Exam 3 Review Flashcards
Financial statements are accounting reports issued periodically to:
Show past performance
Present a snapshot of the firm’s assets
Provide information about how the assets are financed
Financial statements provide reliable information to who?
Investors
Financial analysts
Managers
Creditors
Public companies must file statements with who?
Securities and Exchange Commission
How often must the annual report with financial statements be sent to shareholders?
Every year
Balance sheet lists:
firm’s assets and liabilities
What does the balance sheet provide a snapshot of?
The firm’s financial position at a given point in time
The income statement lists:
revenues and expenses over a period of time
Another name for the income statement
Profit and Loss statement
The bottom line of the income statement is referred to as what?
Net income or earnings
What information does the statement of cash flows use?
Info from the income statement and balance sheet
What does the statement of cash flows determine?
How much cash the firm has generated
How that cash has been allocated during a set period
A forecasting method that assumes that the balance sheet and income statement items grow proportionately with sales
Percentage of Sales Method
What do you typically assume about interest expense?
That it remains the same
What does the difference between assets and L+E indicate on the pro forma balance sheet?
The net new financing to fund growth
When you need new funding on the balance sheet you must choose between what types?
Debt or equity
What will change if debt is chosen for the new funding on the balance sheet?
The interest assumption
This forecasting method first identifies capacity needs and financing options
Capacity-Driven Forecasting
When L+E > A
Excess cash is available
Operating cycle
Length of time between purchasing inventory and receiving the cash back from selling products
Cash cycle
Length of time between payment of cash to purchase initial inventory and receiving cash from the sale of a product
Cash Conversion Cycle
= Inventory Days + A/R days - A/P days
The difference between receivables and payables that is the net amount of a firm’s capital consumed as a result of those credit transactions
Trade Credit
The credit that a firm extends to its customers
Trade Credit
Cost of Trade Credit
Effective Annual Rate
Three steps of establishing a credit policy:
- Establishing credit standards
- Establishing credit terms
- Establishing a collection policy
5 C’s of Credit
Character Capacity Capital Collateral Conditions
Accounts Receivable Days
Average number of days that it takes a firm to collect on its sales
Aging Schedule
Categorizes accounts by the number of days they have been on the firm’s books
Aging Schedule can be prepared using what two ways?
The number of accounts or the dollar amount of the accounts receivable outstanding
Firms should monitor their accounts payable to ensure what?
That they are making their payments at an optimal time
When a firm ignores a payment due period and pays later
Stretching accounts payable
What might the supplier implement if accounts payables are stretched too far?
Cash On Delivery
or
Cash Before Delivery
Benefits of Holding Inventory
Minimize stock-out risk
Can pursue most efficient production cycle rather and try to meet demand patterns (like seasonality)
Costs of Holding Inventory
Acquisition Costs
Order Costs
Carrying Costs
When a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it
Just-In-Time Inventory Management
Motivation for Holding Cash
Transaction Balance
Precautionary Balance
Compensating Balance
Transaction Balance
To meet day-to-day needs
Precautionary Balance
To compensate for the uncertainty associated with cash flows
Compensating Balance
To satisfy bank requirements
The first step in short-term financing is to forecast the company’s future cash flows to discover:
Cash surplus or deficit?
Temporary or permanent?
Reasons for short-term financing needs
Negative cash flow shocks
Positive cash flow shocks
Seasonalities
Matching Principle
Short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds
Permanent working capital
The amount that a firm must keep invested in short-term assets to support continuing operations
Temporary working capital
The difference between the actual level of investment in short-term assets and the permanent working capital investment
Promissory note
Single, end of period payment loan (uses benchmark rate, such as prime rate or LIBOR)
Promissory Note Line of Credit Types
Uncommitted
Committed
Revolving
Evergreen
Bridge Loan
Often a discount loan with fixed interest rate; with a discount loan, borrower pays interest at the beginning of the loan period
Commercial paper
Short-term, unsecured debt used by large corporations
What is commercial paper usually cheaper than?
A short-term bank loan
What is the minimum face value of commercial paper?
$25,000
Interest on commercial paper is typically paid how?
By selling it at an initial discount
Direct Paper
Firm sells directly to investors
Dealer paper
Dealers sell to investors in exchange for a spread (or fee) for their services
The spread decreases the proceeds that the issuing firm receives, increasing the effective cost
Secured Loans
Loans collateralized with short-term assets (usually a/r or inventory)
Most common sources of secured loans:
Commercial banks
Finance companies
Factors (firms that purchase the receivables of other companies)
Pledging of Accounts Receivable
Lender reviews the invoices and decides which credit accounts it will accept as collateral, based on its own credit standards
Factoring of Accounts Receivable
- The firm sells receivables to the lender
- Lender pays the firm the amount due from its customers at the end of the firm’s payment period less a factor’s fee
Lien
All of the inventory is used to secure the loan
Trust receipts loan or floor planning
Distinguishable inventory items are held in a trust as security for the loan
Warehouse arrangement
Inventory that serves as collateral is stored in a separate warehouse
Option
Contract which grants the buyer the right - but not the obligation - to buy or sell an underlying asset at a fixed price at or before an expiration date.
What is the value of an option based on?
The value of some underlying asset
The price or value of this asset gives us a “signal” about what?
Whether or not to exercise an option
Financial options are traded in a what?
Market
What is the cost of the option?
Premium
Call option holder has the right to what?
Buy underlying asset
Put option holder has the right to what?
Sell underlying asset
Price at which the underlying asset can be bought or sold if the option is exercised
Strike price
Last date on which the option can be exercised
Expiration date
These types of options can only be exercised at the expiration date
European options
These types of options can be exercised at expiration or any time beforehand
American
Intrinsic Value
Payoff if option is exercised immediately
“In-the-money”
Intrinsic value > 0
“Out-of-the-money”
Intrinsic value less than 0
“At-the-money”
Intrinsic value = 0
Extrinsic value
Value in waiting to exercise
Increased volatility of stock price always does what to value?
Increases value!!!!
Financial options
Options to buy and sell market-traded assets (stock, commodities, foreign currency, etc)
Real Options
Options to alter the cash flow stream associated with a real asset
Timing Option
Delay a project until expected cash flows are more favorable
Expansion Option
Increase the scale and scope of an investment in response to realized demand
Contract, shut-down, and abandonment option
Slow down, halt, or permanently abandon a project
Switching Option
Switch inputs or outputs in a project
The effect of optimal decision making under uncertainty is to change what?
The distribution (and expected value) of the project NPV
A discrete lattice or tree models what?
The uncertain value of the project over time
Binomial Lattice Model is a convenient what?
Decision-making model
Merger Waves
More mergers during economic expansions
Types of Mergers
Horizontal
Vertical
Conglomerate
Method of Payment for Mergers & Acquisitions
Stock swap
Cash merger or acquisition
Some combination of stock and cash
Why do acquirers typically pay substantial premiums?
Economies of Scale and/or Scope Vertical Integration Expertise Monopoly Gains Efficiency Gains Tax Savings from Operating Losses Diversification Earnings Growth Managerial motives to merge
Valuation Methods in Takeover Process
Compare the target to similar companies or use discounted cash flows
Tender Offer
Public announcement of cash transaction or stock swap
A stock swap has a positive NPV transaction if what?
The share price of merged firm exceeds pre-merger acquirer price
Stock swap is positive NPV if:
Share Price of Merged Firm > Pre-merger Share Price of Acquirer
Friendly Takeover
Target board of directors supports takeover
Hostile takeover
Corporate raider
Reasons board may not approve even if a premium is offered:
Might think offer price is too low
In a stock swap, might think acquirer is overvalued
Might be self interest (agency problem)
Proxy Fights
In a hostile takeover, the acquirer attempts to convince target shareholders to use proxy votes to support acquirers’ candidates for election to the target board
Strategies to stop proxy fights:
Can force a bidder to raise the bid
Can entrench management more securely
Posion Pills
Rights offering that gives existing target shareholders the right to buy shares in the target at a deeply discounted price under certain conditions
Poison Pills do what to the value of shares held by acquirer?
Dilutes them
Downside of Poison Pills
- Makes it more difficult to replace bad managers
- Firm’s stock price drops when poison pill is adopted
- Firms with poison pills have below average financial performance
Staggered boards do what to acquirers?
Makes it more difficult for them to gain board control because only one-third of directors are up for election each year
White Knights
Target looks for a friendlier company to acquire it
White Squire
Large friendly investor only purchases substantial block of shares and does not exercise control rights
Golden Parachutes
Lucrative severance packaged guaranteed to senior managers in the event that the firm is taken over and the managers are let go
Golden Parachutes are suggested to do what to value?
Increase value because management is more likely to be receptive to a takeover.
Recapitalization
Company changes capital structure to make itself less attractive (for example, pay out large dividend)
Other Defensive Strategies for Takeover
- Supermajority voting requirements for merger approval
- Restricted voting rights for large shareholders
- “Fair” price requirements, defined by BOD
Toeholds
Initial ownership stake in a firm that a corporate raider can use to initiate a takeover attempt
In a toehold, a raider can acquire what percent of the firm in secret?
10%
In a toehold, a corporate raider performs what?
An important service because management knows they exist
Leveraged Buyout
A lower-cost mechanism for corporate raiders. Instead of using their own cash, the raider borrows money through a shell corporation with the shares as collateral. If the tender offer succeeds, the raider can merge the target with the shell corporation and debt is owed by the target.
Freezout Merger
Used by companies acquiring other companies. The acquiring company makes a tender offer at a slight premium and if offer succeeds, acquirer gains control and merges into a new corporation.
Non-tendering shareholders faced with losing their shares, because target firm ceases to exist.
No benefit to holding out so existing shareholders will accept offer.
Floating Rate
Exchange rate that changes constantly depending on the supply and demand for each currency in the market
Supply and demand for each currency is driven by three factors:
- Firms trading goods
- Investors trading securities
- The actions of the central banks in each country
Importer-Exporter Dilemma
If companies set prices in a certain currency, they risk losing money if the exchange rate rises or falls
Currency Forward Contract
A contract that sets a currency exchange rate, and an amount to exchange, in advance of a future delivery date
Forward Exchange Rate
The exchange rate set in a currency forward contract, it applies to an exchange that will occur in the future
Cash-and-Carry Trades
- Borrow dollars today at the dollar interest rate
- Exchange the dollars for euros at the spot exchange rate
- Deposit the euros for one year at the euro interest rate
The difference between the forward and spot exchange rates is related to the _______ _________ ___________ between the currencies.
interest rate differential
What allows firms to lock in a future exchange rate?
Currency Forward Contracts
In a currency forward contract must the firm pay the rate it locks in no matter what?
Yes
Allows firms to insure themselves against the exchange rate moving beyond a certain level
Currency Options
In a currency options must the firm pay the rate in the option contract?
No! They can pay the rate in the option or the current - whichever is better
Differences in the forward rate vs option hedge:
- cost of premium (if exchange rate goes up)
- benefit (cost reduction if exchange rate goes down)
When any investor can exchange currencies in any amount at the spot or forward rates and is free to purchase or sell any security in any amount in any country at its current market prices
Internationally Integrated Capital Markets
In Internationally Integrated Capital Markets, the value of an investment does not depend on the ________ used in analysis
currency
Given future expected cash flow in foreign currency, you can either:
- Discount with foreign rate and convert using the spot rate
- Convert future cash flows and discount using dollar rate
When L + E is less than Assets
Additional financing is needed
Internationally Integrated Capital Markets
When any investor can exchange currencies in any amount at the spot or forward rates and is free to purchase or sell any security in any amount in any country at its current market prices
