Corporate Finance Flashcards
Corporate Management Team
Board of directors: ultimate decision making authority
CEO: board delegates day to day decision making to CEO
CFO: responsible for investment and financing decisions
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Agency Problems
Difficult to fulfil requirements of all stakeholders at the same time
Example: employees want higher wages while shareholders want higher dividends
Stock Market
provides liquidity to shareholders
Liquidity = ability to easily sell an asset for close to the price you can currently buy it for
Public vs Private Company
Public: shares traded on public stock exchange
Private: shares may be traded privately
Primary vs Secondary market
Primary: corporation issues new shares to its investors (IPO) on primary market
Secondary: shares are then traded between investors on secondary market
Bid-Ask spread
E.g.: you can sell share at bid price and buy the share at ask price, the difference is the transactions cost (for the market maker)
Market to book ratio
= market value of equity / book value of equity
Low ratio: value stocks –> pay out dividends, but rather low growth
High ratio: growth stocks –> usually don’t pay much dividends, but expected to grow fast
TEV
Total enterprise value = market value of equity + debt - cash
–> Cost of taking over the business
EPS
Earnings per share = net income / shares outstanding
Shares can grow due to stock options or convertible bonds –> diluted eps
NWC and Free cash flow
NWC = current assets - current liabilities –> cash + inventory + receivables - payables
FCF = Unlevered net income (Revenues - cost - depreciation * (1 - tax)) + depreciation - capital expenditure - increase / + decrease of NWC
Financial Statement analysis used to
Compare company to itself over time
compare company to other similar companies
Profitability ratios
–> profitability related to value of sales
Gross margin = gross profit/sales
Operating margin = operating income / sales
Net profit margin = net income / sales
Liquidity ratio
evaluates a company’s financial liquidty
Current ratio = current assets / current liabilities
Quick ratio = (current assets - inventory) / current liabilities
Cash ratio = cash / current liabilities
Working capital ratios
Accounts receivable days = accounts receivable / average daily sales
Accounts payable days = accounts payable / average daily cost of sales
Inventory turnover = annual cost of sales / inventory
Interest coverage ratios
–> company’s ability to meet interest obligations
EBIT / interest expense
EBITDA / interest expense
Leverage ratios
Debt to Equity ratio = total debt / total equity
Net debt = total debt - cash
–> extent to which company relies on debts as source of financing
Investment returns
Return on Equity = net income / book value of equity
Return on assets = (net income + interest expense) / book value of assets
Valuation ratios
P/E = market capitalisation / net income = share price / EPS
- -> years need to earn back the invested money
- -> value stocks: low, growth stocks: high
Valuation principle
Value of benefits > value of costs = decision increases market value of company
Time value of money
difference in value of money today and money in the future
Net present value
NPV = difference between PV of benefits and PV of costs
–> choose the alternative with highest NPV
Arbitrage opportunity
Arbitrage: taking advantage of a price difference arising from buying and selling equivalent goods in different markets
Arbitrage opportunity: any situation where you can make a profit without taking any risk
Rules of time travel
- Compare and combine values only at the same point in time
- moving cashflows forward (compounding) : multiply by (1+r)^n
- moving cashflows back (discounting): divide by (1+r)^n
Perpetuity vs Annuity
Perpetuity: Stream of equal cashflows occurring at regular intervals and lasting forever
Annuity: stream of N equal cashflows occurring at regular intervals lasting for limited period
IRR
Internal rate of return, defined as interest rate that sets the NPV of cashflow equal to zero
Break even of investment decision
Maximum you can earn with the investment
EAR vs APR
Effective annual rate: total amount of interest earned at end of period, considers effect of compounding (interest on interest)
Annual percentage rate: simple interest gained
Nominal and real interest rate
Nominal doesn’t represent increase or decrease in purchasing power
Real: adjusted by inflation/deflation
RR = NM + Deflation RR = NM - Inflation
Yield curve
Term structure: relationship between investment term and interest rate
Yield curve: graph of term structure
Bonds
Zero-coupon bonds: only pay face value at term end, ytm = interest rate
Coupon bonds. pay face value at end and regular coupon payments, ytm = discount rate that equates PV of remaining bond cash flows to its current price
Interest rates and bond prices
Inverse/negative relationship
NPV investment rule
Take the alternative with the highest NPV
Equivalent to receiving NPV in cash today
IRR Rule
Take investment with IRR higher than cost of capital
Reject investment with IRR lower than cost of capital
Payback rule
Take investment where payback period is less than predefined length of time. Otherwise reject
incremental IRR
IRR of incremental cash twos resulting from replacing one project with another
Discount rate at which it makes sense to switch from one products to the other
Profitability index
= NPV / Resource consumed
Capital budget
Lists investments a company plans to undertake and estimates future earning
Capital budgeting: process of analysing alternative investment and deciding which to accept
Incremental earning
Amount by which company’s earnings are expected to change due to the investment decision
Indirect effects on incremental earnings
Opportunity Cost Project externalities Sunk costs (don’t consider in incremental analysis)
Break-even analysis
Break even level of input is the level that causes NPV of investment to be 0
Sensitivity and Scenario analysis
Sensitivity: How NPV changes with a change in one assumption
Scenario: simultaneously changing multiple assumptions
Stock valuation
- PV of dividend payments determines stock price
- PV of total payouts determines equity value
- PV of FCF determines enterprise value
Dividend discount model terminology
- Dividend yield = % return investor expects from dividend paid by stock
- Capital gain = how much investor will earn on the stock
- Capital gain rate = capital gain a % return
- Total return = Dividend yield + capital gain rate
What can a company do with its earnings?
- Pay out dividends (= dividend payout rate)
- Retain and reinvest (= retention rate)
How to increase its dividend
- Increase earnings (net income)
- Increase dividend payout rate
- Decrease shares outstanding
Total payout model
Values all of the company’s equity
PV = PV(Future total dividends + repurchases) / shares outstanding
Share repurchase
Company buys back own stock
Less money to pay dividends
Decrease shares outstanding
Increase EPS and Dividends per share
Discounted FCF Model
Determines value of company to all investors
Enterprise value = Market value of equity + debt - cash
Source of equity capital
Angel investors Venture capital private equity Institutional investors Corporate investors Crowdfunding
Common vs Independent risk
Common: systematic, undiversifiable, market risk
Independent: firm specific, unsystematic, diversifiable
–> well diversified portfolio has no independent risk
CAPM - Capital asset pricing model
Investors…
- can buy/sell all securities at competitive market prices and borrow/lend at risk-free interest rate
- hold only efficient portfolios of traded securities
- have homogeneous expectations regarding volatilities, correlations, expected returns
