BUS-170 notes-2 - PDF

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BUS-170 Salman Tahsin...

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Chapter 1: An overview of the financial management 5 basic duties of corporate accounting ● External financing ○ Raising capital to support companies operations ● Financial management ○ To manage firms internal cash flows, and its mix of debt and equity financing

Chapter 3: Financial statements, cash flow, and taxes 9/1/20 Financial statements ● Accrual approach ○ Revenues recorded at point of sale and cost when they are incurred ● Cash flow approach ○ Used by financial professionals to focus on current and prospective inflows and outflows of cash ○ Revenues recorded when money is received Balance sheet ● Indicates what the firm owns and how assets are financed in the form of liabilities or ownership interest. ○ Delineated the firms holdings and obligations ○ Picture of firm at point in time ○ Items are stated at original cost basis not current Income statement ● Device to measure profitability ● Covered in a defined period of time ● Measures income: ○ Gross profit ○ Earnings before interest and taxes ○ Earnings before taxes ○ Net income ● Formulas for income statement: ○ Gross profit (GP) = Sales - Cost of goods sold (COGS) ○ EBIT or Operating Income = GP- expenses - depreciation ○ EBT = EBIT - Interest ○ Net Income or earnings after taxes = EBT - Taxes Statement of Cash Flows ● Reports the impact of a firm's activity on cash flows over a given period of time ○ Cash flows from: ■ Operating activities ■ Investing activities ■ Financing activities

Cash Flow Analysis ● Although financial managers are interested in the information contained in the firms accrual-based financial statements, their primary focus is cash flows ● Without adequate cash to pay obligations on time, to fund operations and growth, and to compensate owners, the firms will fail

Chapter 4: Analysis of Financial Statements 9/8/20 Why are ratios useful? ● Ratios standardize numbers and facilitate comparisons ● Used to highlight weaknesses and strengths ● Ratios comparisons should be made through time and with competitors ○ Industry analysis ○ Benchmark (peer) analysis ○ Trend analysis Types of ratios ● Liquidity ratios ○ Measure a firm's ability to satisfy its short term obligations as they come due ○ Current ratio = current assets/current liabilities ■ You would want a higher ratio ■ Current assets can be converted to cash within a year ○ Quick ratio = (current asset-inventory)/ current liabilities ● Asset management ratios ○ Measures how effectively a firm is managing its assets ○ Inventory turnover = sales/inventory ■ Preferable to be higher ○ Days of Sales outstanding(DSO) = receivables/Average sales per day ; =receivables/(annual sales/365) ■ Preferably a lower number ratio ○ Fixed asset turnover = sales/net fixed assets ■ Preferable to be higher ○ Total asset turnover = sales/total assets ■ Preferable to higher ● Debt management ratio ○ Measures how a firm is effectively managing its debt ○ Total debt to total capital ratio = total debt/(total debt+equity) ■ Total debt is all debt with interest ex. Notes payable ○ Times interest earned = EBIT/interest ● Profitability ratios ○ Relate a firm's earnings to sales, assets and equity

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○ Operating margin = EBIT/Sales ○ Profit margin = net income/sales ○ Basic earning power = EBIT/total assets ○ Return on assets = net income/total assets ○ Return on common equity = net income/ common equity ○ ROIC = [EBIT(1-T)/total invested capital] Market value ratios ○ Relates a firm's stock price to its earnings and book value per share ○ price/earning ratio = market price per share of common stock/earnings per share ○ Book value per share = common equity stock/ number of shares per shares of common stock outstanding ○ market/book ratio = market price per share of common stock / book value per share of common stock Practice problem- D’Leon (see files from D’Leon for chapter 4 on Canvas) ○ Current ratio = (2680112) / 1144800= 2.3411 ○ Quick ratio = (2680112-1716480) / 1144800= 0.8417 ○ Inventory turnover = 7035600 / 1716480 = 4.0989 ○ DSO = 87800 / (7035600 / 365) = 45.55 days ○ FA turnover = (7035600/817040) = 8.61 ○ TA turnover = (7035600/3497152) = 2.01 ○ Debt to capital ratio = (300,000+400,000)/(300,000+400,000+1,952,352) = .2639 = 26.39% ○ Times-interest-Earned = 492,648/70,008 = 7.04 ○ Operating margin = 492,648/7,035,600 = 7.00% ○ Profit margin = 253,584/7,035,600 = 3.6% ○ Basic earning power = 492,648/3,497,152 = 14.09% ○ Return on assets = 253,584/3,497,152 = 7.25% ○ Return on equity = 253,584/1,952,352 = 12.99% ○ Return on capital (ROIC) = 492,648(1-.40)/(1,952,352+400,000+300,000) = 11.14% ■ Total invested capital = total debt (notes payable + long term debt + total equity) ○ P/E ratio = $12.17/$1.014 = 12.00 ○ M/B ratio = $12.17/7.81 = 1.56 ■ Book value per share = (1,952,352/250,000) = 7.81 Practice problems for Orange Inc. (see files chapter 4) ○ What is the Orange Inc. ratio? ■ A.) 0.5 ○ What are Orange Inc. days sales outstanding (DSO)? ■ D.) 86.90 days ○ What is Orange Inc. debt to total capital ratio? ■ A.) 0.32 ○ If Orange Inc. has 100,000 shares outstanding what is the book value per share?

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A.) $5.00

Chapter 5: Time Value of Money 9/22/20 ● ●

Time lines ○ Ticks Solving for FV: ○

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Practice question ○ You have $1500 to invest today at 7% interest compounded annually how much will be accumulated in three years? Present Value ○ Opposite of compounded is discounting ○

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𝑁

𝐹𝑉𝑁= 𝑃𝑉(1 + 𝐼)

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PV = 𝐹𝑉𝑁/(1 + 𝐼)

○ Interest is in decimal on writing but in calculator it is in percentage Practice question ○ -63.0 Annuity due is always in beginning mode!

Chapter 6: Interest Rates ●

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10/1/20 Four factors of interest rates ○ Production opportunities ○ Time preferences for consumption ○ Risk ○ Expected inflation Nominal vs. real rates ○ R represents any nominal rates ○ Rrf represents the rate of interest on treasury securities ○ r* represents real risk free rate of interest, like a T-bill if there was no inflation. ■ Ranges from 1%-4% Determinants of interest rates ○ r = r* +IP + DRP + LP + MRP ○ r= required return on debt security ○ r* = real risk free rate of interest ○ DRP = default risk premium ○ LP = liquidity premium ○ MRP = maturity risk premium Yield curve and the term structure of the interest rates

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Term structure: relationship between interest rates (yields) and maturities The yield curve is a graph of the term structure

Chapter 7: Bonds 10/6/20 ●

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Key features of bond ○ Par value: ○ Coupon interest rate: stated interest rate paid by issuer. Multiply by par value to... ○ Maturity date: years until bond should be paid ○ Issue date: day it was issued ○ Yield to maturity: Effect of a call provision: allows issuer to refund the bond issue if rates decline ○ Helps issuer but hurts investor ○ Bond investors require higher yields on callable bonds ○ In many cases callable bonds include a deferred call provision and a declining call premium Sinking fund ○ A provision to pay off a loan over its life rather than all at maturity ○ Similar to amortization on a term loan ○ Reduced risk to investors, shortens average maturity ○ But not good for investors if rates decline after issuance How are sinking funds executed ○ Call x% of the issue at par, for sinking fund ○ Buy bonds in open market ■ Likely to be used if coupon rate is below rd and the bond sells at a discount Other types of bonds ○ Convertible bond: may be exchanged for common stock bond of the firm, at the holder’s option ○ Warrant: long term option to buy a slated number of shares of common stock at a specified price ○ Putable bond: allows a holder to sell the bond back to the company prior to maturity ○ Indexed bond: interest rate paid is based upon rate of inflation Practice problem 1: $1000, 10 yr bond, rd= 13%, 13% annual coupon rate ○ PMT = 13% x 1000 = 130 ○ N = 10 ○ I/YR = 10 ○ FV = 1000 ○ PV = -1184.34 Practice Problem 2: 10 year, $1000, rd= 10%, 7% annual coupon rate ○ PMT = 13% x $1000 ○ N = 10

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○ I/YR = 10 ○ FV = 1000 ○ PV = -815.66 Practice Problem 3: $1000, 5 year bond, coupon rate 7%, rd = 8% ○ PMT = The value of an asset equals the present value of future benefits accruing to the asset’s owner

Chapter 8: Risk and Rates of Return ● ● ● ● ●

10/19/20 Higher risk = higher return Probability distribution: a listing of all possible outcomes and the probability of each occurrence. R hat = Σ Standard deviation measures total stand alone risk Coefficient of variance ○

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CV =

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛

Risk aversion: assume investors dislike risk and require higher rates of return to encourage them to hold riskier securities Risk premium: the difference between…. Portfolios risk and return: ○ A portfolio's expected return is a weighted average of the return of the portfolios component assets ○ Most stocks are positively (not perfectly) correlated with the market. Determine Beta through historical data and running a regression on the securities past returns against the past returns of the market The slope of a regression line is defined as the beta coefficient of the security

Chapter 9 10/29/20 ●

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If given D0, you must solve for D1 ○ D1 is for next year ○ D0 is for current year Practice problem: ○ Step 1: solve for r ○ R = required return ■ R = RISK FREE RATE + (MRP) x beta ■ R = 0.04 + (0.055) x 1.15 = 0.10325 ○ Step 2: solve for po ■ P0 = intrinsic value of company ■ Po = D1/(r-g) = 1.25/(0.1033-0.06) = 28.87

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R= rate G = growth

Chapter 10: Cost of Capital 11/3/20 ●

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Capital ○ Debt ■

Debt helps reduce taxes! ● Notes payable ● Long term debt ○ Preferred stock ○ Common equity ■ Retained earnings: what is left after paying dividends ● Old companies are likely to have retained earnings (have established profit) ■ New common stock WACC: weighted average cost of capital ○ The W’s refer to the firm's capital structure weights ○ The R’s refer to the cost of each component ○ Wd = weight of debt ○ Wp = weight of…. ○ Wc = weight of …. ○ Rd = cost of debt ○ Rp = cost of preferred stock ○ Rs = cost of common stock/ retained earnings ■ Rate of return on investors require on the firm's common equity using new equity is re* Should our analysis focus on before tax or after tax capital costs? ○ Focus on after tax Is preferred stock more or less riskier to invest than debt? ○ More risky; company not required to pay preferred dividend Practice problems: which is not a capital component of WACC for use in capital budgeting? ○ B.) Accounts Payable ■ This is considered a liability Practice problem: Before tax cost of debt is lower than after tax cost ○ False ■ Before tax is higher Practice problem: If a firm's marginal rate is increased other things held constant lower the cost of debt to calculate its WACC ○ True Why is there a cost of retained earnings?

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○ Earnings can invested or paid out as dividends ○ Investors can buy other securities, earn a return ○ If earnings are retained there is an opportunity cost Three ways to determine the cost of common equity ○ CAPM ○ DCF ○ Bond-Yield-Plus-Risk-Premium Practice problem: ○ D0 = $4.19 ○ P0 = $50 ○ G =5% ○ D1 = D0 (1 + g) ○ Rs = (D1/P0) +g ○ Rs = (4.3995/50) + 0.05 ○ Rs = 0.13799 or 13.8% Why is the cost of retained earnings cheaper than the cost of issuing new common stock? ○ When a company issues a new common cost they must pay a flotation costs to the underwriter ○ Issuing new common stock may negatively affect the company What factors influence a company’s composite WACC? ○ Factors firm cant control ■ Market conditions such as interest rates and tax rates ○ Factors firms can control ■ Lkmlkm Higher T, lower WACC WACC is the minimum and should preferably be higher

Chapter 15: Dividends to shareholders...