Finance Final Exam PDF

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finance final exam for professor graham at James Madison university....

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FINANCIAL MANAGEMENT 

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Sole proprietorship o Single owner and operator (manager) o Advantages  Simple to set up (little oversight and regulation)  Business income is taxed only once o Disadvantages  Unlimited liability  Owner is liable not only to the extent of what is invested in the business but also for any other assets owned.  Limited Life  Limited access to capital Partnerships o Owned and operated (managed) by two or more people.  Formalized by a partnership agreement, which establishes how decisions are made, such as how each partner can buy out the other in the event that one wants to dissolve the partnership.  Partnership agreement stipulates how the partnership’s income is allocated among the partners. o Advantages  Easy to set up  Business income is taxed only once o Disadvantages  Unlimited Liability  Limited Life  Difficult to transfer ownership  Limited access to funds  Types of partnerships General partnership o All partners share the management and income of the business Limited liability partnership (LLP) or limited partnership o At least one general partner who manages the business, but there may be any number of limited partners, who are passive investors.  The General partner has unlimited liability while limited partners have limited liability Corporations o Business organized as a separate legal entity under corporation law, with ownership divided into transferable shares. o Advantages  Limited Liability  Unlimited Life  Easy to transfer ownership  Separation of Management and ownership  Access to Capital

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o Disadvantages  Double taxation (corporate and personal taxes)  Separation of ownership and management Corporations o In corporations, the owners are the owners of the ownership interests—that is, the shareholders—who elect members of the board of directors, who in turn hire and monitor the company’s management. o For smaller companies, the separation of management and ownership isn’t a problem, but for larger companies, it becomes a serious concern. o This division is the fundamental problem of the governance structure of large companies Limited liability companies o Business organized as a separate legal entity in which owners have limited liability, but the income is passed through to the owners for tax purposes. o Advantages  Limited Liability  Unlimited Life  Business income taxed only once o Disadvantages  Separation of ownership and management of the firm  Limited access to capital Subchapter S corporations o Elects to be taxed as a partnership. o Limited to 100 shareholders and all must be US citizens or permanent residents. Form of business o Initial form  The predominant forms of business are the sole proprietorship, the limited liability company, and the Subchapter S Corporation. o Following the companies in their first 6 years  Start-up companies begin their existence as sole proprietorships, limited liability companies, or Sub S corporations.  Partnerships and C Corporations are rare. How do they finance the business? o Start-up companies are largely funded by the owners themselves. As the business generates cash flows, fewer tap outside sources of funds. How do owners get their funds? o The percentage of owners who rely on credit card funding – personal and business – is high. Primary goal of financial management o The goal of the company is to maximize the market value of the equity interest or, alternatively, maximize owners’ value.  For a corporation, that means to maximize shareholders’ value.  Maximize the present value of all current and future cash flows to owners.

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o The company should take resources and create products that society values more highly than it values the inputs. o The company should operate legally and in compliance with its contractual responsibilities, in the interests of its owners, by creating value for them. There are 3 major determinants in the market value of a firm o Cash flows – Actual cash generated by the operation of a business o Timing – Value of cash received sooner rather than later is dependent on your ability to use that cash o Risk – The greater the perceived risk with an expected cash flow, the greater the rate of return required by investors Divergent Objectives, Agency Issues o The primary reason for divergence of objectives between managers (agents) and shareholders (principals) has been attributed to separation of ownership and control in corporations. o Principal-Agent Problem  Principal hires agent to represent his interests  Agency problem occurs when there is a conflict of interest between the two parties  Agency Costs o There are several ways you can increase the likelihood of managers acting in interest of shareholders  Tie management compensation to market value of firm  Stock options, a proxy for market value, can also be effective in mitigating risk of agency conflicts Aligning managers’ and owners’ interests o The different perspectives of managers and shareholders are evident in terms of performance measurement.  Shareholders are interested in stock market performance because they want managers to create shareholder value.  Shareholders and managers also differ in their approach to risk and financing. o The challenge is to design compensation schemes that encourage managers to act in the best interest of shareholders.  The elements that are typically included are salary, bonus, and options. o Salary compensation is relatively low compared with the total package. This is likely the result of the limitation of $1 million per executive for the deductibility of compensation for tax purposes. o Annual bonuses are generally somewhat larger, but the largest component, by far, is share compensation. Problems aligning managers’ and owners’ interests o Few companies require executives to own the stock after exercising an option, so often the shares obtained with an option exercise are sold immediately o Some companies re-price the options if the stock’s price is far under the original exercise price, setting the exercise price much below the original price.

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o It is challenging to establish a plan that compensates executives for making long-term strategy and investment decisions today that take the long-run view of maximizing owners’ equity. o Corporate governance is the set of processes and procedures established to manage the organization in the best interests of its owners. o In addition to the compensation structure, corporate governance includes  The composition and processes of the compensation committee of the company’s board of directors,  The composition of the committee that selects and oversees the work of the independent auditor and the transparency of financial reporting. o As a result of the SOX Act, publicly traded companies in the U.S. must now have compensation committees that comprise independent directors. Financial management o The management of the financial resources of a business or government entity, where financial resources include both the investments of the entity, but also how the entity finances these assets. Investment decisions o Capital budgeting or capital expenditure analysis is the framework for analyzing long-term investment or asset decisions  These long-term investments include building a new plant, introducing a new product, and acquiring another company. Without capital investments, the company will not continue as a going concern.  Evaluating capital budgets requires analyzing the future incremental cash flows that a project is expected to generate, considering the project’s cost of capital.  In most cases, a capital investment requires a substantial outlay at the beginning, but the investment is expected to generate incremental cash flows for a number of periods into the future. Financing decisions o The financing decisions of a company involve the management of short-term obligations, such as bank loans, and long-term financing, which may be debt and/or equity. o The management of short-term obligations requires understanding the needs of the company throughout the year for short-term borrowing and trade credit. o There are many forms of short-term financing, and the financial manager must evaluate the cost of each available type. o A company’s capital structure is the mix of debt and equity that the company uses to finance its business. o Debt capital consists of interest-bearing debt obligations, which may be notes or bonds, whereas equity capital consists of stock issues and retained earnings and is the ownership interest in a business enterprise.

FINANCIAL STATEMENTS 

Accounting principles

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o Accounting is simply an organized method of summarizing all of a company’s transactions and presenting them in such a way that external users can understand the company’s affairs. o Problems arise when the company tries to present its accounting statements in a way that does not fairly represent its situation, either to creditors, like the bank, or to the common shareholders. o Consequently, external users of the company’s financial statements must become skilled in analyzing the statements. Generally Accepted Accounting Principles o Management prepares the company’s financial statements, not the company’s auditors. o Auditors, such as Deloitte & Touche LLP (Deloitte), attest to whether or not the financial statements fairly represent the company’s financial position according to generally accepted accounting principles (GAAP). o Companies reporting in the U.S. follow the principles promulgated by the Financial Accounting Standards Board (FASB), whereas members of the European Economic Community, and other countries, follow the principles promulgated by the International Accounting Standards Board (IASB). Independent auditors o Independent auditors review the financial statements prepared by a company’s management and provide a report, addressed to the company’s board of directors and shareholders, that generally consists of the following: o 1. A statement that the financial statements are the responsibility of the company, and that the auditor is providing an opinion on the financial statements, not the accounting records themselves. o 2. A description of the scope of the audit, and that it was conducted according to generally accepted auditing standards, o 3. The auditor’s opinion, which is one of four types. Accounting conventions: basic principles o The purpose of financial statements is to provide information, at least annually, to a wide range of external users, including investors, employees, lenders, governments, and the general public. o The underlying assumptions in the financial statements are that transactions are recorded on the accrual basis, and that the entity is a going concern, and hence will continue indefinitely. o Financial statements should possess the qualitative characteristics of understandability, relevancy, reliability, and comparability. Measuring costs and value o Business entities measure and report monetary amounts for the various elements in its financial statements. o The basis for measuring costs differs among accounts, and may differ among entities for the same accounts. Managing financial statements o Accounting principles offer some flexibility because it is simply not possible to design a one-size-fits-all set of principles. For example:

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Mark-to-market - writing the value of an asset up or down, depending on its current market value  Available-for-sale - method of accounting for marketable securities in which unrealized gains or losses are reported as part of accumulated other comprehensive income  Trading securities - method of accounting for marketable securities that occurs when unrealized gains or losses are reported in net income  Held-to-maturity - method of accounting used when marketable debt securities are reported at cost Net income v. comprehensive income o Net income appears in the income statement; o Other comprehensive income is the adjustment to net income. Financial Statements o Financial statements provide a summary of the transactions of a company.  The balance sheet provides a snapshot of the company’s assets, liabilities, and equity at a point in time.  The income statement and statement of cash flows summarize activity over the fiscal period, whether that be a quarter or a year.  The statement of cash flows provides summaries of cash flows by operations, investing, and financing activities over a period of time. o Key to understanding financial statements is appreciating that the balance sheet, income statement, and statement of cash flows are all interconnected. The balance sheet o The balance sheet, which we also refer to as the statement of financial condition, is a snapshot of the company’s financial position, listing assets, liabilities, and equity. o Because of double-entry bookkeeping, assets must be equal to the sum of liabilities and equity. o Balance sheets are as of a particular date, such as the end of the fiscal year or fiscal quarter. The structure of the balance sheet o The order of the assets is by liquidity, with the most liquid listed first, and so on. This is different than what we see for companies reporting based on IFRS. o According to IFRS, unless there is a compelling reason to do otherwise, the asset accounts are listed in two groups: current and noncurrent.  SAP AG, a German computer company, reports the following in its 2010 balance sheet: The income statement o The income statement, or the statement of earnings, is a summary of the company’s performance over a period of time, typically a fiscal quarter or a fiscal year. o The basic structure is as follows: o Revenue (COGS) Gross Profit

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(S&A Expense) EBIT (Interest Expenses) EBT (Taxes) Net Income Income statement: variations in terminology o You will find variations of this basic structure as you examine the income statements of actual companies: o Revenues may be referred to as net revenues, sales, or net sales o The cost of goods sold may be referred to as the cost of sales or direct costs o If the company mines or extracts minerals, gas, or oil, it may have depletion, which is similar to depreciation and amortization o The company may have research and development or other operating expenses that are deducted to arrive at EBITDA o The company may have other income or other expenses that may be added or deducted before or after EBIT, depending on the nature of the income or expense o If the company has preferred stock, net income may be presented before and after preferred stock dividends are subtracted, in which case the bottom-line net income may be referred to as net income available to common shareholders Depreciation o “Wear and tear” has traditionally been referred to by accountants as depreciation because an asset is depreciating or reducing in value through time. o The depreciation expense is the estimate of the loss of value of a long-lived tangible asset over a specified period of time, such as a year or a quarter. o A similar concept is amortization, in which amortization expense is the loss of value of an intangible asset over time. For financial reporting purposes, the company is allowed to use any reasonable method for calculating depreciation or amortization. Straight-line Depreciation o The most common method of depreciation for financial reporting purposes is straight-line depreciation. o Depreciation using the straight-line method is the same each year of the asset’s life, calculated as the depreciable asset’s cost, less an estimated salvage value, divided by its estimated useful life: o "Straight-line depreciation= " "Asset cost -salvage value" /"Useful life" Depreciation o Example: Consider an asset that has a cost of $100,000 and a useful life of 5 years. If the asset’s salvage value—that is, what the company expects to sell the asset for when the asset is at the end of its useful life—is $10,000, the depreciation each year is $18,000 per year: o "Straight-line depreciation= " "Asset cost -salvage value" /"Useful life" o "Straight-line depreciation= " "$100,000-10,000" /"5"

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o In other words, 20% of the asset’s cost (less salvage value) is depreciated each year. Other depreciation methods o Whereas straight-line depreciation results in the same depreciation expense each period, accelerated methods result in more depreciation in earlier years of the asset’s life and less in the later years. o One group of accelerated methods is the declining balance methods of depreciation.  In the declining balance methods, we apply a fixed percentage against the carrying value of the asset, which declines each year with the depreciation. The result is a declining depreciation expense through time. Other depreciation methods o Example: applying the 150% declining method (which is known as 150 DB) in our example is 150% of the straight-line rate, or 1.5 × 20% = 30%.  For the first year, the asset’s depreciation is 30% × $90,000, or $27,000.  In the second year, there is $90,000 - 27,000 = $63,000 remaining to be depreciated.  Twenty percent applied against this value produces $18,900 for the second year’s depreciation. o Another declining balance method, the double-declining balance (DDB) method, follows a similar process, but the rate is twice that of straight-line (that is, 200%).  We often refer to the DDB method as the 200DB method because the rate is 200% of the straight-line rate. Earnings per share o Basic earnings per share (basic EPS) are the earnings per share based on the weighted average of the number of common shares outstanding during the fiscal period: o "Basic earnings per share= " "Net income" /"Weighted average shares" o Companies are also required to report diluted earnings per share (diluted EPS), which is simply the adjusted net income divided by the total possible number of shares that could be outstanding if all potentially dilutive securities outstanding were converted into common shares: o "Diluted earnings per share= " "Adjusted net income" /■8("Weighted average shares" @"potentially outstanding" ) The statement of cash flows o The statement of cash flows is a summary of the sources and uses of cash in the company over a period of time, such as a fiscal quarter or a fiscal year. The statement of cash flows begins with net income from the income statement. o There are three major parts:  Cash flow for/from operations (CFO) - cash flow from the day-to-day operations of the business; the result of subtracting the increase in net working capital from traditional cash flow

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Cash flow for/from investing (CFI) - cash flow, on net, from investing activities  Cash flow for/from financing (CFF) - cash flow, on net, from financing activities Cash flows summary o Cash flow from operations + Cash flow from investing + Cash flow from financing = Net change in cash flow The Tax System o The income tax returns filed with the IRS are similar to the income statements for investors. Interests and Dividends Received by A Firm o Interest is fully taxable when received and fully deductible when paid.  A company may combine these two items into one “net interest” amount. o Dividends are not tax deductible when paid, but there’s dividend tax exclusion when received (70% of dividend received by a firm is tax-exempt). Depreciation o For tax purposes, the government requires a specific form of depreciation. In the United States, this method is the Modified Accelerated Cost Recovery System (MACRS), which is based on the following assumptions:  Using a 200% declining balance method (that is, the annual rate is 200% of what the straight-line rate would be for the same asset life)  Ignoring salvage value for purposes of deprecia...