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85 Cards in this Set

  • Front
  • Back
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 - NON-OPERATING 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
Non-Cash 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
Semi-Annually Compounding Periods
2
Weekly Compounding Periods
52
Quarterly Compounding Periods
4
Daily Compounding Periods
365
Bi-Weekly 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 semi-annually (although interest is compounded every month).
Capital Budgeting
process of planning and managing a firms long-term 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 pre-defined 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 risk-free rate) resulting from bearing risk.
Normal Distribution
Bell Curve
Stock/Bond Significant Observation
- long run excess of security return over the risk-free return.