Principles Of Finance Chapter 2

Front 1

what is finance about?

Back 1

Finance is about measurement. We want to create wealth and value in an ethical way.

Front 2

Finance

Back 2

An asset from which you will gain value and you have to finance it in order to obtain it. You have to raise money from the market.

Front 3

Capital Structure

Back 3

Equity, liabilities, and bonds. Depends on the type of business. Enterpreneur debt prolly don't have alot because ou have a new idea and the bank won't back your idea. Instead you have investors who expect returns. Lots of equity and not much debt in small companies.

Front 4

Financial Instruments

Back 4

Instruments that create returns for owner/capital for the firm. They can go out and sell their interest If people no longer want to invest with you. They do this to meet the needs of their customers.

Front 5

Financial Management

Back 5

Maximize the value of the existing owner's equity.

Front 6

balance sheet

Back 6

Assets, liabilities, and equity. This statement shows a co. assets, liabilities, and equity at a point in time. You can think of it as a snapshot or a picture

Front 7

3 basic financial statements

Back 7

Balance sheet, income statement, Cash flow statement

Front 8

Equity

Back 8

Net worth

Front 9

Assets
Liabilities
Equity

Back 9

what a company owns
What a company owes
A co.'s net worth.

Front 10

Income statement

Back 10

This statement shows the evolution of revenue and expenses over a period of time. Analgous to balancing a checkbook. Start with revenue, subtract expenses, then you are left with a surplus which is a profit. This is like a video recording.

Front 11

Cash flow statement

Back 11

This statemetn shows the sources and uses of cash. Where did it come from and how is it used up?

Front 12

Capital

Back 12

The money a co needs to continue operating. You need huge amounts of money in order to run a bus. Bank won't give you this kind of money so you go to the capital market. Two types of capital. Debt (bonds) and Equity (common stock)

Front 13

High risk
Low Risk
What about the return

Back 13

High risk/high return
low risk/low return

Front 14

debt you are a?
Equity you are a?

Back 14

creditor
owner

Front 15

How do you raise money to start a successful business?

Back 15

Start a successful co. want to raise 100 mil of capital no bank will lend you that kind of money so you go out and raise capital from the capital market. You can either sell stock or bonds.

Front 16

Top advantage of bonds

Back 16

You don't give up ownership

Front 17

Characteristics of debt

Back 17

Bonds
1. Does not dilute ownership.
2. Cost of debt financing is cheaper than equity financing.
3. Interest paid to bondholders is a tax deduction.
Downside to bondholders
Companies ALWAYS have to pay interest. IF you default your company is bankrupt.

Front 18

Characteristics of Common Stock

Back 18

1. C.S. confers ownership rights.
2. C.S. has unlimited life, whereas bonds are for a specific time period. Usually longest is 30 years.
3. Dividends on C. S. can be skipped by the co. with no adverse consequences. There are companies who never issue dividends they just reinvest the profits which in turn makes stock prices rise.

Front 19

Bonds are low risk

Back 19

There is pretty much a guaranteed return as long as the co. doesn't go bankrupt. So the return is low around 6%

Front 20

Common Stock is high risk.

Back 20

High return 12% however the high risk makes it unappealing to some.

Front 21

Priority in Bankruptcy

Back 21

1. Bondholders usually get back about 30 cents per dollar.
2. Preferred stock
3. Common stock.

Front 22

Balance sheet

Back 22

Current Assets
cash, marketable securities, inventory, prepaid expenses, a/r

Fixed assets
machinery, building, less accum depr.

Intangible Assets
copyrights, patents, trademarks.

Total Assets.

Liabilities
Current liabilities:
accounts payable, notes payable, accruals

Long term Liabilities
Bonds/preferred stock

Common Equity
Common Stock
Retained Earnings
TOTAL LIABILITIES AND EQUITY

Front 23

How is preferred stock like a bond:?

Back 23

1. Preferred dividends like bond interest payment is fixed in amount.

Front 24

how is preferred stock like common stock?

Back 24

preferred dividends like common dividends can be skipped with out bankruptcy.

Front 25

Why is preferred stock preferred?

Back 25

1. If a co. goes bankrupt, preferred stockholders have a greater claim on the firms assets than common stockholders.

2. Preferred dividends are paid before common dividends called cumulative feature.

Front 26

Risk and return of:
BONDS
PREFERRED STOCK
COMMON STOCK

Back 26

low risk/low return
moderate risk/moderate return
high risk/high return

Front 27

Total assets

Back 27

Total liabilities + total equity

If they liquidated their assets and they pay off their debt they have leftover is equity

Front 28

Net working Capital

Back 28

Current assets - current liabilities

If this is a negative number the co. is runing a high fever, it doesn't have enough cash to pay off its liabailites in the near future and is likely to go belly up.

Front 29

Debt ratio

Back 29

Total liabilities / total assets

Debt ratio is above 65-70% then you are likely to run into problems.

Front 30

EBIT

Back 30

Earnings before interest and taxes

Front 31

Net income as it relates to share holders

Back 31

Net income is available to common stockholders. It belongs to the owners of the co. So you can use it to reinvest back and add it to retained earnings or you can pay dividends to the stockholders.

Front 32

Net cash flow

Back 32

Net income + depreciation

Profits and cash aren't the same. Cash is always greater.

Front 33

Dividends per share

Back 33

Common dividends / # of common shares

Front 34

Dividend payout ratio

Back 34

Common dividends / net income

Tells what percent of net incom is being paid out in the form of common dividends

Front 35

Retention ratio

Back 35

Addition to retained Earnings / net income

Front 36

Earnings per share

Back 36

Net income / # of shares

Front 37

Price/earnings ratio

Back 37

Price per share / earnings per share (net income / # of shares)

If the P/E is 15/1 then we know stockholders are willing to pay 15x earnings for a particular share. Normal times the P/E is around 20. A higher ratio means they are willing to pay high amounts for 1 dollar of earnings.

Front 38

Net working capital

Back 38

Current Assets less current liabilities.
Positive when CA exceed CA this means that the cash that will become avail over the next 12 months exceeds the cash that must be paid over that same period.

Front 39

Liquidity

Back 39

Refers to the speed and ease with which an asset can be converted to cash. Really has 2 dimensions ease of conversion vs. loss of value. Any asset can be converted to cash if we cut the price enough. Liquidity is valuable. The more liquid a bus. is the less likely it is to experience financial distress.

Front 40

Market Value vs. book value

Back 40

Generally reported on income statements at book value. Managers are interested in knowing the market value because that is where the value is. It is the market value that matters in finance so they will speak of assets in MARKET VALUE.

Front 41

Calculate the addition to retained earnings.

Back 41

Net income less cash dividends

Front 42

Noncash items

Back 42

included on the income statement, however it does not affect cash. Example depreciation. it's an accounting number. The actual cash outflow occurs when the asset is purchased.

Front 43

Time and costs.

Back 43

in the short run costs are relatively fixed. In the long run costs are variable.

Front 44

Average tax rate

Back 44

Total taxes paid divvided by total taxable income.

Front 45

marginal tax rate

Back 45

Amount of tax payable on the next dollar earned.

Front 46

Flat rate tax

Back 46

There is only one rate and the rate is the same for all income levels. The average tax rate never goes down even though the marginal tax rate does. Marginal tax rate is relevant for decision making.

Front 47

Cash flow from assets

Back 47

The total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and change in net working capital.

Front 48

Operating cash flow

Back 48

Cash flow generated from the form's normal business activities.

Front 49

To calculate operating cash flow:

Back 49

We want to calculate revenues minus costs, but we don't want to include depreciation because it's not a cash outflow. WE don't want to include interest because it is a financing expense. TAXES however, are paid in cash and MUST therefore be included.

Front 50

Capital Spending

Back 50

Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets. Net capital spending can be negative if the firm sells off more assets than it purchased.

Front 51

Change in net working capital

Back 51

Ending Net working capital - beginning net working capital equals change in net working capital.

NWC= Current assets minus current liabilities.

Front 52

Cash flow from assets

Back 52

Operating cash flow
- net capital spending
-change in net working capital
=cash flow from assets

Front 53

cash flow to creditors

Back 53

A firm's interest payments to creditors less net new borrowings. Calculated by:

interest paid
-net new borrowing
=cash flow to creditors

Front 54

Cash flow to stockholder's

Back 54

Dividends paid minus net new equity raised equals cash flow to stockholders.