorship
- Partnership - Corporation - Income Trust |
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Agency Problem
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when managers do not always act in the shareholders best interests.
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Financial Institutions
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Indirect Finance: Funds Suppliers - Funds Intermediaries - Funds Demanders
Direct Finance: Funds Suppliers - Funds Demanders |
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Money Markets
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for short term debt instruments
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Capital Markets
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for long term debt and equity
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Primary Market
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original sale of securities by government and corporations via public offerings or private placements
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Secondary Markets
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Where securities are bought/sold after original sale. No new capital is raised. Two types:
1. Dealer Markets 2. Auction Markets |
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Balance Sheet Analysis Concerns
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1. Liquidity
2. Debt vs. Equity 3. Value vs. Cost |
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Accounting Liquidity
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refers to the ease with which assets can be converted to cash
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Debt vs. Equity
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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.
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Value vs. Cost
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Under GAAP (generally accepted accounting principles) audited financial statements of firms in Canada carry assets at historical cost adjusted for depreciation.
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Market Value
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price at which willing buyers and sellers trade assets.
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Income Statement
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Measures performance over a specific period.
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Income Statement - OPERATIONS
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reports the firms revenues and expenses from principal operations
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Income Statement - NON-OPERATING Section
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includes all financing costs, such as interest and expense.
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Income Statement Analyzation
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Keep in mind:
1. GAAP 2. Non Cash Items 3. Time and Costs |
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Income Statement
GAAP Matching Principle |
When goods are sold, sales and profit are reported (whether cash or credit).
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Income Statement
Non-Cash Items |
do not represent cash flow (i.e. depreciation)
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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.
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NWC
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- 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. |
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NWC Formula
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Total Current Assets - Total Current Liabilities
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Current Ratio
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Measure the firms ability to meet recurring financial obligations.
Total Current Assets / Total Current Liabilities *higher ratio indicated greater liquidity |
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Quick Ratio
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Determines firms ability to pay off current liabilities without relying on the sale of inventories.
(Current Assets - Inventories) / Total Current Liabilities |
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Asset Turnover Ratio
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Measures how effectively firm's assets are being managed.
Total Operating Revenues / Average Total Assets *retail/wholesale have high asset turnover compared to manufacturing. |
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Receivables Turnover
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Total Operating Revenues / Average Receivables
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Average Collection Period
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Days in Period (i.e. 365) / Receivables Turnover
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Inventory Turnover
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Cost of Good Sold / Average Inventory
*Measures how quickly inventory is produced. |
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Days In Inventory
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Days in Period (i.e. 365) / Inventory Turnover
*Measures how quickly inventory is produced. |
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Debt Ratio
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Total Debt / Total Assets
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Interest Coverage
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Earnings before Interest & Taxes (EBIT) / Interest Expense
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Interest Coverage
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Earnings before Interest & Taxes (EBIT) / Interest Expense
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Net Profit Margin
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Net Income / Total Operating Revenue
*trade firms = low service firms = high |
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Price/Earnings Ratio
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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. |
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Market Clearing
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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. |
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Borrowing/Lending/Investing
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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? |
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Separation Theorem
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all investors will want to accept or
rreject the same investment projects by using the NPV rule, regardless of their personal preferences. |
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Perpetuity
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stream of constant cash flows that lasts FOREVER.
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Growing Perpetuity
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stream of cash flows that GROWS at a CONSTANT rate FOREVER.
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Annuity
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stream of cash flows that lasts for a fixed number of periods.
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Growing Annuity
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stream of cash flows that grows at a constant rate for a fixed number of periods.
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Growing Annuity Special Cases
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1. When r = g
2. When r = g and CF starts at t0. |
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Annual Compounding Periods
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52
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Semi-Annually Compounding Periods
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2
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Weekly Compounding Periods
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52
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Quarterly Compounding Periods
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4
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Daily Compounding Periods
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365
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Bi-Weekly Compounding Periods
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26
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r
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Stated Annual Interest Rate
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EPR
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Effective Period Interest Rate
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EAR
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Effective Annual Interest Rate
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Mortgage Question Default
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quoted annual interest compounded semi-annually (although interest is compounded every month).
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Capital Budgeting
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process of planning and managing a firms long-term investments.
Management identifies investment opportunities worth more to the firm than they cost to acquire. |
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Monthly Exclusive Projects
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- Ranking Criteria
- only ONE of several potential projects can be chosen. ex. Marriage |
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Independent Projects
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- Minimum Acceptance Criteria
- accepting or rejecting one project does not affect the decision of the other projects. ex. Dating |
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Accepting Positive NPV Projects - benefits to shareholders
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- uses Cash Flows
- uses ALL Cash Flows in project - discounts ALL Cash Flows properly |
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NPV
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total PV of future CF's (benefit) - Initial Investment (Cost)
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NPV Reinvestment Assumption
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the NPV rule assumes that all cash flows can be reinvested at the discount rate.
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Payback Period Rule
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- 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 |
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Discounted Payback Period Rule
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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? |
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ARR
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Average Accounting Return Rule:
= Average income from project / Average book value of the asset |
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Calculating AAR
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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. |
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AAR Advantages
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- Very easy to calculate (just need accounting info)
- Needed info is usually available |
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AAR Disadvantages
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- Time value of money is ignored.
- Based on accounting (book values), not cash flows. |
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IRR
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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 |
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IRR = NPV Conditions
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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). |
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IRR Cash Flow...investment or financing project?
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CF at time 0:
- if negative = investment project - if positive = financing project |
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IRR Advantages
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- 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 |
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IRR Disadvantages
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- 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!!! |
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PI Rule
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Profitability Index:
= PV of CFs subsequent to initial investment / Initial investment MAC - accept if PI > 1 RC - select alternative with highest PI |
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PI Advantages
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- 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 |
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PI Disadvantages
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Problems with mutually exclusive investments (similar scale problem as IRR)
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Taxes & Net Operating CFs
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Tax is a cash outflow.
- must include in capital budgeting analysis. |
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CCA
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Capital Cost Allowance:
- depreciation - used to determine taxable income - not the same as depreciation under GAAP - begins by putting assets into pre-defined class. *Special Case = half year rule |
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Real Interest Rate
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Interest rate in terms of goods. Tells us how many goods one has to repay in exchange for one good today.
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Nominal Interest Rate
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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.
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Inflation
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A sustained rise in the general level of prices
*can affect the amount of CFs and the discount rate. |
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Dollar Returns
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- sum of the cash received and the change in value of the asset, in $.
= Dividends + End of Period Price - Beginning of Period Price |
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Percentage Returns
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- 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 |
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Holding Period Returns
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- 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 |
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Arithmetic Average
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- return earned in an average period over multiple periods
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Geometric Average
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- 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. |
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Standard Deviation
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Measure of Risk:
- the standard statistical measure of the spread of a sample and it will be the measure used most of the time. |
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Risk Premium
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- the additional return (over and above the risk-free rate) resulting from bearing risk.
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Normal Distribution
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Bell Curve
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Stock/Bond Significant Observation
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- long run excess of security return over the risk-free return.
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