Test 1 Flashcards
Goal of financial management
Maintenance and Creation of Wealth
Goal of the firm
Maximization of Shareholder Wealth
maximization of profits
Assumes away uncertainty of returns
maximization of shareholder wealth
Includes effects of all the financial
decisions
legal forms of business organizations
sole proprietorship, general and limited partnership, corporation
sole proprietorship advantages and disadvantage
Advantages
* Easily established with few complications
* Minimal organizational costs
* No sharing of profits
* Avoid corporate income taxes
Disadvantages
* Unlimited liability for the owner
* Equity capital limited to personal resources
* Business terminates with the death of the owner (limited life of business)
general partnership advantages and disadvantage
Advantages
* Minimal organizational costs
* Negligible government regulations
Disadvantages
* All partners have unlimited liability
* Difficult to raise large amounts of capital
* Partnership dissolved with the death or withdrawal of a general partner
* Difficulty in transferring ownership
limited partnership advantages and disadvantage
Advantages
* Liability limited to the capital invested
* Withdrawal does not affect the continuity of business
* Stronger inducement in raising capital
Disadvantages
* One general partner is a must
* More expensive to organize
corporation advantages and disadvantage
Advantages
* Limited liability of owners
* Easy transferability of ownership and unlimited life
* Death of owner does not affect the business
* Ability to raise large amounts of capital
Disadvantages
* More difficult and expensive to establish
* Control of corporation not guaranteed
* Corporate earnings subject to double taxation
recent trends in finance
globalization of the financial markets
technological advances
agency problems-beginnings and some solutions
managers won’t work for the owners unless it’s in their best
interests. Also between the creditors and the mangers
Some ways to overcome this problem
Performance shares
Executive stock options
Direct intervention by shareholders
The threat of firing
The threat of takeovers especially hostile takeovers
* Taxes bias Business Decisions
* Ethical Behavior is doing the Right Thing
annual report
- Verbal letter from the chairperson
- Balance sheet
- Income statement
- The statement of retained earnings
- Statement of cash flows
accounting vs cash flows
Accounting is a process for tracking and reporting a business’s financial performance, while cash flow is the money that goes in and out of a business
qualitative discussion on taxation
Corporate and personal taxes: Both have a progressive structure (the higher
the income, the higher the marginal tax rate).
Tax rates may change due to new tax legislation
in 2017
Corporations
* Rates begin at 15% and rise to 35% for
corporations with income over $10 million,
although corporations with income between $15
million and $18.33 million pay a marginal tax
rate of 38%.
* Also subject to state tax (around 5%).
Individuals
* Rates begin at 10% and rise to 39.6% for single
individuals with incomes over $418,400 and
married couples filing jointly with incomes over
$470,700.
* May be subject to state tax.
How liquid is the firm?
Can we make required payments?
asset management ratios
Is the firm managing its assets well?
Average Collection period
fixed asset turnover
total asset turnover
inventory turnover ratio
average collection period
Days Sales Outstanding (DSO) = AR/Net sales per
day = AR/(annual sales/365)
fixed asset turnover
(how well long-term assets are being managed) net
sales/net fixed assets
total asset turnover
(how well total assets are being managed) net sales/total
assets
inventory turnover ratio
determine whether too much or too little is being
invested in inventories
debt management ratios (longer term solvency ratios)
Is the firm solvent in the long run?
1. By raising funds through debt, stockholders can maintain control of the firm by
limiting their investment. And
2. If firm earns more on borrowed funds , the return to the owners is magnified or
leveraged. however
3. Creditors look at equity not debt for financing because the higher the proportion
of equity in the firm the less is the risk faces by the creditors
debt ratio
Total debt/total assets
times interest earned
(called a coverage ratio because it tells us the number of
times interest expense is covered by income). TIE = EBIT / Interest Expense
EBITDA coverage
(EBITDA+ lease payments)/
(Interest+ Loan repayments + lease payments)
profitability ratios
Is the firm making enough for their common shareholders?
measure overall management performance
net profit margin
give % of each sales dollar this is net profit) = NI/net sales =
(EBIT- interest - taxes)/net sales
basic earning power
(gives the real earning power of the assets): EBIT / total
assets
return on total assets
measure of return to all providers of capital - S/H and
B/H) - ignores how the assets are financed: ROA = NI/total Assets
return on common equity
measure of return to shareholders) - accounts for
how assets are financed : ROE = NI/Stock holder’s equity
price to earnings ratio
Price per share/ earnings per share includes market
conditions – high ratio indicates high growth.
price to cash flow ratio
Price per share/ cash flow per share
market to book ratio
Market price per share/ Book price per share – high
indicates high growth high profile firm while low growth firm has lower values
Is there a trend or pattern in the ratios?
Look for increasing or decreasing trends.
Compare with industry averages trend.
Corporation mission statement
a condensed version of a firm’s strategic plan
corporate purpose
its reason for existing, beyond making a profit
corporate scope
Defines a firm’s lines of business and geographic areas of operation.
corporate objectives
Sets forth specific goals to guide management.
corporate strategies
Broad approaches developed for achieving a firm’s goals.
operating plans
Provides management detailed implementation guidance, based on the corporate strategy, to help meet the corporate objectives
financial plans
The document that includes assumptions, projected financial statements, and projected ratios and ties the entire planning process together.
role of forecasting in the firm’s financial planning process
review of sales during the past 5 years, find average growth in sales, and determine funds availability
forecasting financial statements and balance sheet
Income statement-Use percentage sales method to estimate the reported income and the retained
earnings during the year.
Balance sheet-if sales increase then assets and liabilities must also grow.
constant ratio method for financial forecasting steps
Identify relevant ratios, analyze trends, compare ratios, forecast
What are financial markets?
provide avenues for the net borrowers and the net lenders to come to a place where they can exchange resources (funds)
Why do financial markets exist?
People and organizations wanting to borrow money are brought together with
those who have surplus funds in the financial markets
What are the different methods by which funds transfer takes place?
Direct transfers-when a business sells its stock or bonds directly to savers, without going through any type of financial institution
Indirect transfers- through investment bankers
Types of financial markets
Primary vs secondary markets
Money markets vs capital markets
Organized security exchanges vs over the counter markets
Primary vs secondary markets
Primary markets: Markets in which corporations raise capital by issuing new securities.
Secondary markets: Markets in which securities and other financial assets are traded among investors after they have been issued by corporations.
Money markets vs capital markets
Money markets: The financial markets in which funds are borrowed or loaned for short periods (less than one year).
Capital markets: The financial markets for stocks and for intermediate- or long-term debt (one year or longer).
Organized security exchanges
- Have physical locations
- Have own building that trade takes place in.
- Only members can trade
- Have limited number of members
- Has an elected governing body
- This is an auction market
- Members place buy and sell orders and the trade takes place at the best possible price.
- NYSE has approx. 1300 seats and the seats are auctioned
over the counter markets
- It is an intangible association
- Has dealers who hold inventories in the securities who make the market
- Has many brokers who act as agents
- Electronic network that provides communication link between these brokers.
Investment bankers and their functions
They act as facilitators in transferring funds from the net savers (Individuals) to the net
borrowers (Businesses) by:
* Designing securities for the businesses that are currently in demand and are attractive
to the investors
* Buying these securities for the corporation if necessary
* And reselling them to the savers
E.g.: Merrill Lynch, Goldman Sachs,
Financial intermediaries and their role in the financial markets
Create new financial products. They work on large economies of scale especially in areas
such as
* Analyzing the credit worthiness of the potential borrowers.
* In processing and collecting loans
* In pooling risk and thus helping the investors diversify away their risk
Compare and contrast the financial intermediaries with investment bankers
Investment Banks: Primarily operate in the capital markets, facilitating the issuance of new securities (like stocks and bonds) and advising on mergers and acquisitions (M&A). They help companies raise capital through underwriting.
Financial Intermediaries: Typically include banks and credit unions that accept deposits and make loans, focusing on the secondary market where they facilitate the flow of funds between savers and borrowers.
Types of financial intermediaries and their functions
Commercial banks: The traditional department store of finance serving a variety of savers and borrowers.
Financial services corporations: A firm that offers a wide range of financial services, including investment banking, brokerage operations, insurance, and commercial banking
Credit unions: cooperative associations whose members are supposed to have a common bond, such as being employees of the same firm
Pension funds
Life insurance companies
Mutual funds: Organizations that pool investor funds to purchase financial instruments and thus reduce risks through diversification.
Determinants of market interest rates (cost of money)
the following equation provides an over-simplified
expression of the relationship between the quoted, or nominal, interest rate and factors that
influence interest:
Rate of return (interest) = r = Risk-free rate + Risk premium
= rRF + RP
Fishers equation and the risk premia
RP = payment for additional risk investors take when purchasing risky
investments
Nominal (quoted) interest rate = r = rRF + RP
= [r* + IP] + [DRP + LP + MRP]
inflation
the amount by which prices increase over time
a premium equal to expected inflation that investors add to the real risk free rate of return
rT-Bill = rRF = r* + IP
default
Default risk premium (DRP): the difference between the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability
liquidity
Liquidity premium (LP): a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value”
maturity
Maturity risk premium (MRP): a premium that reflects interest rate risk
How premia are set in the market (define and understand)
set based on the level of risk, historical returns, and expected returns. Premiums can vary over time and are influenced by market conditions and investor sentiment
Term-structure of interest rates and yield curves
Term structure – relationship between interest rates
(or yields) and maturities of securities.
➢ The yield curve is a graph of the term structure.
Shape of yield curve and its interpretations
Upward sloping: due to an increase in expected inflation
and/or increasing maturity risk premium ➔ normal yield
curve
▪ Downward sloping: due to an decrease in expected
inflation ➔ abnormal or inverted yield curve
▪ Humped: medium-term rates are higher than either short-
or long-term rates
