introduction to corporate finance

Question 1

what is corporate finance

Answer 1

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

Question 2

how does a firm raise cash

Answer 2

1. borrowing and issuing equities
2. 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.

Question 3

what are the different types of businesses

Answer 3

1. corporation
   - legal entity owned by, but legally distinct from, its owners (shareholders)
2. sole proprietor
   - business owned and managed by one person, with profits taxed as the owner’s personal income
3. partnerships
   - like sole proprietor but where the business is owned by more than one person

Question 4

what are the key features of the corporation

Answer 4

1. limited liability for its owners
2. separation of ownership and control
3. owners and businesses are taxed separately

Question 5

what is the financial objective of a firm

Answer 5

1. maximise profits
2. maximise sales or market share
   - achieved by cutting prices, but this may conflict with generating profits
3. remain solvent
   - achieved by never taking on debt, but firm may have to forgo some wealth generating projects cuz of insufficient funds
4. maximise shareholder wealth
   - unambiguous and seen as the main financial objective of a firm

Question 6

what is the difference between shareholders and managers

Answer 6

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

Question 7

when do agency problems arise

Answer 7

whenever there is a conflict of interest between a firm’s shareholders and managers
= creating agency costs: losses (both direct and indirect)

Question 8

what are some strategies to mitigate agency problems

Answer 8

1. compensation: align managerial incentive to that of shareholders
   - bonuses
   - share and options-based compensation
2. 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

Question 9

what is the balance sheet (SOFP)

Answer 9

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

Question 10

what is net working capital

Answer 10

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

Question 11

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)

Answer 11

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)

Question 12

what is an income statement

Answer 12

a financial statement that details a company’s revenues, expenses and net income over a period of time

Question 13

what are the calculations of the following earning measures from the income statement

gross profit
operating income
earnings before interest and tax
net income

Answer 13

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

Question 14

how are profits different to cash flows

Answer 14

1. income ignores capital expenditures
2. profits include non-cash items (like depreciation)
3. 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

Question 15

what is amortisation

Answer 15

process of spreading the repayment of a loan, or the cost of an intangible asset, over a specific timeframe

Question 16

what is the statement of cash flows

Answer 16

financial stamens that shows how much cash a firm has generated and how that cash has been allocated, during a set period

Question 17

what are the main components of a cash flow statement

Answer 17

1. 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
2. investment activities
   - capital expenditures
   - other assets purchased/ sold
3. financing activities
   - dividends paid
   - sale/ repurchase of company stock
   - changes to short and long-term borrowing

Question 18

what are financial ratios

Answer 18

allow investors and other stakeholders to use the information contained in a firms accounting statement to

1. compare the firm with itself by analysing how the firm has changed over time
2. compare the firm to other similar firms using a common set of financial ratios

Question 19

what is the market to book ratio

Answer 19

= 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

Question 20

what is a price to earnings ratio

Answer 20

= 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

Question 21

what is the accounting rate of return

Answer 21

1. Return on assets = (net income + interest (1-t) )/ total assets
   - t = tax
2. 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

Question 22

what are the asset efficiency ratios

Answer 22

1. asset turnover = sales over total sales
   - measure of efficiency and indicates the amount of revenue generated by the firm’s assets
2. inventory turnover = cost of goods sold / inventory
   - indicates how efficient a company’s shares are is at turning inventory into sales

Question 23

wha are the profitability ratios

Answer 23

1. gross margin = gross profit/ sales
2. operating margin = operating income/ sales
3. profit margin = net income / sales

Question 24

what are the leverage ratios

Answer 24

1. 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
2. debt equity ratio = debt/ equity
3. debt ratio = debt / debt + equity ratio
4. and 3. measure the degree of leverage of a company. debt can either be expressed as a percentage of equity or total capital

Question 25

what are the liquidity ratios

Answer 25

1. current ratio = current assets/ current liabilities
2. quick ratio = (current assets- inventory)/ current liabilities
3. cash ratio = cash / current liabilities

these ratios helps identify the drivers of ROE but the components are not independent

Question 26

an increase in which ratios will increase ROE

Answer 26

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

2. asset turnover ratio
   - measures how efficiently a company uses its assets to generate revenue
   - vary considerable between indsutries
3. 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)