introduction to corporate finance Flashcards
what is corporate finance
the study of how businesses or firms make financial decisions - investment and financing decisions
investment = the decision of which projects the firm should invest in
financing = the decision of how the firm finances its operations
how does a firm raise cash
- borrowing and issuing equities
- retained cash flow - the cash that the firm retains after generating cash from its activities and paying dividends and interests to finance providers and taxes to the government.
what are the different types of businesses
- corporation
- legal entity owned by, but legally distinct from, its owners (shareholders) - sole proprietor
- business owned and managed by one person, with profits taxed as the owner’s personal income - partnerships
- like sole proprietor but where the business is owned by more than one person
what are the key features of the corporation
- limited liability for its owners
- separation of ownership and control
- owners and businesses are taxed separately
what is the financial objective of a firm
- maximise profits
- maximise sales or market share
- achieved by cutting prices, but this may conflict with generating profits - remain solvent
- achieved by never taking on debt, but firm may have to forgo some wealth generating projects cuz of insufficient funds - maximise shareholder wealth
- unambiguous and seen as the main financial objective of a firm
what is the difference between shareholders and managers
shareholders own the firm but dont run it - they employ managers to operate the firm in shareholders’ interests
managers may pursue actions that benefit themselves at the expense of shareholders
when do agency problems arise
whenever there is a conflict of interest between a firm’s shareholders and managers
= creating agency costs: losses (both direct and indirect)
what are some strategies to mitigate agency problems
- compensation: align managerial incentive to that of shareholders
- bonuses
- share and options-based compensation - corporate governance: the laws, regulations, institutions and corporate practices that protect shareholders and other investors
- legal framework
- board of directors
- activist shareholders
- takeovers
- information for investors
what is the balance sheet (SOFP)
provides information of what the company owns (assets), what it owes ( liabilities) and what is left over for its owners (equity) at a particular point in time
balance sheet identity : assets = liabilities + shareholders’ equity
what is net working capital
net working capital = current assets - current liabilities
a measure of a company’s ability to meet short-term obligations, as well as fund operations of the business
ideal position = positive net working capital balance
why is it important that the value of assets on the balance sheet are recorded as book values rather than the value if they were sold in the market (market values)
certain assets like plant machinery are typically calculated as historical cost - accumulated depreciation
depreciation = an estimate of the cost of the asset each period it is used and wears out (an accounting expense, not a cash flow)
some intangible assets may not appear on the balance sheet. Hence the book value of a company (derived from the balance sheet) will differ from the market value (determined by the share price times the no. of shares issued)
what is an income statement
a financial statement that details a company’s revenues, expenses and net income over a period of time
what are the calculations of the following earning measures from the income statement
gross profit
operating income
earnings before interest and tax
net income
gross profit =sales revenue - cost of goods sold
operating income = gross profit - operating expenses
EBIT = operating income +/- other income/expenses
pre-tax and net income = EBIT - interest - taxes
how are profits different to cash flows
- income ignores capital expenditures
- profits include non-cash items (like depreciation)
- profits dont consider changes in working capital (like inventories, payables)
we need to look at the cash flow statement
earnings before interest, tax, depreciation and amortisation) is more closely related to the cash a firm generates from its operations
- EBITDA = EBIT + depreciation and amortisation
what is amortisation
process of spreading the repayment of a loan, or the cost of an intangible asset, over a specific timeframe
what is the statement of cash flows
financial stamens that shows how much cash a firm has generated and how that cash has been allocated, during a set period
what are the main components of a cash flow statement
- operating activities: adjusts net income by all non-cash items related to operating activities and changes in net working capital
- depreciation - adds the amount of depreciation
- accounts receivable - deducts the increase
- accounts payables - adds the increase
- inventories - deduct the increases - investment activities
- capital expenditures
- other assets purchased/ sold - financing activities
- dividends paid
- sale/ repurchase of company stock
- changes to short and long-term borrowing
what are financial ratios
allow investors and other stakeholders to use the information contained in a firms accounting statement to
- compare the firm with itself by analysing how the firm has changed over time
- compare the firm to other similar firms using a common set of financial ratios
what is the market to book ratio
= market value of equity / book value of equity
- market and book values are likely to be different
- the stock market will place greater value on a company with a well-known brand or growth potential
what is a price to earnings ratio
= market value of equity / net income
= share price/ earnings per share
- measures how expensive a company’s shares are/ how many times current earnings are needed to buy a share
- high ratio = overvalued company
what is the accounting rate of return
- Return on assets = (net income + interest (1-t) )/ total assets
- t = tax - return on equity = net income / book value of equity
these are measures of performance
- ROA measures return generated by total assets purchased
- ROE measures the return generated by equity funding
what are the asset efficiency ratios
- asset turnover = sales over total sales
- measure of efficiency and indicates the amount of revenue generated by the firm’s assets - inventory turnover = cost of goods sold / inventory
- indicates how efficient a company’s shares are is at turning inventory into sales
wha are the profitability ratios
- gross margin = gross profit/ sales
- operating margin = operating income/ sales
- profit margin = net income / sales
what are the leverage ratios
- interest cover = earnings / interest
- the higher this ratio, the more easily the company can pay interest out of its current earnings = less risk of financial distress - debt equity ratio = debt/ equity
- debt ratio = debt / debt + equity ratio
- and 3. measure the degree of leverage of a company. debt can either be expressed as a percentage of equity or total capital
what are the liquidity ratios
- current ratio = current assets/ current liabilities
- quick ratio = (current assets- inventory)/ current liabilities
- cash ratio = cash / current liabilities
these ratios helps identify the drivers of ROE but the components are not independent
an increase in which ratios will increase ROE
1.profit margin
- ratio of bottom line profits compared to total sales revenue
- identifies for every $ of revenue, how much profit is earned
- can be improved by increasing price/ reducing costs
- asset turnover ratio
- measures how efficiently a company uses its assets to generate revenue
- vary considerable between indsutries - equity multiplier
- provides an indirect measure of a firms use of debt to finance assets
- more debt (leverage) the company uses to purchase assets, the higher the assets to equity ratio ( as assets will increase as debt increases and equity remains the same)
