Corporate Finance: From Beginner to Advanced Flashcards
Operating Profit Ratio
A profitability metric that shows the percentage of profit a company makes from its operations, before taxes and interest. It’s calculated by dividing operating profit by total revenue.
In a PriceSmart context, this means that the company’s operating efficiency in generating profit from its retail operations can be measured, excluding external factors like taxes and interest expenses.
ROI Calculation
A measure used to evaluate the profitability of an investment, calculated by dividing the net profit of the investment by the initial cost, then multiplying by 100 to get a percentage.
In a PriceSmart context, this means that PriceSmart can assess the profitability of its investments in new stores, renovations, or any other capital expenditure.
Return on Asset (ROA)
A profitability ratio that shows how efficiently a company uses its assets to generate profit, calculated by dividing net income by total assets.
In a PriceSmart context, this means PriceSmart can evaluate how effectively its physical stores, inventory, and other assets are being used to generate profit.
DuPont Analysis
A financial performance framework that breaks down Return on Equity (ROE) into three components: profit margin, asset turnover, and financial leverage, to assess how a company generates its return.
In a PriceSmart context, this means PriceSmart can analyze its ROE by looking at how well it controls costs, utilizes its assets, and uses leverage to enhance shareholder value.
Time Value of Money (TVM)
A financial concept that asserts money available today is worth more than the same amount in the future due to its potential earning capacity, factoring in interest rates or returns.
In a PriceSmart context, this means PriceSmart must consider the value of its capital today when making investment decisions, as future returns might not be as valuable as immediate investments or savings.
Uses of Time Value of Money
TVM is used to calculate present and future values of cash flows, assess investment opportunities, determine loan payments, and evaluate the profitability of long-term projects.
In a PriceSmart context, this means PriceSmart can use TVM to assess the profitability of expanding into new markets, calculate the present value of future revenues from new store openings, or determine the best financing options for large capital expenditures.
Simple vs Compound Interest
Simple interest is calculated only on the principal amount, while compound interest is calculated on both the principal and the accumulated interest.
In a PriceSmart context, simple interest might apply to short-term loans or investments, whereas compound interest could be relevant for long-term financing options or investment strategies, especially when considering store development or other capital expenditures.
Present vs Future Value (of Money)
Present value (PV) calculates how much a future sum of money is worth today, while future value (FV) determines how much a present sum of money will be worth in the future, considering interest or returns.
In a PriceSmart context, PV helps evaluate the worth of future revenues from new stores or product lines today, while FV is useful when forecasting the potential growth of investments, such as expansion or renovation projects.
Simple Ways to Calculate Present and Future Value
For Present Value (PV):
PV = FV / (1 + r)^n
Where:
FV = Future Value
r = interest rate
n = number of periods
For Future Value (FV):
FV = PV × (1 + r)^n
Where:
PV = Present Value
r = interest rate
n = number of periods
In a PriceSmart context, PV can be used to estimate how much future sales or revenue streams from new store locations are worth today, while FV helps PriceSmart predict the value of its current investments or capital expenditures in the future.
Annuity
A financial product that provides a series of equal payments made at regular intervals over a period of time.
In a PriceSmart context, an annuity could be used to evaluate long-term payment plans for equipment, store leases, or other investments that generate consistent cash flows over time.
Internal Rate of Return (IRR)
The discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero, representing the expected rate of return on a project or investment.
In a PriceSmart context, IRR is useful for evaluating potential store expansions, new projects, or capital investments, helping PriceSmart decide whether the return on an investment meets its required rate of return.
Capital
The financial resources used by a company to fund its operations, investments, and growth, which can include equity, debt, or retained earnings.
In a PriceSmart context, capital refers to the funds used for store expansions, purchasing inventory, or improving facilities, as well as any financial leverage the company uses to support its operations.
4 Types of Capital
- Equity Capital: Funds raised by selling ownership shares in the company.
- Debt Capital: Funds borrowed from external sources, typically in the form of loans or bonds.
- Working Capital: The capital used for day-to-day operations, calculated as current assets minus current liabilities.
- Venture Capital: Investment funds provided to early-stage or high-growth potential companies.
In a PriceSmart context, these types of capital are relevant when considering financing for expansion, new store development, or large-scale investments in inventory and operations.
3 Types of Debt and Tax Benefits on Debt Interest
- Short-Term Debt: Debt with a maturity of less than one year, often used for working capital needs.
- Long-Term Debt: Debt with a maturity longer than one year, typically used for larger investments like store expansions or equipment.
Convertible Debt: Debt that can be converted into equity at a later date. - Secured Debt: Debt backed by collateral, reducing the lender’s risk.
Unsecured Debt: Debt not backed by collateral, generally carrying higher interest rates.
Tax Benefits: Interest payments on debt are tax-deductible, which lowers the company’s taxable income and reduces its overall tax liability. This is an advantage for companies like PriceSmart when financing through debt.
In a PriceSmart context, using debt financing can provide cost-effective ways to fund expansion while reducing taxable income through interest deductions.
Bonds
Debt securities issued by companies or governments to raise capital, where the issuer agrees to pay interest periodically and repay the principal at maturity.
In a PriceSmart context, bonds could be issued to finance large-scale projects like store expansions or renovations, providing an alternative to equity financing while offering fixed interest payments.
Cost of Equity
The return required by shareholders for investing in a company’s equity, often calculated using models like the Capital Asset Pricing Model (CAPM).
In a PriceSmart context, the cost of equity represents the return PriceSmart must offer to its investors to maintain shareholder satisfaction and attract investment, especially when seeking funds for growth or expansion.
Capital Asset Pricing Model (CAPM)
A model that calculates the expected return on an asset based on its risk compared to the overall market, using the formula:
Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate).
In a PriceSmart context, CAPM can help determine the cost of equity by assessing the risk of investing in PriceSmart relative to the broader market, aiding in investment decisions and financing strategies.
Retained Earnings
The portion of a company’s profits that is kept and reinvested in the business rather than paid out as dividends to shareholders.
In a PriceSmart context, retained earnings are used to finance new projects, store expansions, or debt reduction, helping the company grow without relying entirely on external funding
Leverage and 4 Different Types
Leverage refers to using borrowed capital (debt) to increase the potential return on investment. The main types of leverage are:
Financial Leverage: The use of debt to acquire assets, aiming to increase returns on equity.
Operating Leverage: The degree to which a company uses fixed costs in its operations to amplify changes in profits relative to sales.
Combined Leverage: The combined effect of financial and operating leverage on a company’s overall profitability.
In a PriceSmart context, financial leverage might be used for store expansions, operating leverage could impact profit margins as sales grow, and combined leverage would reflect the overall risk and return dynamics of PriceSmart’s financial strategy.
Break-even Analysis
A calculation to determine the point at which total revenues equal total costs, resulting in no profit or loss. The formula is:
Break-even Point = Fixed Costs / (Selling Price per Unit - Variable Cost per Unit).
In a PriceSmart context, break-even analysis helps determine the sales volume required to cover the costs of opening a new store or launching a new product, guiding decisions on pricing and cost management.
Net Operating Income (NOI)
A measure of a company’s profitability, calculated by subtracting operating expenses (like rent, salaries, and utilities) from revenue, excluding interest, taxes, depreciation, and amortization.
In a PriceSmart context, NOI is used to evaluate the profitability of individual stores or business units, helping the company assess operational efficiency and make informed decisions about potential expansions or cost-saving measures.
Trade-Off Theory
A theory in corporate finance suggesting that firms balance the benefits and costs of debt. The benefit of debt includes tax shields (interest deductions), while the costs include the risk of bankruptcy and financial distress. Companies seek an optimal capital structure where the marginal benefit of debt equals the marginal cost.
In a PriceSmart context, the trade-off theory can guide decisions on whether to take on more debt for expansion (to benefit from tax shields) or maintain a more conservative capital structure to avoid financial risk, especially in volatile markets.
EBIT and EBITDA
Earnings Before Interest and Taxes
- A measure of a company’s profitability that excludes interest and income tax expenses, calculated as revenue minus operating expenses (excluding interest and taxes).
Earnings Before Interest, Taxes, Depreciation, and Amortization
- A measure of a company’s operating performance that excludes interest, taxes, depreciation, and amortization, offering a clearer view of core profitability.
In a PriceSmart context, EBIT and EBITDA help evaluate the performance of individual stores or business units by focusing on operational efficiency and profitability before external factors like financing and taxes. EBITDA is often used to compare profitability across companies or industries.
Relationship between EBIT, Market Price, Earnings Per Share
In a PriceSmart context, EBIT reflects the company’s operational performance, EPS indicates profitability per share, and MP shows how the market values PriceSmart’s stock based on its financial health and future prospects.
Relationship between Return on Assets, Financing Costs, Earnings Per Share
In a PriceSmart context, improving ROA through better asset utilization could lower the company’s financing costs and result in higher EPS, enhancing both financial stability and investor confidence.
Over and Undercapitalization
Overcapitalization: A situation where a company has more capital (debt or equity) than it needs to finance its operations and growth, leading to inefficient use of resources and potentially lower returns on equity.
Undercapitalization: A situation where a company does not have enough capital to finance its operations and growth, limiting its ability to expand, invest, or meet financial obligations.
In a PriceSmart context, overcapitalization could lead to higher debt servicing costs or underutilized equity, while undercapitalization might restrict the company’s ability to open new stores or make necessary investments. Balancing capital effectively ensures operational efficiency and financial flexibility.
Functions of a Finance Manager
Financial Planning and Forecasting: Developing budgets, forecasts, and long-term financial plans to ensure the company’s financial health.
Capital Management: Deciding the best sources of funding (debt, equity, or internal funds) and managing the company’s capital structure.
Investment Decisions: Evaluating and making decisions on investments, such as new projects, acquisitions, or capital expenditures.
Risk Management: Identifying financial risks and developing strategies to mitigate them, such as through insurance, hedging, or diversification.
Financial Reporting and Analysis: Preparing financial statements, analyzing performance, and ensuring compliance with regulatory requirements.
Cash Flow Management: Ensuring the company has sufficient liquidity to meet day-to-day operational needs while managing surplus funds effectively.
In a PriceSmart context, the finance manager plays a crucial role in managing the finances of various stores, ensuring there is enough capital for expansion, investments, and operational activities, while also minimizing financial risks and maximizing profitability.
Capital Budgeting
The process of planning and evaluating long-term investments in projects or assets, such as new stores, equipment, or expansion, to determine their potential returns and align them with the company’s financial goals. Methods include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.
In a PriceSmart context, capital budgeting helps the company decide which expansion projects or major investments will yield the best returns, ensuring that funds are allocated efficiently to grow the business while minimizing risks.
Expansion and Diversification Decisions
Expansion Decisions: A good expansion decision is based on identifying regions or markets where PriceSmart’s operational model can be replicated successfully, while managing the risk of overextension. Key factors include market demand, location costs, and the ability to generate sustainable growth with existing resources.
Diversification Decisions: A good diversification decision occurs when PriceSmart enters new product lines or markets that complement or enhance its existing operations, reducing dependence on a single revenue stream. The decision should be driven by solid market research and the potential to leverage existing capabilities to capitalize on new opportunities, thus spreading risk and increasing resilience.
Tax Benefit on Depreciation
The tax benefit of depreciation comes from the fact that depreciation is a non-cash expense, which reduces taxable income. This leads to lower taxes owed, providing a company with additional cash flow. The benefit is realized as the company can claim depreciation on its capital assets over time, lowering its overall tax liability.
In a PriceSmart context, the tax benefit from depreciation would help reduce taxes on income generated from investments in assets like store buildings, equipment, or other long-term capital expenditures, freeing up capital for reinvestment into the business.
Opportunity Cost
The cost of forgoing the next best alternative when making a decision. In finance, it’s the potential return or benefit lost when choosing one investment or project over another.
In a PriceSmart context, opportunity cost helps guide decisions like whether to invest in opening a new store or upgrading existing locations. If PriceSmart chooses one option, the opportunity cost is the potential return from the alternative that was not pursued.
Working Capital
The difference between a company’s current assets and current liabilities, reflecting its ability to cover short-term obligations and fund day-to-day operations. Positive working capital indicates financial health and operational efficiency.
In a PriceSmart context, maintaining adequate working capital ensures the company can manage inventory, pay suppliers, and meet other short-term financial obligations, supporting smooth operations and growth without relying on external financing.
Allocated Overheads
The portion of overhead costs (like rent, utilities, and administrative expenses) that is assigned to specific departments, projects, or products based on a predetermined allocation method. These are indirect costs that need to be distributed to accurately assess the cost structure.
In a PriceSmart context, allocated overheads ensure that each store or department contributes fairly to the company’s overall overhead costs, helping the company assess profitability at a granular level and make more informed decisions about pricing, cost control, and resource allocation.
3 Types of Cashflows
- Operating Cash Flow (OCF): Cash generated or used by a company’s core business operations, such as revenue from sales and expenses for goods and services.
- Investing Cash Flow (ICF): Cash used for or generated from investments in assets like property, equipment, or securities. This includes purchases, sales, and investments in long-term assets.
- Financing Cash Flow (FCF): Cash flows related to changes in the company’s capital structure, including issuing or repaying debt, and issuing or repurchasing stock.
In a PriceSmart context, understanding these cash flows is critical for managing liquidity and funding expansion, as well as assessing the company’s ability to generate cash through core operations, investments, and financing activities.
Basic Principles for Calculating Cashflows
Start with Net Income: Cash flows from operating activities begin with net income, which is adjusted for non-cash expenses like depreciation and changes in working capital (e.g., inventory, receivables).
Adjust for Non-Cash Items: Add back non-cash items (depreciation, amortization) and deduct gains/losses that are not related to core operations.
Account for Changes in Working Capital: Adjust for changes in current assets and liabilities, such as increases in accounts payable or receivable, as these affect cash flow.
Include Investing and Financing Activities: Subtract cash used for investments (purchasing assets) and add cash raised from financing (issuing debt/equity), while subtracting cash used to repay debt or distribute dividends.
In a PriceSmart context, calculating cash flows helps the company assess its ability to meet short-term obligations and fund growth initiatives, such as new store openings or equipment investments.v
Post-Tax Principle
The post-tax principle refers to making financial decisions based on the impact after taxes have been deducted. It ensures that all evaluations, such as profitability or investment returns, reflect the actual financial benefit to the company after accounting for taxes.
In a PriceSmart context, applying the post-tax principle helps in more accurately assessing the net benefit of investments, capital expenditures, or financing options, as it considers the tax impact on cash flows, profitability, and overall financial performance.
Overview of Capital Budgeting Techniques
Net Present Value (NPV): Evaluates an investment by calculating the difference between the present value of cash inflows and outflows. A positive NPV indicates a profitable investment.
Internal Rate of Return (IRR): The discount rate that makes the NPV of an investment zero. A project is considered good if its IRR exceeds the required rate of return.
Payback Period: The time it takes for an investment to recover its initial cost. Shorter payback periods are preferred, though this method doesn’t consider the time value of money.
Profitability Index (PI): The ratio of the present value of cash inflows to the initial investment. A PI greater than 1 suggests the project is viable.
Modified Internal Rate of Return (MIRR): A variation of IRR that assumes reinvestment at the project’s cost of capital rather than at the IRR, providing a more realistic measure of return.
In a PriceSmart context, these techniques help assess potential store expansions, capital expenditures, or new business investments, ensuring that funds are allocated efficiently to maximize returns and align with the company’s strategic goals.
Overview of Payback Period
The payback period is the time it takes for an investment to recoup its initial cost through cash inflows. It’s a simple method to evaluate how long it will take for a project to break even.
In a PriceSmart context, the payback period helps quickly assess the risk of an investment, like opening a new store or purchasing equipment, by showing how long it will take to recover the initial capital expenditure. However, it doesn’t account for the time value of money or cash flows beyond the payback period.
