Exam 1 Flashcards
Chapters 1-6
What is the Present Value (PV) Formula for a Growing Perpetuity?
C1 = cash flow in 1st year
r = discount rate
g = growth rate
How do you calculate Future Value in Excel?
Formula: =FV(rate, nper, pmt, pv, type)
What is return on equity (ROE)?
ROE = Net Income / Total Equity
What is the agency problem?
Conflict between managers (agents) and shareholders (principals) due to differing goals.
What is the primary goal of a firm according to traditional profit maximization theory?
Maximizing shareholder wealth
What is the percentage of sales approach in financial planning?
A method where financial statement items are expressed as a percentage of sales to project future needs.
What is the Present Value (PV) Formula for a Perpetuity?
C = annual cash flow
r = discount rate
What are common-size financial statements?
Financial statements expressed as percentages of totals (e.g., revenue or assets) to allow comparison across companies.
Why is accelerated depreciation (MACRS) beneficial?
It provides earlier tax shields, increasing NPV.
The current worth of a future sum of money, given a specific discount rate.
Present Value (PV)
What are the 3 pitfalls of IRR?
Multiple IRRs – Some projects have more than one IRR.
No IRR – Some projects never reach NPV = 0.
Scale and Timing Issues – IRR ignores the magnitude of investment.
What does financial leverage measure?
The degree to which a firm uses debt financing.
What is inventory turnover?
Inventory Turnover = Cost of Goods Sold / Inventory
What is the main focus of the 1934 Securities Exchange Act?
Regulating securities trading post-issuance, corporate reporting, and insider trading.
What is the PI Rule for investment decisions?
PI > 1 → Accept the project
PI < 1 → Reject the project
The IRR of the difference in cash flows between two mutually exclusive projects.
Incremental IRR
How do you calculate the Effective Annual Rate (EAR)?
EAR = (1 + APR/m)^m - 1
What is the formula for Present Value (PV)?
PV = FV / (1 + r)^t
What is the Tax Cuts and Jobs Act (2017) impact on depreciation?
Bonus depreciation allows firms to deduct 100% of asset costs in the first year.
Reduced to 80% in 2023, decreasing annually to 20% by 2026.
The discount rate at which two mutually exclusive projects have the same NPV.
crossover rate in IRR
How is the return on assets (ROA) calculated?
ROA = Net Income / Total Assets
What are spontaneous liabilities?
Liabilities that naturally vary with sales, such as accounts payable.
How is EPS (Earnings Per Share) calculated?
EPS = Net Income / Number of Shares Outstanding
What are the key regulatory acts in U.S. corporate finance?
The Securities Act of 1933 and the Securities Exchange Act of 1934.
What happens if cash paid to shareholders and debtholders exceeds cash raised in financial markets?
Value is created for the firm.
How can financial analysis help management?
By identifying areas to improve efficiency, control costs, and optimize capital structure.
What happens to NWC at the end of a project?
It is fully recovered, creating a positive cash flow.
What is risk aversion in the context of finance?
Most investors prefer lower risk for a given level of return, so firms must consider the risk associated with cash flows.
Should you include interest expense when estimating project cash flows?
No. Ignore financing costs when analyzing project viability.
What does the income statement measure?
Financial performance over a specific period of time.
How does dividend policy impact the sustainable growth rate?
Lower dividend payouts increase retained earnings, which boost internal financing and the sustainable growth rate.
What is external financing needed (EFN)?
The amount of external financing required to support a firm’s projected growth.
What is the residual claim equation for shareholders when the firm’s value exceeds debt obligations?
Shareholder’s claim = Value of firm - Amount owed to debt holders.
What is Section 404 of Sarbanes-Oxley (SOX)?
A requirement that companies assess and report on their internal control structure and financial reporting annually.
What does the right side of a firm’s balance sheet represent?
The firm’s obligations (liabilities) and the value attributed to shareholders’ equity.
What is the capital intensity ratio?
The amount of assets required to generate $1 of sales. A higher ratio indicates a more capital-intensive business.
What is the sustainable growth rate?
The maximum growth rate a firm can achieve using internally generated funds and maintaining a constant debt ratio.
The time required for cumulative cash flows to recover the initial investment.
Payback Period
What happens to the cash generated by the firm?
It is distributed as dividends, used to repay debt, reinvested in the firm, or paid as taxes.
How does a firm raise money for investments?
By selling debt (e.g., loans, bonds) and equity shares (e.g., stocks) to investors.
What is the primary goal of financial statements?
To communicate financial information useful for decision-making, both within and outside the firm.
What happens to shareholder claims if the firm’s value is less than its debt obligations?
Shareholder claim = $0, and debt holders claim the remaining firm value.
What does a high debt-equity ratio imply about a firm?
The firm relies heavily on debt financing, which increases financial leverage and risk.
What is the relationship between NPV and PI?
Both use discounted cash flows.
NPV measures absolute value, while PI measures relative value.
When projects are mutually exclusive, NPV should be preferred.
What is the receivables turnover ratio, and why is it important?
Receivables Turnover = Sales / Accounts Receivable; it shows how quickly a firm collects payments from customers.
What is the difference between tangible and intangible fixed assets?
Tangible assets are physical (e.g., machinery), while intangible assets include patents and trademarks.
Why is the cash coverage ratio important?
It provides a better measure of a firm’s ability to meet interest obligations by accounting for noncash expenses.
How do you calculate Operating Cash Flow (OCF)?
OCF = EBIT - Taxes + Depreciation
What does the DuPont Identity reveal about ROE?
It breaks ROE into three components: operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier).
What does the profit margin measure in the DuPont Identity?
Operating efficiency, or how well a firm controls costs.
What is the cash coverage ratio?
Cash Coverage = (EBIT + Depreciation + Amortization) / Interest Expense
What is the purpose of the Sarbanes-Oxley Act (SOX)?
To protect investors from corporate abuses and enforce strict auditing and financial reporting standards.
What does the equity multiplier represent in the DuPont Identity?
Financial leverage, indicating the degree of debt financing.
What is the IRR Rule for investment decisions?
IRR > Required Return → Accept the project
IRR < Required Return → Reject the project
What is net working capital important for?
Managing short-term cash flow mismatches between inflows and outflows.
How do you calculate NPV in Excel?
Formula: =NPV(rate, value1, value2, …)
make sure to add year 0
How is the return on assets (ROA) calculated?
ROA = Net Income / Total Assets
What are two types of agency costs?
Direct costs (perks, unnecessary spending) and indirect costs (poor investment decisions, missed opportunities).
Why is external financing costlier than internal financing?
External financing involves transaction costs, such as interest or issuance fees, which are not present with retained earnings.
What are spontaneous liabilities?
Liabilities that naturally vary with sales, such as accounts payable.
What are the four key elements of a project cash flow analysis?
Capital investment
Net working capital changes
Operating cash flows
Salvage value
What is external financing needed (EFN)?
The amount of additional financing required to support projected sales growth and asset investment.
What are two common pitfalls of IRR?
Multiple IRRs for unconventional cash flows and incorrect reinvestment assumptions.
What is the formula for sustainable growth rate?
ROE × Retention Ratio / (1 - ROE × Retention Ratio)
What is the goal of a firm?
shareholder value and to max cash value
How do you calculate Equivalent Annual Cost (EAC)?
Find the NPV of each machine or investment.
Convert NPV into an annual payment using:
T = years
What are irrelevant cash flows in capital budgeting?
Sunk costs – past expenses that cannot be recovered.
What is a Growing Perpetuity?
A perpetuity where cash flows grow at a constant rate.
An annuity where the first payment occurs immediately.
Annuity Due
What does total asset turnover measure in the DuPont Identity?
Asset use efficiency, or how well a firm manages its assets.
What is the NPV Decision Rule?
NPV > 0: Accept the investment
NPV < 0: Reject the investment
How do differing fiscal years complicate comparisons?
Firms may report financials on different schedules, making direct year-over-year comparisons unreliable.
What is the significance of the quick (acid-test) ratio compared to the current ratio?
The quick ratio excludes inventory, which is often less liquid, providing a stricter measure of liquidity.
Why might firms avoid issuing new equity?
To maintain control, avoid dilution, and minimize issuance costs.
What is the separation of ownership and control in corporations?
Shareholders own the firm, but managers (agents) control operations and make decisions.
What is the agency problem in corporations?
A conflict of interest between stockholders (principals) and management (agents).
The discount rate that makes NPV = 0.
Internal Rate of Return (IRR)
What formula determines the required interest rate for an investment?
Use RATE function in Excel:
Formula: =RATE(nper, pmt, pv, fv, type, guess)
Why do stock prices increase when a company performs well?
Positive performance signals value creation, attracting more investors and driving up demand for shares.
What are the advantages of PI?
Useful when investment funds are limited.
Easy to understand and communicate.
Correct decision-making when evaluating independent projects.
What are the three components of the DuPont Identity for ROE?
Profit Margin, Total Asset Turnover, and Equity Multiplier.
The present value of future cash flows minus the initial investment cost.
Net Present Value (NPV)
What is the purpose of the statement of cash flows?
To report cash inflows and outflows categorized as operating, investing, and financing activities.
What is the importance of financial markets to firms?
Financial markets provide the capital firms need to invest in projects and create value.
What is return on equity (ROE)?
ROE = Net Income / Total Equity
Why is depreciation important in investment decisions?
It provides a tax shield (Depreciation × Tax Rate).
The goal of financial management focuses on the fact that
the current stockholders are the owners of the corporation
The actual annual interest rate considering compounding periods.
Effective Annual Rate (EAR)
What is the sustainable growth rate?
The maximum growth rate achievable without external equity financing while maintaining a constant debt-equity ratio.
What is the set-of-contracts perspective of a firm?
The firm is viewed as a collection of contracts between stakeholders, such as shareholders and managers.
What is the formula for Future Value (FV)?
FV = PV × (1 + r)^t
What are the flaws of the Payback Period method?
Ignores time value of money (TVM).
Ignores cash flows after the payback period.
Uses an arbitrary cutoff period.
What is the primary role of a financial manager?
To create value from the firm’s capital budgeting, financing, and net working capital activities.
What are stakeholders?
Groups or individuals with a claim on the firm’s cash flows, such as employees, customers, suppliers, and the government.
What are the roles of a treasurer and a controller in financial management?
The treasurer handles cash flows and capital expenditure decisions, while the controller manages accounting, taxes, and information systems.
What is the Future Value (FV) Formula?
C0 = initial cash flow
r= interest rate
T = number of periods
What is the caution when using IRR for capital budgeting?
Managers should double-check using NPV, especially for mutually exclusive projects.
What is the Internal Rate of Return (IRR)?
The discount rate that makes NPV = 0.
How do you determine the value of a firm?
The value of a firm is the PV of its expected future cash flows.
What is the relationship between nominal and real rates?
R = nominal rate
r = real rate
h = inflation rate
What is the formula for after-tax salvage value?
What is the primary purpose of a firm in corporate finance?
To create value for the owner, reflected in the balance sheet model of the firm.
What is the most commonly used investment evaluation technique?
NPV, because it directly measures value added to the firm.
How is the times interest earned (TIE) ratio calculated?
TIE = EBIT / Interest Expense
What is the primary purpose of EBITDA?
To measure operating cash flow by removing the effects of financing and noncash expenses like depreciation.
What are the determinants of growth in the DuPont framework?
Profit margin (operating efficiency)
Total asset turnover (asset use efficiency)
Financial leverage (debt ratio)
Dividend policy (reinvestment vs. payout)
What is a partnership agreement?
A document or oral understanding specifying the nature of the partnership arrangement, including contributions, profits, and losses.
What is the relationship between dividend policy and growth?
Retaining earnings (lower dividends) increases internal funds available for reinvestment, supporting growth.
Why is benchmarking important in ratio analysis?
It helps compare a firm’s performance to industry standards and historical data.
What are the steps to evaluate a project?
Identify initial costs.
Determine operating cash flows.
Account for salvage value & NWC recovery.
Calculate NPV and IRR.
What are the steps to estimate NPV?
Estimate future cash flows (how much and when?).
Estimate the discount rate.
Estimate initial costs.
The time required to recover the initial investment using discounted cash flows.
Discounted payback period
What is cannibalization in capital budgeting?
When a new project reduces cash flows from an existing product.
What are the three types of cash flows considered in capital budgeting?
Initial cash flows, operating cash flows, terminal cash flows.
What is the formula for the total asset turnover ratio?
Total Asset Turnover = Sales / Total Assets
What is the percentage of sales approach in financial planning?
A method where financial statement items are expressed as a percentage of sales to project future needs.
Which one of these is most apt to be an agency problem?
Forsaking a profitable project because it involves some risk
What is the formula for the total asset turnover ratio?
Total Asset Turnover = Sales / Total Assets
What is one of the three sources of cash flows in a project?
Changes in Net Working Capital (NWC)
How does inflation impact NPV calculations?
Use nominal rates for nominal cash flows.
Use real rates for real cash flows.
What is the quick (acid-test) ratio?
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
How are spontaneous liabilities related to sales?
They naturally vary with sales, such as accounts payable increasing with higher sales volumes.
What is the formula for price-to-earnings ratio
Formula: P/E = Price Per Share / Earnings Per Share
What is the Effective Annual Rate (EAR)?
EAR is the actual annual interest rate accounting for compounding.
What are the main disadvantages of sole proprietorships and partnerships?
Unlimited liability, limited life, difficulty transferring ownership, and difficulty raising large amounts of cash.
How can agency costs be mitigated in a corporate setting?
aligning the interests of managers and shareholders
What is the quick (acid-test) ratio?
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
How do you calculate the PV of an annuity due in Excel?
Formula: =PV(rate, nper, pmt, fv, 1)
What is a financial market?
Any platform or venue where firms can raise capital for investments, such as stock markets, banks, or private equity firms.
What do profitability ratios evaluate?
A firm’s ability to generate income relative to revenue, assets, or equity.
What happens if you sell an asset before its useful life ends?
If Sale Price > Book Value → Capital Gain (Taxed).
If Sale Price < Book Value → Capital Loss (Tax Refund).
Why do many firms still use IRR despite its issues?
Easy to interpret as a rate of return.
Often aligns with NPV decisions.
What ensures efficient labor markets for managers?
Managers who maximize shareholder wealth gain higher demand and better compensation opportunities.
What is a major flaw of the payback period method?
It ignores the time value of money (TVM).
What is the formula for total debt ratio?
Formula: Total Debt Ratio = (Total Assets - Total Equity) / Total Assets
A series of fixed payments for a specific period.
Annuity
What are examples of current assets?
Inventory and accounts receivable—assets with short lives.
What is the purpose of pro forma financial statements?
To project a firm’s future financial performance based on assumptions about growth and financial policies.
How is EPS (Earnings Per Share) calculated?
EPS = Net Income / Number of Shares Outstanding
What are the traditional goals of corporate firms?
Maximize current wealth.
Transform wealth into desired consumption patterns.
Choose the risk characteristics of wealth.
What does a high total asset turnover ratio indicate?
The firm efficiently uses its assets to generate sales.
What is insider trading?
Illegal activity where individuals with nonpublic, material information trade securities for personal gain.
What are some challenges with financial statement analysis?
Lack of underlying theory to determine the most relevant ratios
Difficulty benchmarking diversified firms
Variations in accounting procedures and fiscal years
Reliance on historical data
What is long-term debt?
Debt that does not need to be repaid within one year.
How does return on equity (ROE) benefit shareholders?
ROE reflects how well a company generates profit from shareholders’ investments.
How do shareholders achieve risk and consumption goals?
By using capital markets, while managers focus on maximizing wealth.
Why might a firm with high growth opportunities have a high P/E ratio?
Investors expect future earnings growth and are willing to pay more for current earnings.
What is the main focus of the 1933 Securities Act?
Regulating the issuance of new securities and requiring registration with the SEC.
What is a Perpetuity?
A perpetuity is a constant stream of cash flows that lasts forever.
What mechanisms align manager goals with shareholder interests?
Incentive-compatible contracts, shareholder voting, and the threat of hostile takeovers.
What is the formula for the current ratio?
Current Ratio = Current Assets / Current Liabilities
What is EBITDA?
Earnings before Interest, Taxes, Depreciation, and Amortization; used to measure cash flow from operations.
What are some other corporate goals besides maximizing shareholder wealth?
Maximizing profits
Minimizing costs
Increasing market share
However, these goals are secondary to maximizing shareholder wealth.
How is net income linked to shareholder returns?
Net income determines dividends and retained earnings, which directly affect shareholder value.
What is the capital intensity ratio?
The amount of assets needed to generate $1 of sales.
Formula: Total Assets / Sales
What is the cash coverage ratio?
Cash Coverage = (EBIT + Depreciation + Amortization) / Interest Expense
When should you use EAC?
When comparing two assets with different useful lives (e.g., machines).
What is the Net Present Value (NPV) rule?
Accept projects where NPV > 0.
What is the formula for Average Accounting Return (AAR)?
What is the internal growth rate?
The maximum growth rate achievable using retained earnings as the only source of financing.
Why is managerial independence sometimes seen as a conflict?
Managers may prioritize their own goals, such as job security or perks, over maximizing shareholder wealth.
What is the sustainable growth rate?
The maximum growth rate achievable without external equity financing while maintaining a constant debt-equity ratio.
Formula: ROE × Retention Ratio / (1 - ROE × Retention Ratio)
Why is NPV considered the best investment evaluation method?
Uses cash flows, not accounting profits.
Includes all cash flows of the project.
Properly discounts future cash flows.
Assumes cash flows are reinvested at the discount rate.
What are the advantages of corporations over sole proprietorships and partnerships?
Limited liability, ease of ownership transfer, perpetual existence, and enhanced ability to raise cash.
What is the difference between book value and market value?
Book value is the value recorded on the financial statements, while market value reflects the current value investors are willing to pay.
What are common limitations of financial planning models?
They often rely on accounting relationships instead of financial relationships and may overlook key factors like cash flow, risk, and timing.
What is market-to-book ratio?
Market-to-Book Ratio = Market Value Per Share / Book Value Per Share
How does financial planning ensure consistency?
By aligning growth targets with financial policies and operational capabilities.
Why is the separation of ownership and control important?
It allows professional managers to operate the firm while shareholders retain ownership but not direct control.
What does capital intensity ratio indicate?
The amount of assets required to generate $1 of sales, showing how capital-intensive a business is.
What is the enterprise value (EV) multiple used for?
Comparing firms while accounting for differences in capital structure, taxes, and capital spending.
Why should financial planning models avoid being purely mechanical?
They risk overlooking strategic and value-adding decisions, focusing only on accounting relationships.
What is the formula for capital intensity ratio?
Formula: Total Assets / Sales
What is the goal of financial statement analysis?
To compare a firm’s performance with industry peers and evaluate financial trends over time.
What is the tax shield on depreciation?
A tax depreciation system that accelerates deductions, increasing early-year tax shields.
MACRS depreciation
The decision-making process for selecting long-term investments that generate revenue.
Capital budgeting
How is a common-size income statement created?
By dividing each line item by sales.
What is a sole proprietorship?
A business owned by one individual with no corporate income tax but unlimited liability for debts.
The discount rate at which two projects have the same NPV
Crossover rate in capital budgeting
How do you decide between mutually exclusive projects?
Use NPV for long-term value.
Use IRR cautiously (may not align with NPV).
What are the disadvantages of AAR?
Ignores time value of money.
Uses arbitrary cutoff rates.
Based on accounting profits, not cash flows.
How does bonus depreciation differ from MACRS?
Bonus depreciation allows for a large first-year deduction, while MACRS spreads depreciation over time.
What does the total debt ratio measure?
The proportion of total assets financed by debt.
Formula: Total Debt Ratio = (Total Assets - Total Equity) / Total Assets
What is the impact of inflation on capital budgeting?
Nominal cash flows should be discounted at nominal rates.
Real cash flows should be discounted at real rates.
What role does financial leverage play in growth?
Higher leverage provides additional funding but increases risk and limits financial flexibility.
What is the difference between an Annuity Due and an Ordinary Annuity?
Annuity Due: First payment is made immediately.
Ordinary Annuity: First payment is made at the end of the period.
What is the purpose of ratio analysis in financial statements?
To investigate relationships between different pieces of financial data and facilitate comparisons.
What is the present value of a perpetuity?
PV = C / r
How is a common-size balance sheet created?
By dividing each line item by total assets.
What is the difference between market capitalization and enterprise value?
Market capitalization includes only the equity value, while enterprise value accounts for both equity and debt, minus cash.
What is inventory turnover?
Inventory Turnover = Cost of Goods Sold / Inventory
Name the five categories of financial ratios.
Liquidity, long-term solvency, asset management, profitability, market value.
How is the profit margin calculated?
Profit Margin = Net Income / Sales
Why might shareholders design contracts for managers?
To align managerial incentives with shareholder goals and reduce agency problems.
An annuity where payments begin after a certain number of periods.
Delayed Annuity
Why is the timing of cash flows important?
Cash received sooner is more valuable due to the time value of money.
What are fixed assets?
Assets that last a long time, such as buildings, machinery, equipment, patents, and trademarks.
What is the residual claim of shareholders?
The amount left after debtholders are paid; shareholders receive this residual value.
What is the equity multiplier, and how is it calculated?
The equity multiplier measures financial leverage.
What are the three main categories on the balance sheet?
Assets, liabilities, and shareholders’ equity.
What are common managerial goals that may conflict with shareholder interests?
Spending on unnecessary perks
Prioritizing survival and independence
Growing the firm without increasing shareholder wealth.
What is Incremental IRR used for?
Comparing projects of different sizes to assess additional returns.
What are the tools used for financial statement analysis?
Standardized statements (common-size balance sheet and income statement)
Financial ratios
What is the tax shield approach for Operating Cash Flow (OCF)?
Why is globalization a challenge for financial analysis?
It introduces complexity due to differences in international accounting standards and competition.
How do you calculate the time required to double an investment?
Use NPER function in Excel:
Formula: =NPER(rate, pmt, pv, fv, type)
Why is the balance sheet considered a snapshot?
It shows the firm’s financial position at a specific point in time rather than over a period.
How is the profit margin calculated?
Profit Margin = Net Income / Sales
Why are common-size financial statements useful?
They allow for easier comparison of financial performance across companies of different sizes by standardizing data as percentages.
What is the goal of financial management?
To maximize the current value of the existing stock or owner’s equity.
What does the balance sheet provide?
A snapshot of a firm’s accounting value (book value) at a specific point in time.
Why is total asset turnover critical in the DuPont Identity?
It measures how efficiently a firm generates sales from its asset base, a key driver of profitability.
A perpetuity where cash flows increase at a constant rate over time.
Growing Perpetuity
What are contingent claims in corporate securities?
Debt: Fixed claim to firm value.
Equity: Residual claim after debt obligations are met.
What is the internal growth rate?
The maximum growth rate achievable without external financing.
Formula: ROA × Retention Ratio / (1 - ROA × Retention Ratio)
What is external financing needed (EFN)?
The amount of external financing required to support a firm’s projected growth.
How does a higher profit margin influence sustainable growth?
It increases the firm’s ability to generate funds internally, allowing for faster growth
What is the internal growth rate?
The maximum growth rate achievable without external financing.
What is the Present Value (PV) Formula?
CT= future cash flow
r = interest rate
T = number of periods
What is capital budgeting?
The process of making and managing expenditures on long-lived assets, involving decisions to accept or reject projects.
What are common-size financial statements?
Financial statements expressed as percentages of totals (e.g., revenue or assets) to allow comparison across companies.
What is an example of an opportunity cost in capital budgeting?
Using existing factory space for a new product instead of leasing it.
What is Net Working Capital (NWC)?
What does the “Procrustes approach” to financial planning imply?
Upper management sets goals, and planning teams work to create a feasible plan that meets those goals, often through compromise.
What is the NPV Rule for investment decisions?
NPV > 0 → Accept the project
NPV < 0 → Reject the project
How can a firm increase its sustainable growth rate?
By increasing profit margin, asset turnover, financial leverage, or retention ratio.
What investment decision technique is most commonly used by CFOs?
NPV and IRR, as shown by financial surveys.
What role does the CFO play in financial management?
The CFO ensures the firm’s financial strategies align with its goals, such as maximizing shareholder value.
What is an agency relationship?
A situation where one party (the agent) acts on behalf of another party (the principal), such as management acting for stockholders.
How is the times interest earned (TIE) ratio calculated?
TIE = EBIT / Interest Expense
What is Equivalent Annual Cost (EAC) used for?
Comparing projects with different lifespans.
What is the Securities and Exchange Commission (SEC)?
A regulatory body overseeing securities trading, corporate reporting, and preventing insider trading.
How does maximizing shareholder wealth relate to fundamental stock price?
Maximizing shareholder wealth equates to increasing the fundamental stock price, reflecting the value created for owners.
What does a low days’ sales in inventory ratio indicate?
The firm efficiently converts inventory into sales.
How can the DuPont Identity help diagnose performance issues?
By breaking down ROE into profit margin, asset turnover, and financial leverage, it shows which area needs improvement.
How is enterprise value calculated?
Enterprise Value = Market Capitalization + Market Value of Debt - Cash
What is the Time Value of Money (TVM)?
The concept that money available today is worth more than the same amount in the future due to its potential earning capacity.
What is the role of debt holders in a firm?
Debt holders are promised fixed payments (interest and principal) and are paid before shareholders.
What do liquidity ratios assess?
A firm’s ability to meet short-term obligations without financial stress.
Why is benchmarking diversified firms challenging?
Their operations span multiple industries, making it difficult to find comparable peers.
How do agency problems increase costs for firms?
By requiring monitoring, such as auditing, and creating inefficiencies like missed opportunities.
How do you calculate the PV of an annuity in Excel?
Formula: =PV(rate, nper, pmt, fv, type)
Why are market value ratios important?
They reflect investor sentiment and expectations about a firm’s growth potential and performance.
What is shareholders’ equity?
The difference between the value of a firm’s assets and its liabilities.
What is compounding, and how does it affect future value?
Compounding allows investments to grow faster by earning interest on interest over time.
Projects where only one can be chosen, such as selecting between two factory locations.
mutually exclusive projects
What determines the value of a firm?
The price of any asset is the Present Value of expected future cash flows.
What does the left side of a firm’s balance sheet represent?
The assets the firm owns or has bought.
Why does NWC increase in a project?
It represents an investment in short-term assets, causing a negative cash flow at the start.
Why are extraordinary events problematic for ratio analysis?
They can distort results, making it difficult to assess a firm’s true performance.
What does the price-to-earnings (P/E) ratio indicate?
How much investors are willing to pay per dollar of current earnings.
Formula: P/E = Price Per Share / Earnings Per Share
How is enterprise value calculated?
Enterprise Value = Market Capitalization + Market Value of Debt - Cash
What is the difference between sustainable and internal growth rates?
Sustainable growth rate maintains a constant debt ratio, while internal growth rate uses only retained earnings.
How do shareholders control a corporation?
Through electing the board of directors, who appoint the top management to run the company.
What is a proxy fight?
A mechanism where unhappy stockholders solicit proxies to replace the board of directors and, consequently, management.
What is the primary goal of financial statements?
To communicate financial information useful for decision-making, both within and outside the firm.
What distinguishes a limited partnership from a general partnership?
Limited partners have liability only up to their contributions, and they do not participate in managing the business.
What are bylaws in a corporation?
Rules regulating the corporation’s existence, concerning its shareholders, directors, and officers.
What is the decision rule for acquiring a firm?
If NPV > Purchase Price → BUY
If NPV < Purchase Price → DO NOT BUY
How does retained cash flow benefit a firm?
It provides internal funds for future investments without relying on external financing.
Why might a high inventory turnover ratio be a warning sign?
It could indicate the firm is frequently running out of stock or overpaying for shipments.
What is the primary goal of a corporation?
shareholder value and max cash flow
What are the three components of the DuPont Identity for ROE?
Profit Margin, Total Asset Turnover, and Equity Multiplier.
What is the formula for the current ratio?
Current Ratio = Current Assets / Current Liabilities
What are the five categories of financial ratios?
Liquidity ratios
Long-term solvency ratios
Asset management (turnover) ratios
Profitability ratios
Market value ratios
How do you calculate Present Value in Excel?
Formula: =PV(rate, nper, pmt, fv, type)
What are agency costs?
Costs arising from conflicts between managers (agents) and shareholders (principals), including contracting and monitoring expenses.
How is the price-to-earnings (P/E) ratio useful?
It indicates how much investors are willing to pay per dollar of current earnings, often used to gauge growth expectations.
What happens if a firm exceeds its sustainable growth rate?
The firm must adjust by increasing leverage, improving efficiency, or raising external equity.
When should you prefer NPV over IRR?
When mutually exclusive projects exist.
When cash flows are non-standard (multiple IRRs).
When comparing large vs. small projects.
How can shareholders influence managerial behavior?
Through voting for the board of directors, incentive-aligned contracts, and market discipline (e.g., risk of hostile takeovers).
What is a hostile takeover?
When an outside entity acquires a poorly managed firm to replace management and create value.
What are the advantages of IRR?
Easy to understand and communicate.
Considers time value of money.
What happens when growth exceeds the internal growth rate?
The firm must secure external financing to support additional asset investments.
What is one of the three sources of cash flows in a project?
Operating Cash Flow (OCF) – EBIT - Taxes + Depreciation
What unique financial issues do nonprofits and governments face?
They mirror basic financial principles of businesses but operate under different constraints and objectives.
Why is financial planning considered an iterative process?
Plans are created, reviewed, and adjusted multiple times to align goals across different departments.
Why is the timing of cash flows important in finance?
A dollar received today is worth more than a dollar received in the future due to time value of money principles.
What does capital structure represent?
The mix of a firm’s financing from current and long-term debt and equity.
What is Compounding?
The process of earning interest on both the initial principal and the accumulated interest from previous periods.
What is the formula for NPV?
NPV = PV of inflows - PV of outflows
What is the impact of bonus depreciation on NPV?
Year 1 OCF increases (higher tax shield).
Later-year OCFs decline (lower depreciation).
Salvage cash flow decreases (lower book value).
The process of evaluating and selecting long-term investments that are in line with the firm’s goal of maximizing shareholder wealth.
Capital Budgeting
What is the basic idea behind the Time Value of Money (TVM)?
Money today is worth more than the same amount in the future due to its earning potential.
What does the price-to-earnings (P/E) ratio indicate?
How much investors are willing to pay per dollar of current earnings.
Why is it important to benchmark financial performance?
To provide a standard for comparison, either within the industry or over time.
What are relevant cash flows in capital budgeting?
Incremental cash flows
Opportunity costs
Side effects (e.g., cannibalism, synergy)
Taxes
Inflation
What is the DuPont Identity formula for ROE?
ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
What is net working capital?
The difference between current assets and current liabilities.
What is the primary advantage of internal financing?
It avoids the transaction costs and dilution associated with raising external capital.
What does the total debt ratio measure?
The proportion of total assets financed by debt.
Formula: Total Debt Ratio = (Total Assets - Total Equity) / Total Assets
How does increasing financial leverage affect ROE?
It amplifies ROE if returns on assets exceed the cost of debt but increases risk.
What are the two broad categories of financial goals?
Profitability goals (e.g., maximizing profits) and risk control goals (e.g., avoiding bankruptcy).
ROA × Retention Ratio / (1 - ROA × Retention Ratio)
Internal growth rate formula
What is the formula for Profitability Index (PI)?
What are sunk costs?
Costs that have already been incurred and should not affect investment decisions.
The mix of a firm’s debt and equity used to finance its operations and investments.
capital structure
What is the significance of the profit margin ratio?
It measures how much profit is generated from each dollar of sales, indicating operational efficiency.
How can agency problems be reduced?
Incentive compensation, corporate governance, and market discipline.
What is the disadvantage of PI?
Does not work well for mutually exclusive projects due to scale differences.
What are the three key financial decisions reflected in the balance sheet model of the firm?
1.Capital budgeting (long-term investments)
2. Capital structure (how to finance investments)
3. Net working capital (managing short-term assets and liabilities).
What is the capital intensity ratio?
The amount of assets needed to generate $1 of sales.
How do you calculate IRR in Excel?
Formula: =IRR(values, guess)
What is the rule for making an investment decision using Net Present Value (NPV)?
If NPV > 0, purchase the investment.
If NPV < 0, do not purchase the investment.
How do spontaneous liabilities reduce external financing needs?
They increase automatically with sales, providing a natural source of funding.
What is the purpose of ratio analysis in financial statements?
To investigate relationships between different pieces of financial data and facilitate comparisons.
What is the goal of the corporate firm?
To maximize shareholder wealth by increasing the fundamental stock price.
What is the DuPont Identity?
ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
The total Present Value (PV) of future cash flows minus the initial investment.
Net Present Value (NPV)
What are the two types of agency costs?
Indirect costs (lost opportunities) and direct costs (expenses to monitor management or excessive expenditures).
What is the Present Value of an Annuity Formula?
Why is ROE a key determinant of the sustainable growth rate?
ROE directly influences the firm’s ability to grow without external equity financing by reflecting profitability and leverage.
What is a proxy vote?
Authority given by a shareholder to someone else to vote their shares at a shareholder meeting.
A constant stream of cash flows that continues indefinitely.
Perpetuity
When a new project boosts cash flows of an existing product.
Synergy in capital budgeting
What is an Annuity?
A fixed stream of cash flows for a set period.
What is net working capital?
Current assets minus current liabilities.
What is the correct way to handle working capital changes?
Initial Increase → Negative cash flow.
Recovery at Project End → Positive cash flow.
What is the formula for equity multiplier?
Formula: Equity Multiplier = Total Assets / Total Equity
How can a firm increase its sustainable growth rate?
By increasing profit margin, asset turnover, financial leverage, or retention ratio.
What is one of the three sources of cash flows in a project?
Net Capital Spending (NCS) – Upfront and salvage value
Earnings before Interest, Taxes, Depreciation, and Amortization; used to measure cash flow from operations.
EBITDA
How do you calculate EAR in Excel?
Formula: =EFFECT(nominal_rate, nper)
Projects that can be accepted or rejected independently without affecting other decisions.
independent projects
What is market-to-book ratio?
Market-to-Book Ratio = Market Value Per Share / Book Value Per Share
What are the components of cash flow in a firm?
Cash inflows: From selling debt and equity shares to investors.
Cash outflows: Investments in assets, payments to shareholders (dividends), debtholders (interest and principal), taxes, and retained cash.
