Fin 301 Mid Term Flashcards
Explain Capital Budgeting
planning and managing a firm’s long-term investments (fixed assets) , identify investments where the value of cash flow generated by the asset exceeds the cost of the asset
Explain Capital Structure
determining the mix of long-term debt and equity that is used to finance its operations
Explain Net Working Capital Management
Involves managing the firm’s short-term assets and liabilities (everyday activities)
What is an example of Capital Budgeting?
Opening a Walmart in a new town (do we need it?) and updating an operating system
What is the formula for Capital Structure?
Debt (Bonds, Loans) + Equity (Stock) = Capital Structure
In what order of liquidity are Current Assets and Current Liabilities found on the balance sheet?
Most liquid to least liquid
What are 5 factors you should consider before creating a business?
- Cost to create organization
- Continuity/Stability of organization
- Control of decisions
- Personal Liability of owners
- Taxation of Earnings and the distribution of profit to owners
Explain a Sole Proprietorship
owned by one person, least regulated, unlimited personal liability, owner keeps all profits
Explain a General Partnership
partners share in gain/loss, both equal in unlimited liability
Explain a Limited Partnership
limited partner that does not participate in business and is only liable for their portion of particpation
Explain a Corporation
a business created as a formal legal entity, separate and distinct from its owner, public ownership, limited liability, strict regulation
How often are Corporations taxed?
Taxed twice, once when profits are reported and once if dividends are paid
When forming a Corporation, what are the Articles of Incorporation?
- Includes corporations name
- owners name
- intended life
- business purpose
- number of shares to be issued
When forming a Corporation, what are the Bylaws?
Description of how the business will operate, and how the corporation regulates its own existence
When forming a Corporation, what is the hiring process?
Stockholders elect the Board of Directors, who ultimately hire management
What is a Limited Liability Corporation?
hybrid of partnership and corporation, have limited liability but are taxed like a partnership
What is the Primary goal of Financial Management?
maximize current value per share of existing stock
What are the 5 Secondary goals of Financial Management?
- Survive
- Avoid Bankruptcy
- Minimize Costs
- Maximize Profits
- Maintain Steady Growth
What is the goal of the Sarbanes-Oxley Act?
Enacted by Congress, protect investors from corporate abuse
How does the Sarbanes-Oxley Act achieve its goals?
- Management is responsible for accuracy of financial statements
- No false statements or “material” omissions
- Annual report that contains an assessment of internal control structure and financial reports
Why did some companies “go dark” when the Sarbanes-Oxley Act was passed?
It was too expensive for them to comply
What is the Agency Problem?
Highlights potential conflicts of interest between stockholders and management
What is the Owner’s priority in the Agency Problem?
seek new investment and raise share value
What is Management’s priority in the Agency Problem?
pursue job security, corporate luxury, higher compensation at expense of shareholders
What are Direct Agency Costs?
Corporate expenditure that benefits management, but costs stockholders, like buying a corporate jet
What are Indirect Agency Costs?
Lost opportunities rise from the lack of risk taking by management, like if a company backs out of an aquisition
How do stockholders decide who controls the firm?
Stockholders elect a board of directors who hire and fire management
What are proxy fights in regards to stockholders in a company?
Stockholders can replace existing managers through proxy fight
What are Primary Markets?
Markets in which the original sale of securities by governments and corporations occurs (IPO), corporations are the seller
Public Offerings, a type of Primary Market, is
securities sold to general public, debt/equity must be registered with SEC and is very expensive
Private Placement, a type of Primary Market, is
a negotiated sale involving a particular buyer like a life insurance company
What are Secondary Markets?
Markets in which securities are bought and sold to the public after original sale, corporation is not directly involved
A Dealer Market, a type of Secondary Market, is
no physical location, transactions are made by a dealer electronically
An Auction Market, a type of Secondary Market, is
sellers and buyers of securities are matched at a physical site
What is the Balance Sheet?
What the firm owns and what they owe, prepared at the end of the month
What equation must always be balanced?
Assets = Liabilities + Equity
What are Current Assets?
life of less than one year (cash, accounts receivable, inventory prepaids)
What are Fixed Assets?
Assets with a relatively long life (PPE)
What are Current Liabilities?
Have a life of less than one year (must be paid within current year), (Accounts Payable, Wages Payable, Notes Payable)
What are Long-Term (Fixed) Liabilities?
Have a relatively long life (Bonds Payable, Mortgage Payable)
If the firm were to sell all assets to pay debts, who would the residuals go to?
the owners
What is the order for Equity Accounts?
Common Stock, Paid-in Capital, Retained Earnings
Liquidity, an important item on a Balance Sheet, is
- Speed and ease at which an asset can be converted to cash without loss of value
- Highly liquid companies are less likely to have financial issues
What is Financial Leverage?
amount of debt in a firm’s capital structure , with more debt leading to a greater advantage but too much can lead to failure
What is Market Value?
True worth of the firm TODAY
What is Book Value?
Historical cost of the firm, used for GAAP
What is the Income Statement?
Summarizes the company’s operating performance over time, usually a one month period
The Realization Principle, from GAAP, is
Recognize revenue when earnings process is virtually complete, and the transaction value is known
Revenue is recognized that the time of sale, not necessarily at the time of collection (Accrual Accounting)
The Matching Principle, from GAAP, is
Revenues must be matched with costs incurred to generate them
Since there is a time difference between costs and payments, the income statement may not match the cash flows for the period
What are Non-Cash Items on the Income Statement?
Expenses which have no direct effect on the firm’s cash flow
What are 3 aspects of Depreciation?
- Highly effective tax shield
- Non-Cash expense
- Firms use depreciation to match the cost of purchasing the asset with the revenues produced from owning it over time
What are considered Short-Run Costs and Time?
Firm varies output by varying expenditure types (both fixed and variable)
What are considered Long-Term Costs and Time?
All business’ costs are variable
Are Federal Tax Codes due to Political or Economic reasons?
Political Factors
How many Tax Brackets are there?
7, ranging from 10% to 37%
What is the Federal Corporate Tax Rate?
21%
What is the Marginal Tax Rate?
tax rate charged for one additional dollar of income
What is the Cash Flow Identity?
Difference between the number of dollars that came in and the number that went out
Does the Cash Flow Identity equal the Statement of Cash Flows?
No goober
How is cash generated, considering Cash Flow Identity?
Cash is generated by selling a product or asset, borrowing, or selling equity interest (stock) in the firm)
How is cash spent, considering Cash Flow Identity?
Cash is spent by acquiring assets, paying for materials and labor, and by paying creditors and owners
What activities involve spending cash?
- Increase in Accounts Receivable
- Increase in Inventory
- Decrease in Long Term Debt
- Decrease in Notes Payable
- Purchase of fixed assets (PPE)
What activities involve generating cash?
- Increase in Accounts Payable
- Increase in Common Stock
- Increase in Retained Earnings
Regarding sources of cash, the asset account should…
decrease (left side)
Regarding sources of cash, the liabilities or equity account should…
increase (right side)
Regarding uses of cash, the asset account should…
increase (left side)
Regarding uses of cash, the liabilities or equity account should…
decrease (right side)
What is a Statement of Cash Flows?
A firm’s financial statement that summarizes its sources and uses of cash over a specified period
What are the three groups that contain the changes in the Statement of Cash Flows?
- Operating Activities
- Investing Activities
- Financing Activities
What is the issue with standardized financial statements?
Different sized companies make it impossible to compare financial statements
What is a common size statement?
Show all items in terms of percentages
A common size statement for the Balance Sheet…
Show items as percentages of asset, found by dividing by Total Assets
A common size statement for the Income Statement…
Show items as percentages of sales, found by dividing by Total Net Sales
What are Financial Ratios?
relationships determined from a firm’s financial information and used for comparison purposes
What is the purpose of the Short Term Solvency Ratio (Liquidity Ratio)?
- Provides information about a firm’s liquidity
- Important to short term creditors
- Reflect company’s ability to pay bills over the short run without undue stress
What is the ideal Liquidity Ratio?
the higher the current ratio, the better; (2:1) or better is desired
What is the purpose of the Interval Measure Ratio?
Provides an idea of how long the business can keep running, not usually a good sign
What is the Long Term Solvency Ratio?
Company’s ability to meet long-term financial obligations and measure a company or firm’s financial leverage
Also referred to as debt (how heavily in-debt is this company), helps determine if a company can pay back its debt in the long term
What is the purpose of the Times Earned Ratio?
Measures how well a company has its interest obligations covered
EBIT found on Income Statement
Interest found on Income Statement
What is the Cash Coverage Ratio?
Basic measure of a firm’s cash available to meet interest expense obligations
Frequently used as a measure of available cash flow
What is the purpose of the Asset Management Ratio (Asset Utilization Ratios)?
Effective measure of turnover
Describes how efficiently or intensively a firm its assets to generate or “turn” sales
What does a high Turnover Ratio indicate?
a company is effectively managing inventory
What does the Days Sales in Inventory Ratio mean?
Represents the average number of days that inventory sits before it is sold
What does the Receivables Turnover Ratio represent?
how fast the company collects on sales
What does the Days Sales Outstanding mean?
Represents the average time it takes to collect on credit sales
“Average collection period”
What does the Net Working Capital Turnover Ratio mean?
Measures how much work we get out of our working capital
How fast can we turn NWC into sales
What is significant about the Total Asset Turnover Ratio?
Reciprocal of Capital Intensity Ratio
Also known as 1 / Capital Intensity Ratio
What does the Profitability Ratio describe?
how efficiently a firm uses its assets and manages its operations with a focus on Net Income
What does the Net Return on Sales (profit margin) indicate?
how many cents per dollar of sales become part of net income
What does the Net Return on Assets measure?
how net income is generated per dollar of assets
What is Net Return on Equity?
Indicates how the stockholders fared during the year
Measures how much net income is generated per dollar of equity
What is the Market Value Ratio?
Based on the market price per share of a stock, not on financial statements
Can only be calculated if the company is publicly traded because the information needed is only available for public companies
What is the Price Earnings Ratio?
Measures how much an investor is willing to pay for a dollar of current earnings
What is the Market to Book Ratio?
Compares the market value of the firm’s investments to its historical costs
This ratio is historically 7:1
What does the Enterprise Value to EBITDA Ratio do?
Estimate of the market value of the firms operating assets excluding cash
What is the DuPont Identity?
Breaks return on equity (ROE, net income / equity) into three parts
- Operating Efficiency
- Asset Use Efficiency
- Financial Leverage
What is Operating Efficiency (DuPont Identity) measured by?
Measured by Profit Margin
What is Asset Use Efficiency (DuPont Identity) measured by?
Measured by Total Asset Turnover
What does Financial Leverage (DuPont Identity) measured by?
Measured by Equity Multiplier
What are the Internal Uses of Financial Statements?
- Performance Evaluation
- Future Planning
- Division Performance Comparisons
- Salary Decisions
What are the External Uses of Financial Statements?
- Evaluation of Suppliers
- Evaluation of Competitors
- Evaluation of Outside Parties (creditors, potential investors)
- Acquisition of another firm
The Time Trend Analysis, a way of choosing a benchmark, is…
Uses a company’s history to make comparisons across various periods
Frequently utilizes standardized statements
Shown in bar or line graphs
The Peer Group Analysis, a way of choosing a benchmark, is…
Establishes a benchmark for companies that compete in similar markets and are similar in size / assets / operation
Standardized Industrial Classification (SIC) Code , was a US govt. Code to classify firms by type of business operations
What is the Problem with Benchmarks?
No underlying theory to help identify which quantities to consider when establishing benchmarks
What can you do with a company that is making a positive net income?
Dividends: portion of net income given away, represented by (d)
Retained Earnings: portion of net income kept, represented by (b)
What are the 4 key elements to Financial Planning?
- Capital budgeting (PP&E decision)
- Capital Structure (Debt vs. Equity decision)
- Net Working Capital (liquidity decision)
- Dividend Policy
What are the 6 Ingredients to a Successful Financial Plan?
- Economic Assumptions
- Sales Forecast
- Pro Forma Statements
- Asset Requirements
- Financial Requirements
- Plug it in
What is the purpose of Financial Planning?
- Formulates the way in which financial goals are to be achieved
- Avoids “stumbling into the future backwards” , Anticipating possible problems before they arrive
- Establishes guidelines for change and growth in a firm
How long is the short term?
one year
How long is long term? (Planning Horizon)
2-5 years
What is Aggregation?
The process by which smaller investment proposals of each of a firm’s operational units are added up and treated as one big project
Is growth a financial management goal?
Growth itself is not an appropriate goal
Rapid growth is not always a good thing , (Management loses control because of rapid growth)
Desirable, but not a good end goal
What is the planning for the worst case scenario?
Disaster planning to withstand significant economic adversity
Details on cost cutting, divestiture, and liquidations
What is the planning for the best case scenario?
Rosy economy and company outlook
New products, expansion, and financing to fund expansion is received
What is a Pro Forma Income Statement?
Need a growth rate (ideal growth rate)
Look at cost as a percentage of sales
Adding money to retained earnings
What is a Pro Forma Balance Sheet?
ssume some items vary directly with sales and others do not
For items that DO vary with sales, express as percent of sales
For items that do NOT vary with sales, write “n/a”
What happens when you have an unbalanced balance sheet?
Assets does not equal liabilities + owners’ equity (HAS TO)
External Financing Needed (EFN)
What does the Capital Intensity Ratio represent?
amount of assets needed to generate $1 of sales, Reciprocal of Total Assets Turnover
A 3:1 means it took $3 to generate $1 in sales
How are EFN and Growth related?
All other things being equal, the higher the rate of growth in sales or assets, the greater the need external financing
“It takes money to make money”
What is the Internal Growth Rate (%IGR)?
The maximum growth rate a firm can achieve without external financing of any kind (taking on additional long-term debt or raising new equity) Use year 1
What is ROA and B within the IGR?
ROA = return on assets
B = retention ratio
What is the Sustainable Growth Rate (%SGR)?
The maximum growth rate a firm can achieve without equity financing while maintaining the same debt/equity ratio (taking on debt is ok). Use year 1
What do IGR and SGR represent?
IGR is the rate at which a company can grow with no external financing (EFN = 0) while SGR is the rate at which a company grow while financing only through debt (while maintaining a constant debt to equity ratio)
What are the 4 determinants of Growth?
- Profit Margin (net return on sales)
- Dividend policy
- Financial policy
- Total asset turnover
What are three components of ROE according to the DuPont Identity?
Profit Margin, Financial Policy, and Total Asset Turnover, anything that affects ROE is a determinant of growth
What are the Caveats to Financial Models
Financial planning models do not always ask the right questions, they tend to rely on accounting and not financial relationships
Financial planning models sometimes do not produce output that gives the user meaningful clues about what strategies will lead to increases in value
Financial planning is an iterative process, plans are created, examined and modified over time
What is the rule of 72?
the amount of time it takes for money to double
What is Future Value?
amount an investment is worth after one or more periods
What is Compounding Value?
accumulating interest on an investment over time to earn more interest
What is Interest on Interest?
Interest earned on the reinvestment of previous interest earned
What is Compound Interest?
Interest earned on both the initial principal and the interest invested from the prior periods
What is Simple Interest?
Interest earned only on the original principal amount invested
What is the Discount Rate?
Rate used to calculate present value of future cash flows
What is the Discounted Cash Flow Valuation (DCF) ?
Calculating the present value of future cash flow to determine its worth today
What is the Relationship between Present Value and Future Value?
The Present Value Factor is the reciprocal or the inverse of the Future Value Factor
What are the two ways to calculate Future Values with Multiple Cash Flows?
- Compound the accumulated balance forward one period at a time
- Calculate the future value of each cash flow first and then add them up
What are the two ways to calculate Present Value with Multiple Cash Flows?
- Discount the balance back one period at a time
- Calculate the present value of each cash flow first and then add them up
When do Cash Flows occur?
Cash flows occur at the end of the year unless otherwise specified
What are Annuities?
A series of constant or level cash flows that occur at the end of a period or some fixed number of periods
College loans, home loans, car loans
What is an Annuity Due?
An annuity for which the cash flows occur at the beginning of a period
Lease and rental payment
What are Perpetuities?
An annuity in which the cash flows continue forever, the cash flow is the same each year
Preferred stock
What are Stated Interest Rates?
The interest rate expressed in terms of the interest payment made each period.
%APR on a loan or a quoted loan
What is the Effective Annual Rate (%EAR) ?
The interest rate expressed as if it were compounded once per year. It is the compounded interest during the year as if it only happened once a year
Use EAR when you see compounded
What is the Annual Percentage Rate (APR) ?
Interest rate charged per period multiplied by the number of periods per year
All lenders must disclose a %APR on consumer loans
%APR is a quoted rate or stated rate
What is a Pure Discount Loan?
The simplest form of a loan where the borrower receives money today and repays a single lump sum at some time in the future
Very common, repaid in a short period of time
Treasury Bill (T-Bill)
What is an Interest Only Loan?
A loan where the borrower pays interest every period and repays the entire principal at some point in the future
Corporate Bonds
What are Amortized Loans?
Borrower pays some fixed interest and principal every month, usually from fixed payments
Mortgages, cars, homes
