Mid-terms cheatsheet - Cheat Sheet for the mid-terms PDF

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Cheat Sheet for the mid-terms...

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Goal of financial management : maximise current value per share of existing stock

Financial Manager The top financial manager within a firm is usually the Chief Financial Officer (CFO) Treasurer: oversees cash management, credit management, capital expenditures and financial planning Controller: oversees taxes, cost accounting, financial accounting and data processing Sole Propietorship Advantages : Easiest to start, least regulated, Single owner keeps all the profits, Taxed once as personal income Disadvantages : Limited to life of owner, Equity capital limited to owner’s personal wealth, Unlimited liability, Difficult to sell ownership interest Partnership Under this organization method, a group of individuals collectively own and manage the business. Advantages: Two or more owners, more capital available, relatively easy to start, income taxed once as personal income Disadvantages : –Unlimited liability •General partnership •Limited partnership –Partnership dissolves when one partner dies or wishes to sell –Difficult to transfer ownership Corporation -Set out the purpose of the business. -Establish the number of shares that can be issued. -Set the number of directors to be appointed. Ownership and management are separated. A corporation issues equity shares. The holders of these shares are the owners of the firm. Although stockholders own the corporation, they do not necessarily manage it. Instead they vote to elect a Board of Directors (BOD). The BOD represents the shareholders and in this vein, (i) selects the management team, (ii) appoints the auditors and (iii) is responsible for checking/monitoring management’s actions.

Corporation Advantages: limited liability, unlimited life, separation of ownership and management, transfer of ownership is easy, easier to raise capital Disadvantages: Separation of ownership and management (and the resulting potential for agency costs), double taxation (income taxed at the corporate rate and then dividends taxed at personal rate) Private Companies–firm’s shares are usually closely held, i.e., ownership is closely held by a relatively small number of shareholders and shareholders often include the companies’ original founders, some financial backers (e.g., venture capitalists) and others. Shares are not traded on any exchange. Public Companies–firm’s shares are listed on a stock exchange, whereby the company’s shares are widely dispersed and traded in the secondary markets. Corporations: Two Main Sources of External Financing –Debt & Equity Debt •Lenders–By lending money to the corporation, debt holders become the corporation’s creditors and lenders. •Relationship Determined by Contract-A debt contract is a legally binding agreement. It specifies principal, interest, maturity date, and specific protective covenants. •Security and Seniority–In case of bankruptcy, debt holders collect before equity holders. However, different debt holders have different priority claim to the cash flows and assets of a bankrupt firm, according to their respective debt contracts.

Equity •Shareholders’ Ownership Rights–by buying shares in the corporation, shareholders become the owners of the firm. Shareholders are the residual claimants of the firm. •Shareholders’ Payoffs–shareholders receive monetary returns in the following ways: –Dividend per share, paid to investors from the corporation’s after tax dollars. –Capital gain from the sale of shares (ownership rights) at a price higher than they were purchased for. Goal of the firm is to maximise value Maximising stock price : Three aspects of cash flows that affect asset value and thus stock prices –Amount of cash flows expected by shareholders –Timing of the cash flow stream –Riskiness of the cash flow stream All these determine stock intrinsic value intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data (amount, timing and riskiness of cash flows). –An “estimated” value, not a precise objectively known measure market price is the actual selling price of a stock. It is based on perceived information as seen by the marginal investor in the market. Market values are observable while intrinsic values are unobservable Agency relationship: –Principal hires an agent to represent their interest –Stockholders (principals) hire managers (agents), via the Board of Directors, to run the company •Agency problem –Conflict of interest between principal and agent •Corporate Organization Potential Conflict of Interests: –Shareholders and managers –Shareholders and creditors Agency costs Direct agency costs –expenditures that benefit management: car and accommodation, big office, high pay –monitoring costs: auditors, audit committee, corporate governance •Indirect agency costs –lost opportunities which would increase firm value in the long run, if accepted Managers are naturally inclined to act in their own best interests. But the following factors affect managerial behavior: –Compensation plans tied to share value –Direct intervention by shareholders –The threat of firing –The threat of takeover Addressing the agency problem 1.Compensation plans that tie the fortunes of the managers to the fortunes of the firm. 2.Monitoringby lenders, stock market analysts and investors. 3.The threat that poorly performing managers will be fired. 4.The growing awareness of the importance of good Corporate Governance. Good corporate governance requires you to view organizations as a web of relationships between and among various stakeholders and to manage their interests in a responsible manner. Financial markets – where financial instruments are traded, act as intermediaries between savers and borrowers Money markets –where debt securities of less than one year are traded: treasury securities, commercial paper, bills, inter-bank loans –loosely connected dealer markets –banks are major players Capital markets -equity and long-term debt claims are traded -usually auction markets like Singapore Exchange Primary market –for government and corporations initially issued securities –public offering -where securities are offered to public at large; needs underwriting, more regulatory requirements, costly –private offering -where securities are offered to large financial

institutions or wealthy individuals etc.; less costly Secondary market –where existing financial claims are traded –dealer market (e.g. OTC markets) –auction market (e.g. SGX, NYSE) –where getting market value of securities is easier

Balance sheet–provides a snapshot of a firm’s financial position at one point in time. Income statement– summarizes a firm’s revenues and expenses over a given period of time. Statement of retained earnings–shows how much of the firm’s earnings were retained, rather than paid out as dividends. Statement of cash flows– reports the impact of a firm’s activities on cash flows over a given period of time. Assets = Liabilities + Equity Resources must equal claims, order of listing – highest to lowest liquidity, valuing of items generally at original cost or historical cost Book values determined by IFRS,GAAP Market value determines current trading price in the market Profits vs. Cash Flow •“Profits”subtract depreciation (a non-cash expense) •“Profits”ignore cash expenditures on new fixed assets (the expense is capitalized) •“Profits”record income and expenses at the time of sales, not when the cash exchanges actually occur •“Profits”do not consider changes in working capital (consider, why do changes in working capital not show up in the ‘profits’,i.e., Income Statement?) 1.Operating Activities– includes net income and changes in most current accounts (A/P A/R Inv) 2.Investment Activities– includes changes in fixed assets 3.Financing Activities– includes changes in notes payable, long-term debt and equity accounts as well as dividends Operating working capital is working capital stemming from our operating policies (A/R, Inventory, A/P, etc.) and removed from our financing decisions. (Thus we exclude non-operating working capital such as Notes Payable from our calculation of changes in Net Operating Working Capital)

Financial Statement Analysis

NWC = C.A. – C.L. Liquidity refers to speed and ease with which an asset can be converted to cash. Assets listed on balance sheet in order of decreasing liquidity. Most liquid assets listed first Debt versus Equity, use of debt in a firm’s capital structure is called financial leverage. More debt, greater degree of financial leverage

FA Turnover = Sales / Net fixed assets TA Turnover = Sales / Total Assets Profitability Profit margin = Net income / Sales BEP (Basic Earning Power) = EBIT/Total assets ROA= Net income / Total assets ROE= Net income (preferred dividend deducted)* / Total common equity Market Value Ratios P/E= Price / Earnings per share M/B= Mkt price per share / Book value

Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net Capital Spending (NCS) – Changes in NOWC (Net Operating Working Capital) *CFFA => Cash flow generated from a firm’s operating assets after taking into account all present investment needed for its on-going operations. Cash Flow From Assets (CFFA) + Interest Tax Shield = Cash Flow to Creditors + Cash Flow to Stockholders When taking into account CFFA, do not take into account interest tax shield, interest tax shiled increase amount of cash available to creditors and shareholders OCF ( Operating Cash Flows ) = EBIT*(1-Tax Rate) + Depreciation – Taxes paid NCS ( Net Capital Spending ) = Ending Net Fixed Assets – Beg. Net Fixed Assets + Depreciation Changes in NOWC = Ending NOWC –Beginning NOWC Calculate OWC = ( Current Assets. – Current Liabilities ) Interest Tax Shield = Cash generated from the reduction in the amount of taxes paid due to tax deductibility of interest Cash Flow to Creditors (refer to B/S and I/S) = interest paid –net new borrowing (LT Debt and Notes Payable) Cash Flow to Stockholders (refer to B/S and I/S) = dividends paid –net new equity raised Cash flow to Creditors and Stockholders = CFFA + Interest tax shield Enterprise Value = Market Value of Equity + Debt – Excess Cash Net New Borrowing = change in N/P + change in L.T debt Div paid = Net income – change in retained earnings Long-Term Solvency (Financial Leverage) ratios show how heavily the company is in debt. Asset management (Turnover / Efficiency) ratios measure how productively the firm is using its assets Profitability ratios measure the firm’s return on its investments

Market value ratios provides indications on the firm’s prospects and how the market values the firm: Liquidity Ratios Current ratio = Current assets / Current liabilities Quick Ratio = (CA –Inventory) / Current liabilities Long-term solvency Total Debt Ratio = Total Debt / Total Assets VARIATIONS: Debt/Equity Ratio = (total assets –total equity) / total equity Equity Multiplier = total assets/total equity = 1 + debt/equity ratio Long-Term Debt Ratio = long-term debt / (long-term debt + total equity) COVERAGE RATIOS: ♦Times Interest Earned Ratio = EBIT / interest ♦Cash Coverage Ratio = (EBIT + depreciation) / interest Asset Management Ratios Inventory Turnover = COGS / Inventory Days’ Sales in Inventory = 365 / Inventory Turnover Rec. turnover = Sales / Receivables

The effective annual rate of interest refers to the actual annual rate paid (or received) after taking into consideration any compounding that may occur during the year. If interest is compounded more than once a year, then the stated rate will be different from the effective rate. If interest is compounded (or applied) exactly once a year, then the effective annual rate will be equal to the stated rate. •If you want to compare two investments with different compounding periods you need to compute the EAR and use that for comparison

Ave. return of asset – ave risk-free rate = ave. risk premium Approx.. real t-bill rate = expected t-bill rate – inflation rate The volatility of a portfolio is the total risk of the portfolio, as measured by the portfolio standard deviation. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns ( arises because worse-than-expectedreturns from one asset are off-set by better-than-expectedr eturns from another) However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion.

Risk and Return

= ( X1- X ) ( Y1-Y) + ( X2-X) (Y2-Y) +… / n-1

Total risk (σ) = Systematic risk + Unsystematic risk Expected return on asset only depends on systematic risk (market risk)

Inp uts used to directly calculate beta of an asset: asset’s s.d., market portfolio’s s.d, asset’s correlation coefficient with market portfolio Expected return < Required return -> Stock overvalued Expected Return > Required return -> Stock underpriced Two assets with same s.d. are perfectly positively correlated, combined portfolio will have the same s.d. Required return of asset = risk free rate + market risk premium * beta of asset

A beta = 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market...