Session 1: Introduction Flashcards
What are the three main areas of corporate finance, and what do they involve?
- Investment – Choosing the best projects, capital budgeting (evaluating and selecting long-term investments like new product lines, infrastructure, or mergers and acquisitions).
- Financing – Choosing sources of financing, capital structure (mix of debt and equity to balance risk and return while minimizing cost of capital).
- Liquidity – Ensuring sufficient cash and inventory, short-term financial planning (managing cash flow to meet obligations), managing day-to-day finances.
What is capital budgeting, and why is it important in corporate finance?
- Capital budgeting is the process of evaluating and selecting long-term investments such as new product lines, infrastructure, or mergers and acquisitions.
- It is crucial because it determines which projects a company should undertake to maximize growth and profitability.
What is capital structure, and how does it impact financing decisions?
- Capital structure refers to the mix of debt and equity a company uses to finance its operations and investments.
- It aims to balance risk and return while minimizing the overall cost of capital.
- Financing decisions involve determining how to pay for assets—whether to use debt or equity.
What does the Balance Sheet Model of the Firm illustrate?
The Balance Sheet Model of the Firm shows how a company finances its assets through:
- Capital Budgeting (investments in current and non-current assets).
- Capital Structure (how these assets are financed through liabilities and equity).
- Net Working Capital (NWC) (the difference between current assets and current liabilities, essential for short-term financial planning).
Note: The model depicts the accounting value of assets, not the company’s actual market value.
What is the difference between capital budgeting and capital structure?
Capital Budgeting: The firm invests in assets, including:
- Current assets (e.g., inventory).
- Non-current assets (e.g., buildings, machinery, patents).
Capital Structure: The firm finances these assets using:
- Current liabilities (short-term loans).
- Non-current liabilities (long-term loans).
- Shareholders’ equity (investors’ capital).
What is Net Working Capital (NWC), and why is it important?
NWC = Current Assets - Current Liabilities
- It represents the firm’s ability to manage short-term financial planning and maintain liquidity.
- A positive NWC ensures the firm can meet short-term obligations and operate smoothly.
How does a firm obtain cash and use it according to the Cash Flow Model?
- The firm raises funds by issuing securities (stocks, bonds) to financial markets (A).
- These funds are used for investments in assets (B).
- Operating cash flow is generated from business activities (C).
- Cash is distributed to taxes (D), retained earnings (E) for growth, and payments to investors (F) (dividends and debt repayment).
What happens to the firm’s generated cash in the Cash Flow Model?
- A portion goes to the government as taxes (D).
- Some cash is retained (E) for reinvestment and future growth.
- The remaining cash is used for dividends and debt repayments (F) to investors in financial markets.
What is the key difference between Accounting Flow and Cash Flow?
- Accounting Flow (Accrual Accounting): Records revenue when earned and expenses when incurred, even if no cash has been received or paid.
- Cash Flow (Cash Accounting): Only records actual cash movements, reflecting liquidity rather than profitability.
How can a company be profitable but still face cash shortages?
- Under accrual accounting, profit is recorded even if cash hasn’t been received.
- In the example, the company reports a €670,000 profit, but since cash inflows are €0, it has a -€1M cash outflow.
- This highlights the importance of managing accounts receivable and cash flow to avoid liquidity problems.
Why does cash flow matter even if a company is profitable on paper?
- Cash flow determines whether a company can pay its expenses in the short term.
- A firm with high profits but poor cash flow can struggle to meet obligations.
- Proper cash flow management ensures a company remains solvent despite reported profits.
Why is the timing of cash flows important in investment decisions?
- Liquidity Management: Early cash inflows help cover expenses and reduce reliance on external funding.
- Risk Reduction: Delayed cash flows increase uncertainty and financial risk.
- Time Value of Money: Money today is worth more than the same amount in the future due to investment opportunities.
- Flexibility & Stability: Regular cash inflows provide financial stability and adaptability.
- Decision Making: Firms must balance higher total returns (late inflows) vs. early cash inflows based on financial needs.
How do discount rates and risk preferences affect investment decisions?
- Companies prefer different investments based on their risk tolerance and discount rate.
- Higher discount rates favor early cash inflows (e.g., Product B) since future cash flows lose value quickly.
- Lower discount rates make total returns (e.g., Product A) more attractive despite delayed inflows.
- Businesses must consider risk-adjusted returns when making final investment decisions.
