FINC311 exam 1 - Exam 1 study guide with Professor Lynch PDF

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Exam 1 study guide with Professor Lynch...

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FINC311 EXAM 1 (CH. 1-4) MATERIAL Chapter 1 Textbook Notes Four Basic areas: 1. Corporate finance 2. Investments a. What determines the price of a financial asset? b. What are the potential risks and rewards associated with investing in financial assets? c. What is the best mixture of different types of assets to hold? 3. Financial institutions 4. International finance  The financial manager’s office handles cost and financial accounting, tax payments, and MIS o Capital budgeting – the process of planning and managing a firm’s long-term financial investments  Treasurer’s office is responsible for a firm’s cash and credit Capital Budgeting  When capital budgeting, the financial manager tries to find investment opportunities that are work more to the firm than they cost to acquire (cash flow generated by the asset should exceed the cost of acquiring it)  Evaluating the size, timing, and risk of future cash flows is essential in any financial decision Capital structure  How and where to raise money: o How much should a firm borrow? o What are the least expensive sources of funds for the firm? Working Capital Management  Managing this ensures the company’s ability to carry on its operations o How much inventory should we keep? o Should we sell on credit to our customers? o How will we obtain any short-term financing? Forms of business organization 1. Sole proprietorship a. Simplest and least regulated b. Unlimited liability for business debt meaning creditors can look to personal assets for payment c. All business income is taxed as personal income d. Often Unable to try new things because of limited personal wealth 2. Partnership a. General partnership – all partners share gains or losses and have unlimited liability for all debts, described by a partnership agreement b. Limited partnership – liability is limited to the amount the partner contributes to the partnership c. Disadvantages: unlimited liability, taxed as personal income, limited life of business, difficult to transfer ownership 3. Corporation a. A legal “person” separate and distinct from its owners, and it has the rights, duties, and privileges of an actual person – borrow money, own property, be sued, enter into contracts

b. Stockholders elect board of directors who hire managers who run the business for the stockholders so stockholders basically run the business c. The most the owners can lose is what they’ve invested d. Advantages: ease of transferring ownership, limited liability of debt, unlimited life of business e. Disadvantages: must pay taxes, money paid out to stockholders is taxed again (double taxation) Goal of Financial Management  The goal of financial management is to maximize the current value per share of existing stock  General: maximize the market value of the existing owner’s equity Agency Relationship  The relationship between stockholders and management  Agency problem - the possibility of conflict of interest between the owners and management of a firm Stakeholders Ex. Employees, customers, suppliers, and even some government all have financial interest in the firm Chapter 1 Vocab Capital budgeting – the process of planning and managing a firm’s long-term investments Capital structure – the mixture of debt and equity maintained by a firm *working capital – a firm’s short term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers sole proprietorship – a business owned by a single individual partnership – a business formed by 2+ individuals/entities corporation – a business created as a distinct legal entity owned by one or more individuals or entities Agency problem – the possibility of conflict of interest between the owners and management of a firm Stakeholders – someone other than the stockholder/creditor who potentially has claim on the cash flows of the firm Chapter 2 Textbook Notes *note: 1) the difference between accounting value and market value *note: 2) the difference between accounting income and cash flow The Balance Sheet  Snapshot of firm  Convenient means of summarizing what a firm owns (Assets), what a firm owes (liabilities), and the difference between the two (equity) at any given point in time  LEFT = assets o Current  Life of less than one year, will normally convert to cash within 12 months, accounts receivable o Fixed  Relatively long life, tangible (like a truck) or intangible (like a patent)  RIGHT = liabilities and stockholder’s equity o Liabilities  Current – life of less than one year (must be paid within a year) and are listed before long-term liabilities (ex. Accounts payable)  Long-term – a debt that is not due in the coming year (bonds, bondholders) o Shareholder’s equity – if a firm were to sell all of its assets and use the money to pay off its debts, then whatever remains belongs to the shareholders Assets = liabilities + stockholder’s equity

Net Working Capital  A firms current assets – current liabilities  Usually positive in a healthy firm Liquidity Liquidity – the speed and ease in which an asset can be converted to cash  2 dimensional: ease of conversion v. loss of value Debt V. Equity  the use of debt in a firm’s capital structure is called financial leverage o the more debt a firm has, the greater its degree of financial leverage (greatly magnifying gains or losses) Income Statement  measures performance over some period of time, usually quarterly or yearly  revenues – expenses = income  we recognize revenue when the earnings process if virtually complete and the value of the exchange of goods can be reliably determined  we recognize expenses for creating the product (based on matching principle) at the time of the sale noncash items – expenses charged against revenues that do not directly affect cash flow, such as depreciation  depreciation is the most important Cash Flow  the difference between the number of dollars that came in and the number that went out cash flow from assets = cash flow to creditors + cash flow to stockholders cash flow from assets – the total of cash flow to creditors and cash flow to stockholders, consisting of: operating cash flow, capital spending, and change in net working capital Operating Cash Flow operating cash flow – cash generated from a firm’s normal business activities (day to day producing and selling) operating cash flow = revenues – costs (including taxes, not including depreciation or interest)  tells us whether the firm’s inflows are sufficient enough to cover everyday outflows capital spending – the net spending on fixed assets Change in Net Working Capital  difference between beginning and ending net working capital cash flow to creditors = interest payments – net new borrowing (more borrowing debt) cash flow to stockholders = dividends paid out – net new equity raised Chapter 2 Vocab Balance sheet- financial statement showing a firm’s accounting value on a particular date Net working capital – current assets – current liabilities Chapter 3 Textbook Notes  to start comparing different companies we need to find a way to standardize financial statements common-size statements – a standardized financial statement presenting all items in percentage terms Common-Size Balance Sheets  shown as a percentage % of assets Common-Size Income Statement  shown as a percentage % of total sales Ratios

Financial ratios – relationships determined from a firm’s financial information and used for comparison purposes Short term solvency/liquidity: current ratio = current assets/current liabilities Current assets = cash, inventory, accounts receivable Current liabilities = accounts payable  the higher the ratio, the better for short term creditor  over 1 means you have assets you can use to pay back debt Quick ratio Quick ratio = (current assets – inventory)/current liabilities  tells us how much of our assets are super liquid (getting rid of the more obsolete assets) cash ratio (interesting to very short-term creditors) cash ratio = cash/current liabilities Long-Term Solvency – addresses the firms ability to meet its long term obligations or its financial leverage Total debt ratio: takes into account all debts of all maturities to all creditors Total debt ratio = (total assets-total equity)/total assets ^the answer to this ratio can then be plugged in as “total debt” in the debt-to-equity ratio: debt-equity = total debt/total equity equity multiplier = total assets/total equity inventory turnover = COGS/inventory days’ sales in inventory = 365/inventory turnover receivables turnover = sales/accounts receivable days’ sales in receivables = 365/receivable turnover total asset turnover = sales/total assets profit margin = net income/sales return on assets = net income/total assets return on equity = net income/total equity earnings per share (EPS) = net income/shares outstanding Price earnings ratio = net income/shares outstanding

Exam 1 Material Friday, Feb. 10 Financial Statements, Taxes, and Cash Flows Chapter 2 (Part A)  Financial statements serve as a foundation for business decisions Book Value vs. Market Value  Often different  We care about market value when making decisions Average vs. Marginal Tax Rates Marginal tax rate = % of tax paid on the next dollar earned Average tax rate = total tax paid divided by taxable income Role of Financial Statements  Best information about a company o Provide actual results o Serve as company report card  Basis for analyzing performance of company (health, growth, opportunities)

Primary financial Statements Balance sheet  assets, liabilities, equity  as of a specific date  Snapshot of a point in time  Assets – what the company owns  Liabilities – what the company owes  Equity – what is left over  Assets = liabilities + equity Net working capital = current assets – current liabilities We WANT more current assets than current liabilities. *Net working capital includes an invoice from a supplier. *Net working capital increases when inventory is sold at profit. Liquidity  Speed and ease of conversion to cash without significant loss of value  Valuable in avoiding financial distress Debt vs. equity Shareholder’s equity = assets – liabilities. Income statement  revenue and expenses (performance)  over a period of time Revenue – expenses = net income GAAP Matching Principle  Recognize revenue when it is fully earned  Match expenses required to generate revenue to the period of recognition Noncash Items  Expenses charged against revenue that do not affect cash flow  Depreciation is a common noncash expense *Given a profitable firm, depreciation lowers taxes and taxable income. Net income  dividend paid to shareholders  added to retained earnings (on balance sheet) Monday, Feb. 13 Financial Statements, Taxes, and Cash Flows Chapter 2 (Part B) Cash flow – the difference between the number of dollars that came into the company and the number of dollars that go out  Cash flow is one of the most important pieces of information that can be derived from financial statements o Cash is the basic element of what is needed to operate a business o Expenses are paid in cash o Companies with no cash can end up bankrupt o Understanding cash flow is the basic element to making decisions  Positive net income doesn’t necessarily mean positive cash flow Second Year of Operations vs. First Year of Operations:  Some sales from 2017 will be collected in 2018  Some COGS from 2017 will be paid in 2018 Operating Cash Flow Definition Operating cash flow = earnings before interest & taxes + depreciation – taxes Operating cash flow = net income + depreciation + interest  Finance’s focus is how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase Cash Flow from Assets

Cash flow from assets = operating cash flow – net capital spending – changes in net working capital Cash flow from assets = cash flow creditors + cash flow stockholders Net Capital Spending Net capital spending = ending net fixed assets = beginning net fixed assets + depreciation Change in Net Working Capital Ending net working capital = Cash flow to creditors = interest paid - net new borrowing Cash flow to stockholders = dividends paid – net new equity raised *An increase in depreciation will increase operating cash flow for profitable, tax-paying firm Wednesday, Feb. 15 Working with Financial Statements Why evaluate financial statements? External uses  Creditors, stockholders, suppliers, customers Internal uses  Planning for the future (budgeting and forecasting) Basis for new investment decisions Performance evaluation The Earnings Cycle  The basis for many business news articles comes from financial statements and publicly released details

Standardized Financial Statements  Makes it easier to compare companies o Different sizes o Different currencies o Different time periods  Common-size statements o Balance sheet: items as a % of assets o Income statement: items as a % of revenue Categories of Financial Ratios Liquidity Ratios  An asset that can be converted to cash quickly without using value More liquid (cash)  contracevable  inventory  less liquid (fixed assets) *A sale of inventory on credit will decrease the liquidity of a company. *Credit sale of inventory at cost increases the liquidity of a firm  Liquidity ratios are also known as short term solvency ratios o Trying to measure: the level of liquidity a firm has. o This is important because: it indicated whether or not the firm can pay its bills over the short term Current ratio = current assets/ current liabilities Quick ratio = (current assets – inventory)/current liabilities Cash ratio = cash/current liabilities Friday, Feb. 17

Financial Leverage Ratios Financial leverage refers to the use of debt to finance and asset  Increased the potential return on an investment  A firm with a significant amount of debt relative to its equity is considered to be highly “leveraged” Leverages are trying to measure: the level of a firm's indebtedness and their ability to service debt This is important because: it indicates whether or not the firm can meet its obligations over the longterm Total debt ratio = total debt / total assets Debt-to-equity ratio = total debt/total equity Equity multiplier = total assets/total equity = 1+ (total debt/total equity) Times interest Earned = EBIT/interest Cash coverage = (EBIT + Depreciation)/interest *EBIT = Earnings before Interest & Taxes  A high cash coverage ratio means you have more cash to pay interest  A low debt to equity means you have more equity than debt Profitability Ratios these ratios trying to measure: a firm’s profitabilty in relation to sales, assets, and equity This is important because: it shows how efficiently the firm uses its assets and manages its operations Profit margin = net income / sales Return on assets = net income / total assets Return on equity = net income / total equity Monday, Feb. 20 Asset Management Ratios  Asset management ratios are also called asset utilization (turnover) ratios o They are intended to describe how effective a firm uses its assets to generate sales Inventory Ratio  Measures how quickly inventory turns over  Important because it indicates whether or not inventory may be getting obsolete or potential stock-out issues Inventory turnover = costs of goods sold / inventory Days sales in inventory = 365/inventory turnover Receivable Ratios  Trying to measure how quickly sales get collected from our customers  Important because it indicates whether receivables are taking too long to collect and the potential for uncollectable accounts Receivable turnover = sales / accounts receivable Days in sales in receivables = 365/receivable turnover  want low number Asset Turnover Ratio  Trying to measure how much sales are generated for every $ of assets  Important to prove the level of assets needed to generate sales Total asset turnover = sales / total assets Market Value Ratios  Based on the market price per share of stock and are thus relevant only for publicly-traded companies  Trying to measure the market value of the firm relative to financial results  Important because it indicates how the public equity markets value the firm Price-earnings ratio = price per share/earnings per share

Price-sales ratio = Price per share / sales per share Market-to-book ratio = Price per share / book value per share EBITDA ratio = Enterprise value /EBITDA Wednesday, Feb. 22 Chapter 4: Introduction to Valuation What Matters about money? Both, how much and when you get/pay it Time Value of Money  How the factor of time impacts the value of money  Money available today is worth more than the same amount of money in the future o Because you can earn money on money via interest and return on investment Interest – the price paid to borrow money  Expressed as a percentage rate over a period of time o Simple interest = interest on principal o Compound interest = interest on interest Future Value (FV) – the amount an investment is worth after one or more periods - “later” money on a time line Present Value (PV) – the current value of future cash flows discounted at the appropriate discount rate - value at t=0 on a time line Friday, Feb. 24  long-form approach isn’t practical when numerous time periods are involved FV=PV*(1+r)t Future Value, Important Relationship #1:  for a given interest rate o the longer the time period, the larger the future value Future Value, Important Relationship #2:  for a given time period o the higher the interest rate, the larger the future value Rule of 72 – quick approximation on doubling dollar amounts based on any combination of rate and years equaling ~72 Present Value Future Value (FV) – the amount an investment is worth after one or more periods - later money on a timeline Present Value (PV) – the current value of future cash flows discounted at the appropriate discount rate - value at t=0 on a time line Today Future Period $1,000  COMPOUNDING to future FV PV  DISCOUNTING to today $1,000 - When you decrease the interest rate, the present value of the dollar goes up and future value decreases Monday, Feb. 27 For a given interest rate:  The longer the time period the lower the present value For a given time period:  The higher the interest rate the smaller the present value Wednesday, Mar. 1 Connect Practice Questions 3) Net working capital decreases when: a dividend is paid to current shareholders

BECAUSE this decreases the cash at hand 15) Net capital spending is equal to: ending net fixed assets - beginning net fixed assets + depreciation BECAUSE depreciation is not a cash item and it’s already accounted for...