Finance Flashcards
Calculation for total assets
A= l + oe (assets = liabilities + owners equity)
Calculations for common equity
common equity= common stock + APIC common+ retained earning - treasury stock OR common equity= total owners equity - (preferred stock + APIC preferred)
Current ratio
current ratio= current assets/current liabilities
(net) working capital
working capital= current assets - current liabilities
Debt-equity ratio (aka debt-to-total assets ratio)
debt-equity ratio= total liabilities/total owners’ equity
debt ratio (aka total debt ratio)
debt ratio= total liabilities/total assets
times-interest-earned (aka interest coverage)
TIE=EBIT/interest expense
Gross profit margin
=gross profit/net sales OR (Sales - COGS)/Sales
operating profit margin
=EBIT/net sales
net profit margin=
=net income/net sales
dividend payout ratio
=dividends/earnings
earnings per share
=(net income- preferred stock dividends)/ # of common shares outstanding
ROA
=(net income-preferred dividends)/average total assets
ROE
=(net income-preferred dividends)/average common equity
Outstanding stock
=issued stock - treasury stock
Earnings per (common) share
=net income- preferred dividends/weighted average of # of common shares outstanding
Profit (additional terms)
earnings; net income
Dividend payout ratio
=dividends/net income
ending retained earnings=
= beginning retained earning + net income - dividends
Top Line
Sales;Revenue
Bottom Line
Net Profit; net income
P& L (aka Income Statement)
Revenues
(COGS Cost of Goods Sold)
Gross profit
(operating expenses)
EBIT
(interest expense)
EBT
(taxes)
Net Income
Where would you find the retained earnings?
Balance sheet (owner’s equity section)
When preparing the pro forma income statement, you start with the __________ because ____________
sales forecast; many other items on the incomes statement are a function of sales
What 5 balance sheet items change at the same rate as revenue changes?
Cash
A/R
Inventory
A/P
Accrued payables (e.g.,salaries payable)
Risk-return tradeoff
the greater the risk, the greater the potential return
Risk (definition)
possibility of financial loss; possibility undesired outcome; uncertainty
Rate of return=
Profit measured in %; aka return in %; yield
Income (definition)
periodic cashflow received from the investment
Income (examples)
Interest; rent; dividends;
Interest (formula)
=principal x interest rate x fraction of a year
Dividends
distribution of the corporation’s net income to the shareholders
Role of the Board of Directors
Protect interest of the stockholders; decided if/when to issue dividends
Growth
(aka capital gain, appreciation); increase in the investment’s market value
Total return=
Income + growth
Calculating return $
=amount received from investment - amount invested
Calculating return %
= return in $/amount invested
Terms for return in %
rate of return; yield
Required return
minimum acceptable potential return on an investment, given the risks involved
portfolio
collection of investments
Expected Return of portfolio (formula)
outcome x probability = product
efficient portfolio
Provides either the greatest expected return for a given level of risk OR provides the least risk for a given potential return
Diversifiable risk
company-specific; non-systemic
Non-diversifiable
Market-risk; systemic
Future value
amount to which money will grow by a specified date if invested today at a given rate; expressed in $
CAGR
Compound annual growth rate; i in time value of money formula
Present Value
The amount which if invested at a given rate would grow to a specified future amount by a specified future date
Discounting
Finding the present value (*if discounting problem, probably using present value rather than future value)
Discount rate
i in present value formula
How to explain discounting/PV formula
If you invest PV today at x% compounded annually [i] for 2 years [n], you will have FV
OR
If you forecast receiving FV from an investment in 2 years [n] and you require a return of x% compounded annually [i], you must invest PV today.
R
If you have PV at x% compounded annually [i] for [n] years, you will have FV.
PV (formula)
PV= FV/ (1+i)^n
Free Cashflow
Cashflow generated by the business above and beyond the capital needed to operate it
Free Cashflow Formulas
Free Cashflow = [EBIT x (100%- tax rate)] - net change in total operating capital
OR
Free Cashflow= [(EBIT x (100% - tax rate)] - (ending total operating capital - beginning total operating capital)
Total Operating Capital
Capital needed to run/operate the business; includes cash , inventory, & net fixed assets
Free Cashflow- 5 uses
Pay interest to debtholders; repay debt; pay dividends to shareholders; repurchase stock from shareholders; buy short-term investments/other non-operating assets
EBIT
Operating profit; operating income
Goal of financial management
Maximize the wealth of the business owners
Net Worth
measure of wealth; assets- liabilities= net worth
LLC
Limited liability company; owners are “members”
Balance sheet forman
Assets Liabilities
current
long term
intangible Equities
Sales discounts
Discounts given to A/R customers for paying early
Price markdown
Selling at lower sales price
What is 100% on a vertical balance sheet
total assets
What is 100% on vertical income statment
Total sales (top line; net sales)
Leverage use: risks & benefits
interest expense may be greater than operating profit; mace face bankruptcy
Potential to increase ROE; can start enterprise with less capital
Capital budgeting
The process of determining which proposed projects (business opportunities) to implement
What financial statement is prepared first and why?
Pro forma income statement; net income gets added to retained earnings on the balance sheet
When preparing the pro forma P&L, start with a projection of
Revenues, because sales drive over costs/line items
Excess capacity
Ability to produce more without expanding facilities (versus @ capacity- maximum productive ouput)
Full capacity sales
=actual sales/actual capacity used
annuity
Series of equal, regularly-occurring cashflows
Ordinary annuity
the regularly-occurring payment comes at the END of each period
Annuity-due
the regularly-occurring payment comes at the BEGINNING of each period
Annuity formula n
n=number of equal payments being made (*NOT # times interest compounding)
Future value of an annuity
The amount that a stream of fixed cashflows will accumulate to in the future, based on the compound growth rate; in $
Present value of an annuity
The amount an investor would pay today in order to receive a specified number [n] of fixed period cashflows (PMT), given the required return [i] for the investment; in $
OR
the amount a visit would invest in a project today to receive a specified number [n] of fixed cashflows [PMT], given the required return [i] for the project; in $
Valuation
determining the fundamental value of as asset (aka intrinsic or theoretical value; V)
Discounted cashflow analysis
finding the present value of an asset’s expected future cashflows best way to find intrinsic value
Absolute valuation
fundamental value is based on the asset’s characteristics/qualities
Relative valuation
an asset’s fundamental value is based on a comparison to the value of similar assets
Bull market
Prices rising
Bear market
Prices falling
Public market
Open to public investors (e.g., anyone with money)
Securities & Exchange Commission
Part of Federal govt; regulates public securities markets (& public financial markets); private markets much less regulated
IPO
Initial Public Offering; 1st time a private corporation sells shares to public investors
Functions of securities underwriter
Helps issuer comply w/ SEC rules; pricing the issue; locates investors to buy the issuer’s securities
Seasoned ofering
subsequent issuance of stock by a public corporation
Primary market
transactions involving the issuance of new securities (e.g., IPO); issuers to investors
Secondary market
Transactions involving previously-issued securities (e.g., seasoned offerings); investors to investors through brokers; ex: NASDAQ, NYSE
Market Capitalization
total market value of company’s outstanding shares
market cap = current market price of stock x number shares outstanding
Indexes
hypothetical basket of securities intended to measure the investment performance of a specified investment market
Spread
Difference between 2 interest rates; changes over time
positive yield curve (aka & definition)
normal; upward sloping; long-term interest rates greater than short term
Negative yield curve (aka & definition)
inverted; abnormal; short-term interest rates greater than long-term; indicates recession coming
Basis points (bp, bps)
.01% difference in interest rates
Fed fund rate
rate that banks charge each other to loan money bank to bank overtnight
Prime rate
“bank prime”; rate a bank charges its most creditworthy customers
yield curve
shows the relationship between interest rates and time remaining until maturity at a given point in time; term structure of interest rates
positive yield curve
normal; upward sloping; long-term interest rates > short term rates
Negative yield curve
inverted; abnormal; short term interest rates > long term rates; suggests recession ahead
Flat yield curve
short-term and long-term interest rates are equal
maturity
when bond holder repays the principal and makes final interest payment
real
adjusted for effects of inflation
NOT real
nominal, stated, quoted; does not account for inflation
Positive real rate of interest
nominal interest rate greater than inflation
Negative real rate of interest
nominal interest rate less than inflation
inflation risk
possibility of loss of purchasing power due to rising prices
Required interest rate (formula)
=expected inflation + profit above inflation
inflation premium
average projected annual inflation rate over life of the investment
real risk-free interest rate
r*; interest rate on a risk-free investment, assuming 0% inflation
Inflation premium
Average annual inflation over the life of a loan
Required return (definition & formula)
the minimum acceptable potential return on an investment, given the risks
Required return= nominal risk-free rate + default risk premium + LP + MRP
=(r* + inflation premium) + risk premiums
Nominal risk-free rate
Treasury bills (short term) or treasury notes & bonds (long-term)
r= r* + IP (real risk-free interest rate + Inflation premium)
Required return (formula)
=(r* + IP) + risk premium(s)
Required rate of return on a debt security (formula)
=(r* + IP) + default risk premium + liquidity premium + maturity risk premium
Money market
market for short-term debt securities (mature in 1 year or less); sellers: corporations & governments; buyers: investors
2 types: treasuries or commercial paper
Includes US Treasury Bonds & Bills
Bonds
Long-term debt securities
Bonds whose interest rate (coupon rate) paid on the par value does not change over time
fixed-rate bonds
Bonds whose coupon rates change over the life of the bond as the market rate of interest changes
variable-rate, floating-rate or adjustable rate bonds
Par value of bonds issued by corporations
$1,000
Indenture
the contract between the issuer and the bondholders
trustee
protects the bondholders’ interests
Coupon rate
interest rate paid on the bond’s par value (principal)
A fixed-rate bon’s coupon rate reflects
The market rate of interest at the time the bond was issued
When market rate of interest increases, market price of bonds___-
Decreases; When market rate of interest decreases, price of bonds increases
indenture
Contract between the issuer & the bondholders
Who represents the interests of the bondholders?
Trustee
How often is bond interest paid?
Semi-annually
Terms of bond issue
interest rate, how frequently interest paid, maturity date, collateral
Covenants
restrictions imposed on the bond issuer under the indenture
Sinking funds
Requires the issuer to retire a portion of the bond issued each year
Terms for principal of the bond
maturity value; par value; face value
Institutional investors that need investment income, so invest heavily in bonds
Pension funds; insurance companies
Reasons why a bond’s market value may change over time
- Change in bond’s rating (rare) or change in market interest rates
What kind of capital are bonds?
Debt
Interest on corporate vs municipal bonds
Corporate bonds are taxable, so investors require higher interest rate than municipal bonds
Private placements
bonds sales in private market to institutional investors; avoids costly SEC registration
Mortage
A bond secured by real estate; secured bonds= backed by collateral
Debentures
Bonds that are unsecured (e.g., no collateral)
Zero-coupon bonds
Bonds that pay no periodic interest; higher risk to investors, but helps issuer b/c decreases cashflow needs
When do issuers call bonds?
Once the interest rates have declined; e.g., when the bonds are at a premium
Refunding operation
When corporations issues new bonds at lower rates and use that money to pay off older bonds; favors the issuer
Coupon rate on callable vs non-callable bonds
Higher rate on callable because greater risk to the bond holder
Convertible bonds
May be exchanged for common stock; benefits bondholder, but current stockholders face risk of dilution; lower coupon rate than non-convertible
Current yield
= annual coupon interest in $ (PMT) / current market price of the bond; given as percent; only indicates income portion of total growth
Relationship between bond’s market price/market value and its current yield
inverse
yield-to-maturity
The compound annual total return earned if bond is held to maturity; indicates current/market rate of interest and investors required rate of return for the bond; i variable in Vbond calculations; total return
Yield-to-call
Current market rate of interest for the callable bond; required return for callable bond; i for callable bond valuation if interest rates have fallen; total return
Advantages of purchasing preferred stock
with fewer investors in a market, the market is less efficient and easier to outperform
Stated dividends
Dividends to preferred stock owners; fixed rate ($ or % of par); paid before common stockholders, but not guaranteed **No growth potential over time
Benefits to issuing preferred stock instead of bonds
not required to pay dividends (legally)
Liquidation asset claims priority
Secured creditors, unsecured creditors, preferred shareholders, common shareholders
Timeline & impact on books when issuing dividends
Date of declaration: A + L increases- dividend payable + equity- (decreases retained earnings); payment date A (cash decreases) = L (decreases dividend payable) + cash
Flotation costs
Paid by issuers to securities underwriters
Who is more likely to invest in commercial than treasuries?
Institutional investors (compared to individual investors)
2 services of investment banks
Mergers & Acquisitions; Securities underwriting
Functions of a securities u nderwriter
Helps issuer comply with SEC rules; pricing the issue; locates investors to buy the securities
When do companies want to do IPOs and season offerings?
Bear markets
Efficient market hypothesis (4 implications)
1 If all investors have same info, its factored into security’s price as soon as available; 2 markets react to new info only if it differs than what was expected; 3 it’s impossible to consistently beat an efficient market; 4 the larger the number of participants, the greater the market efficiency
S&P 500
Measures performance of 500 large US companies’ stocks
Russell 20000
Measures performance of 2000 small US companies’ stocks
EAFE
Measures performance of developed-country stocks in Europe, Australasia & far east
Dow Jones Industrial Average
30 large- cap US companies
3 examples of debt capital
Bank loans; short-term debt securities; long-term debt securities (aka bonds)
Monetary policy
Policy regarding the growth of the money supply, set by the federal reserve bank; Either loosening/stimulative with higher monetary supply and decreasing interest rates
or
tightening, restrictive with decreased money supply and increasing interest rates
Junk Bonds
aka Speculative or high-yield bonds; anything BELOW BBB-
Bond rating agencies
Moody’s & S&P Standard & Poor’s; for-profit agencies (NOT the govt)
TIPS
Treasury Inflation-Protected Security; REAL interest rate; principal adjusts annually for inflation; backed by “the full fait & credit of the US Govt” and most secure investment in the world- taxes to pay; extremely liquid; “government securities”
Timeline of treasury securities
Bills (up to 1 year); notes (2-10 years); bonds (10+ years)
How would you know on statements if corporation has issued bonds?
Balance sheet; liabilities
DRIP
Dividend reinvestment plan; automatically uses cash dividends to buy more shares of stock
3 ways corporations pay dividends
$; stock- % par; property
CAGR formula
FV= PV * (1+i)^n
Dividend
Payment of corporation’s net income/profit to the shareholders; BoD decides whether and when corporation will pay a dividend; typically paid quarterly
Dividend types
cash (most common); Stock (DRIP Dividend Reinvestment Plan); or Property
Transfer agent
maintains shareholder roster
How dividends affect books- timeline
On declaration date, liabilities increase and OE retained earnings decreases; on record date, book aren’t affected; on payment date, assets cash decreased and liabilities dividend payable decreases
Dividend Yield
annual dividend in $/current market price of stock (answer is a %); only measures income not the total return
Beta
the slope o a regression line (x=market performance, y=stock’s performance; market=1..0; 1+ higher risk, >1 lower risk
equities market
market for common stock; stock=equities
Required return on a stock (formula)
=nominal risk-free rate + [beta x market risk premium]
Marketrisk premium (formula)
expected return on the makret- nominal risk-free rate
At equilibrium, required return =
expected return
WACC=
Weighted average cost of capital; the corporation’s required return on proposed projects
Impact of WACC on Vfirm
As WACC decreases, Vfirm increases; as WACC increases, Vfirm decreases
Capital Structure
the % of the corporation’s capital from bonds rbonds, preferred stock rpreferred and common stock rstock
Optimal capital structure
the capital structure that produces the lowest WACC; the capital structure that maximizes Vfirm (value of common stock)
The security that will increase in value the most if the company is successful is _______
common stock; riskiest and highest required return for investors
Flotation costs for debt securities
are lower than for preferred and common stock; these go to securities underwriters
How does new debt affect WACC?
Increases debt weight and decreases stock weight in WACC (WACC decreases) BUT higher cost of new debt increases WACC; increases shareholders’ risk, so required return on stock increases (WACC increases)
How does more debt affect interest rate and risk to common stockholders?
increases risk to common stock holders; increases interest rate
Recapitalization
significant change in the capital structure
Why is debt cheaper than equity capital?
- bonds are less risky than socks, so investor’s required rate of return is lower; flotation costs for deb securities are lower than for stock; interest paid on debt is tax deductible (unlike dividends)
Net issue price
the amout the issuer receives after paying flotation costs to the securities underwriter; =offering price-flotation costs
Preferred vs common stock dividends
preferred stock dividends are fixed; common can change over time
offering price
price investors pay for the security
Most expensive capital?
common equity; issuing new common shares 2/2 flotation costs
a DRIP allows the corporation to issue shares without using
securities underwriter; so cheaper
Common equity types
Retained earnings (reinvested profits); issuance of new common shares
Factors influencing WACC
corporation cannot control: 1. market prices/interest rates 2… market risk premium/investors’ risk aversion 3. tax rates; Can control 1. capital structure policy, 2 dividend policy, 3. investment (capital budgeting) policy
How to maximize the value of the firm?
maximize the value of the common stock (aka maximizing the wealth of the owners, maximizing the shareholder value)
Vfirm (formula)
=future free cash flows/ (1+i)^n ; i=WACC and it’s a %
Future cashflows (formula)
=[EBIT x (100%-tax rate)] - increase in total operational capital
Price earnings ratio
indicates how much investors must pay for $1 of free cashflow; = market price per share/free cash flow per share; aka earning multiple
PE ratio and stock valuation
if high P/E ratio, investors perceive greater growth potential and stock could be overvalued; if low PE ration, investors perceive less growth potential and stock could be undervalued
Price/cashflow useful when
company has reported a loss but has positive cashflow (e.g., when significant depreciation or amortization expense)
3 drawbacks of payback period method of capital budgeting
does not account for time value of money; does not account for cashflows received after the payback period; no relationships between payback period and investor wealth, so impossible to say what payback period is acceptable
Capital budgeting
budget for fixed assets & long-term expenditures; based on pro-forma cashflow estimates
Fixed assets aka
plant assets; Property, plant & equipment PPE; hard assets; capital assets
Expenditure
Cash outflow (*Not same as expense)
Optimal capital budget
capital budget that maximizes the value of the firm
Capital rationing
not funding/pursing all projects that would increase the value of the firm
Payback period
How long it takes the firm to recover its initial cash investment in the project; sometimes used to eliminate opportunities
Disadvantages of the payback method:
does not account for time-value of money; does not account for cashflows received after the payback period; doesn’t tell rate of return or impact on firm’s wealth
Net Present Value
PVinflows - PVoutflows; in $; use WACC for i
IRR
Internal Rate of Return; expected return; invest if greater than WACC; i variable; discount rate at which NPV = 0
MIRR
Modified internal rate of return; %; assumes cashflows re-invested @ WACC; invest if greater than WACC
Drawbacks of IRR
can give multiple/different answers; assumes cashflows are reinvested @ project’s IRR
Effective Annual Rate
Annual Percentage Yield; EFF; annualized rate when interest in compounded more frequently than annually; the actual annual rate earned
Vfim
present value of its expected future free cashflows; capital budgeting based on pro forma (projected) cashflows
Capital budgeting should only take into account_______
Incremental cashflows
Sunk cost
cost that has already been incurred & cannot be altered by future courses of action ; NOT incremental/relevant
Opportunity cost
the cost of not pursuing another alternative; foregone costs; ARE incremental/relevant
