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104 Cards in this Set
- Front
- Back
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Business finance is also referred to as |
-corporate finance -managerial finance |
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Business finance deals with financial decision making w/in the |
corportation |
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6 examples of financial decisions |
-choosing long-term investments -managing risk -raising capital through the issuance of socks and bonds -manage short-term capital flows (inventory, cash, short-term investments, accts rec) -managing currency issues |
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Form of business organization which separate ownership from management |
corporation |
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owners of corporations are passive investors referred to as |
stockholders |
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Structured loan (debt) finite time horizon-will retire at some point |
bonds |
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ownerships (equity) potentially infinite time horizon- can be help for a second or for many years
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stocks |
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Fixed cash flow stream:
coupon payments each year: 8% coupon 5 year bond, coupon payment of $80 (8% of $1,000) per year for 5 years, at end of the 5th year pays $1,000 par value, has to be sold if you do not want to wait till maturity date and can be sold for more than purchased
par value returned at maturity: bonds can be bought at discount rates opposed to full price, can eventually be returned on full price |
bonds |
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Bonds have ___ risk and a _____ expected return |
less lower -Cash flows are known so bondholders will get most of their money back |
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Stocks have a ______ risk and a ________ expected returns |
higher higher -Dividends are variable so investors do not know when they will receive cash flows
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The primary goal of financial management is to |
maximize shareholder wealth -NOT to maximize profits -you buy share to make money, not to better the company -you want to add value in the next 5-10 years, not within the next day or week |
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How do we maximize shareholder wealth? Focus on the |
1. magnitude of expected cash flows 2. timeliness of expected cash flows 3. riskiness of expected cash flows |
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Why focus on cash flows? The accrual based approach of net income ignores |
the timing of cash inflows and outflows |
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Why focus on cash flows? Gives firms the ability to use "aggressive" accounting to |
distort net income -Can choose any GAAP that makes them look the best |
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We need to generate ____ _____ not just _____ ______ in order to pay bills and operate the business |
cash flow net income |
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The concept that people prefer less risk
If two investments have the same expected return, investors will choose the one with the least risk
Implies a risk return TRADEOFF
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risk aversion
*not the same as risk minimization*
A valid assumption for most people, but not in the cases of gambling/Las Vegas: small stakes, not expecting a big return on investment
Level of risk aversion is personal |
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In order to get investors to take on more risk, they need to be _________ compensated |
adequately Not exact for a reason, the adequacy depends on on the risk aversion level of the person |
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Why is globalization important? -magnitude, timeliness, riskiness |
-U.S. only makes up 4.4% of world population -Target market exists outside the U.S. -But not everyone has the cash flows -Good for increasing magnitude, bad for increasing risk. Magnitude dominates because successful companies are global |
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Refers to being proactively concerned with the welfare of society |
social responsibility
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Refers to a moral code of conduct |
ethics Ex: It is socially responsible to donate, but it is not ethical to donate 100% of shareholder profits |
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What is a corporation? |
Business organization that separates management and ownership of the business Ex: Owning 100 shares in Ford makes you part owner of the firm but you have no say in the process of running business |
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What is limited liability? |
Owners losses are only tied to their initial investment: you invest $1,000 then you can only lose $1,000 Even if the company goes bankrupt you do know owe anything |
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What is double taxation? |
Shareholders being taxed twice -- once at the corporate level and once when they receive dividends and/or capital gains. |
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Explain higher regulatory costs in terms of preparing financial statements. |
-Costly, but necessary to gain information from management so stockholders can make the right decisions with investments. -Corporation might not make enough of a profit after preparing financial statements. |
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Cash flow to investors: stocks/bonds |
Stocks: paid out in dividends sometimes higher sometimes lower, depends on business because a more successful a business the greater the value of the stock is
Bonds: do not increase/decrease over time, two payments: 1. coupon 2. par value/maturity value |
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Lifespan: stocks/bonds |
Stocks: exists as long as the firm does, can get rid of stock by selling it to someone else or the firm goes bankrupt and stock ceases to exist
Bonds: Maturity dates are issued with the bond, does not have to be kept until maturity, |
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Control for stockholders and bondholders |
Stocks: have limited control through their board of directors but no control through running the firm/making decisions
Bonds: Have no control over the firm, can protect their interests when bonds are issued |
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Why should we focus on cash flows overr earnings per share? |
-Accounting earnings distort timeliness, value of cash flows is dependent on when we receive them -Accounting earnings are easily distorted through LIFO, FIFO, etc. Changing the accounting method does not affect value -Firms need healthy cash flows in order to stay in business. It is possible to generate high profits but still not have money to pay the bills |
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Assume that for $1 you have the opportunity to flip a coin. For heads you get $2, for tails you get $0. If you are risk averse, should you take the coin flip? |
Half the time you will get $2 Half the time you will get $1 The average is $1 You are already paying $1 for the opportunity so you will not gain or lose anything. A risk averse person would not take this chance because there is no payoff. |
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How does globalization relate to the concept of maximizing firm value? |
-Globalization opens up new markets which will increase expected cash flows. -Exposes firms to new risk factors but higher cash flows offsets these risks. |
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How does social responsibility and ethics relate to the firm? |
-Help achieve goal of maximizing firm value in the long run -Ethical companies can better keep customers and suppliers because they are trustworthy -Socially responsible companies have customers/suppliers who feel better about doing business with them - |
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Define an agency relationship |
Exists when one party (principle) hires another party (the agent) to perform a task then grants that agent decision making authority |
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What major problems do agency relationships encounter? What can be done to help this problem? |
-Stockholders want to managers to maximize firm value while managers want to maximize their own happiness. -Managers should be compensated for engaging in value maximizing behavior. This can be done with stock, which will make managers into stockholders to align their goals. |
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Make an argument for the current state of executive compensation being okay and an argument to reduce executive compensation |
Okay: Executive compensation reflect market forces and the job is demanding and consuming. No one is forcing theses firms to pay high compensation levels.
Against: Board of directors are not ideally suited to determine with CEO salaries |
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Management recently declared a 2-for-1 stock split. Prior to the split, the stock was worth $40 per share and it is now worth $20 per share. Since the stock price has dropped in half, this decision has lowered shareholder wealth (firm value) and should have not been done. True or False |
False Stock splits are neutral events that neither increase or decrease shareholder wealth |
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Socially responsible behavior can be consistent with the primary objective of the firm, but should not be the primary objective of the firm. True or False? |
True Spending money on social responsibility is spending shareholders money |
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Which of the following is inconsistent with risk-aversion?
A. You pay $1 to participate in a fair coinflip that pays $1.50 for heads and $0 for tails
B. You pay $1 to participate in a fair coinflip that pays $2.50 for heads and $0 for tails.
C. You pay $1 to participate in a fair coinflip that pays $2 for heads and $0 for tails. |
A and C |
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The concept of limited liability associated with the corporate form of ownership implies that owners in corporations can not lose money if the corporation is sued. True or False |
False Limited liability says they can only lose as much as they've invested |
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Globalization tends to increase the value of the firm by increasing the __________ of expected cash flows |
magnitude
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Which of the following would likely lead to a higher firm value (shareholder wealth)? |
Creating a receivables collection policy that collects credit sales faster (without impacting the magnitude or riskiness)
Reducing the riskiness of expected cash flows (without impacting the magnitude or timeliness) |
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The concept of double taxation refers to ___. |
Shareholders being taxed twice -- once at the corporate level and once when they receive dividends and/or capital gains. |
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Who is the principle in agency relationships? Who are the agents? |
Principle: Shareholders Agents: Management |
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Key to agency relationships |
Aligning goals of the principle/agent |
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The right, but not the obligation, to buy the stock at a fixed price w/ in a specific time create short term focus |
Options |
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EBITDA |
earnings before: interest, taxes, depreciation, ammortization
A very rough measure of cash flows |
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captures transactions over a period of time |
income statement |
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a snapshot of values at a point in time |
balance sheet |
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Historical cost basis may understate assets due to |
1. some assets appreciate: paying for land on the easy cost 100 years ago, today it would be worth much more
2. arability to generate cash flows higher than ?
3. intangible assets: brand name, patents, copyrights, etc. |
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Reports cash flows by operating activities, investing activities, and financing activities |
statement of cash flows |
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-Reports the firms ability to generate cash from their basic day to day business operations -Should be positive and growing over time. If not, we need to understand why and how (if) it can be fixed |
cash flows from operating activities most important component |
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-reports the firm's use of cash to purchase (or sell) property, plant and equipment (or other LT investments) -almost always negative |
cash flows from investing activities |
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reports the firm's use (or proceeds) of capital for dividends, paying off existing debt, buying back shares of stock, or issuing new debt/equity |
cash flows from financing activities |
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Cash flows from financing activities are typically _____ for younger and/or rapidly growing firms and ___________ for more mature firms |
positive;negative |
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________ values in cash flows from financing activities are typically "healthier" than positive values |
Negative |
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Combine information from the income statement and/or balance sheet in a manner to identify potential strengths and weaknesses of the company |
financial ratios |
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Expresses each item on the income statement as a percentage of revenues |
common size income statement |
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Expresses each item on the balance sheet as a percentage of total assets |
common size balance sheet expresses |
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Allow us to better analyze the income statement and balance sheet over time and across companies as it standardizes the information in an easily comparable manner |
common size statements |
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The income statement captures a company's performance over time while the balance sheet captures its status at a point in time. What does this mean? |
-Income statement captures all activity related to revenues and expenses over a particular time period, Ex: For the quarter, beginning and end of quarter are treated the same -Balance sheets represent a firm’s assets, liabilities, and owners’ equity at a particular point in time, Ex: Quarterly balance sheet only reflects the last day of the year, Annual reflects the last day of the year |
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A company has $100 million in total assets and $40 million in equity. How much does it have in total liabilities? |
The firm has $60 million in total liabilities. A = L + OE $100M = L + $40M $60M = L |
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How does depreciation create a difference between earnings and cash flows? Are there any other ways/reasons in which accounting earnings can be different from cash flows? |
-Depreciation is a non cash expense, it lowers net income but the firm is not actually paying for anything= No impact on cash flows -Asset is purchased=cash flow impact is spread out over time to understate the true cost of the purchase
Other examples: revenue recognition, prepaid expenses
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What types of people use ratio analysis? Who might be most interested in liquidity ratios? asset management ratios? debt management ratios? profitability ratios? market value ratios? |
primary parties interested are: -Management (all ratios) -Competitors -Stockholders (and potential stockholders) -Long-Term and Short-Term Creditors |
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Who cares about liquidity ratios? |
Management
Short term creditors: have enough liquid capital to meet short term obligations |
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Who cares about asset management ratios? |
Management
Competitors: gauge their own performance against other firms
Stockholders: firms ability to generate profits/increase firm value |
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Who cares about debt management ratios? |
Management
Short and Long Term Creditors: want to see confident in seeing they will be payed back in full
Stockholders: will lose investment if the firm is unable to meet it's debt obligations |
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Who cares about profitability ratios? |
Management
Competitors: gauge their own performance and compare
Stockholders: the profits belong to them |
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Who cares about market value ratios? |
Management: high ratios mean high firm value
Stockholders: Potential stockholders will want low stock, "cheap" |
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Company A has a ROA of 8% and a ROE of 12%. Company B has a ROA of 7% and an ROE of 15%. What does this tell us about the relative levels of debt financing between these two companies? Which company’s approach is better? |
Company B has a lower ROA and a higher ROE (relative to Company A), we know that Company B is using more leverage (debt financing) than Company A.
Company B is using a more aggressive (riskier) strategy of financing.
The higher level of debt increases the risk, but also means stockholders earn a greater return on their money when the company does well. However, if the company does poorly, the higher leverage (debt financing) will magnify the losses (as the interest must still be paid and the loss is spread over less shareholder capital). |
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Company A tends to have most of its sales in the fourth quarter and does a large percentage of sales on a credit basis. Company B also sells primarily on credit, but most of its sales come in the first and second quarter. An analyst looks at their DSO ratio from the annual balance sheet and income statement and notices that company A has a much higher DSO outstanding. The analyst concludes that Company A is doing a poor job of managing its accounts receivable. Is the analyst correct? Explain? Which company would likely have a higher inventory turnover ratio and why? |
-A high DSO ratio can be an indication of a problem in managing a firm’s
-DSO uses both balance sheet and income statement values to calculate the ratio. As the Annual Income statement is not subject to seasonality while the Annual Balance Sheet is, there is the potential for seasonality issues to distort the ratio |
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Which statements are subject to seasonality? A) Quarterly Income Statement B) Annual Income Statement C) Quarterly Balance Sheet D) Annual Balance Sheet |
Subject to Seasonality : Quarterly Income Statement Quarterly Balance Sheet Annual Balance Sheet
Not Subject to Seasonality: Annual Income Statement |
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Company A has a Profit Margin of 3% while company B has a Profit Margin of 8%. This tells us that company B is outperforming company A. Is this statement true or false and explain your answer? |
-Not enough information -Ignoring both trend analysis and comparative analysis -We don’t have the necessary context (industry type) to evaluate the profit margin number -ONE RATIO WITH CONTEXT IS CLOSE TO MEANINGLESS |
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Identify at least one potential problem with trend analysis and one potential problem with comparative analysis. Trend Analysis |
-trends can change -some patterns are not trends, they could just be a "one year change" -past data may be irrelevant |
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Identify at least one potential problem with trend analysis and one potential problem with comparative analysis. Comparative analysis |
-some industries make it hard to compare ratios -when there are few competitors, a dominating industry will make comparisons hard |
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Why might a very low quick ratio be a cause for concern? How about a large quick ratio? |
Low QR: liquidity concerns, have a hard time paying off liabilities when they come due
High QR: inefficient allocation of resources,
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From the perspective of MANAGEMENT, what is the primary objective of financial statement analysis? What are some difficulties management might encounter in doing a complete financial statement analysis?
Re-examine these two questions from the perspective of the stockholder. |
Identify potential strengths and weaknesses of our firm relative to our competitors so we can take full advantage of our strengths and work on fixing our weaknesses.
Difficulties: -trend/comparative analysis -analysis cannot recommend HOW we can fix weaknesses or exploit strengths
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From the perspective of STOCKHOLDERS, what is the primary objective of financial statement analysis? What are some difficulties management might encounter in doing a complete financial statement analysis?
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Identify companies to invest in (potential stockholders) or evaluate the companies the stockholder currently owns (current stockholders)
Difficulties: -Must not only analyze the company’s financial health, but also evaluate how much they are paying for it |
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A negative value in which component of the Statement of Cash Flows is the likely to be the biggest concern to stockholders? |
Cash flows from operating activities -Measures our profitability -Negative indicates losing money |
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Which of the following ratios would we generally want to be higher rather than lower? (This is a multiple answer format question which means you should check all that apply...there may be more than one correct response).
Return on Assets (ROA) Return on Equity (ROE) Inventory Turnover
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Return on Assets and Return on Equity are profitability ratios. In general, higher profitability is good. Inventory Turnover tells us how often we sell through our inventory. The higher this is, the greater profits we generate for every dollar invested in inventory, which is good
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The current ratio will always be greater than the quick ratio (assuming inventory is positive). |
False This is true because the difference between the current and the quick ratio is the quick ratio SUBTRACTS inventory from the numerator. Thus, with any positive inventory value, the quick ratio will be smaller. |
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You evaluate two companies that have very similar levels of return on assets. However, firm A's return on equity is much higher than firm B's return on equity. This means ___. (This is a multiple answer format question which means you should check all that apply...there may be more than one correct response). |
Firm A uses more debt financing than firm B -Higher return on equity=more debt financing |
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The Days Sales Outstanding ratio reflects how long it takes us on average to collect our sales. Since the sooner we receive cash flows, the more they are worth to us, a lower Days Sales Outstanding ratio is always better than a higher Days Sales Outstanding ratio |
False -Too high and too low are equally bad |
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You have gathered the following information: * Total Assets = $50,000* Total Liabilities = $20,000 * Net Income = $4000 * Number of shares outstanding = 2000 * Price/Earnings Ratio = 15 Based on this information, the Market Value/Book Value ratio is |
2
First, calculate stock price through the PE ratio. PE = Price/EPS 15 = Price/(4000/2000) 15 = Price/2 Price = $30 Next, solve for Book Value per share. BV = Owners Equity/Shares BV = (50,000 - 20,000)/2000 BV = $15 Now, solve for MV/BV ratio MV/BV = $30/$15 = 2.0 |
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You have the following information of Firm A: * Total Assets = $10,000* Net Profit Margin = 5.6% * Return on Assets 8.8% Based on this, what are Firm A's Sales? |
15714
ROA = NI/Assets 0.088 = NI/10,000 NI = 0.088*10,000 = $880 NPM = NI/Sales 0.056 = $880/Sales Sales = $880/0.056 Sales = $15,714 |
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The purpose of comparative analysis is to |
see how the firm's financial ratios and common size statements compare to their industry averages |
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In a common size balance sheet |
All items on the balance sheet are expressed as a % of total assetsThe balance sheet represents a point in time while the income statement reflects transactions that have occurred over a period of time. |
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The balance sheet represents a point in time while the income statement reflects transactions that have occurred over a period of time. |
True |
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Ratios can only be evaluated with _______ |
context |
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-Ratio to measures a firms liquidity -How easy is it for the firm to meet its current liability obligations |
quick ratio QR: (current assets-inventory)/current liabilities Rule of thumb: >1 |
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Trend analysis is looking at ratios over a _____ year time period |
3-5 |
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Problems with trend analysis |
1. A trend can stop at any time because it's what IS HAPPENING 2. Trends can be difficult to evaluate, there is not always a clear trend that we can identify |
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Problems with comparative analysis |
1. Some industries have too few participants 2. Some industries have the "800 pound gorilla" aka Wal-Mart 3. Some firms defy industry classification |
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Common size |
Revenue is 100% Everything else is a percentage of that sales **check homework problem** |
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ROA ROE Formulas |
ROA=NI/assets ROE=NI/owners equity |
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add formulas:
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from time value of money handout |
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a series of equal, periodic cash flows |
annunity (PMT) |
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Explain why $1 received today is worth more than $1 received a year from now? |
-As soon as we have the money, we start making a positive rate of return. -The earlier I get the money, the more time I have to make it work in my favor. |
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What do we mean when we refer to an annuity? Difference between annunity and annutiy due? |
Annuity: Equal periodic cash flow stream |
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What is the relationship between present value and future value? |
Present value: What the cash is worth today Future value: What the cash flow will grow over time -Once we have one, we have the other |
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Why is compounding on a monthly basis better than compounding on an annual basis? |
-Allows us to start earning interest sooner -Both the principle and interest work for us |
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All else equal, increasing the discount rate will always lower the present value of a positive cash flow stream |
Higher discount rates (required returns) make the cash flow stream worth less to you today every time. |
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Assume you put away a fixed amount today for 20 years at a positive rate of return. You will earn more money during the last ten years than you did during the first 10 years. |
This is due to the compounding effect. Over the last 10 years, you have had time for your balance to grow, so each year you will earn more and more interest. |
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Assume you put away a fixed amount today for 20 years at a positive rate of return. You will earn more money during the last ten years than you did during the first 10 years. |
This is due to the compounding effect. Over the last 10 years, you have had time for your balance to grow, so each year you will earn more and more interest. |
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Ratios we want to be higher rather than lower |
ROE ROA Inventory Turnover |
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An annunity that lasts forever |
perpetuity |
