Term
| What is the goal of financial management? |
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Definition
| To maximize the value of the company's stock. |
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Term
| What are the questions a financial manager must answer? |
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Definition
1) What long term investments should the firm take on?
2) How will the firm finance these investments?
3) How is the firm managing their short term, day-to-day activity? |
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Term
| What long term investments should the firm take on? |
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Definition
CAPITAL BUDGETING
Size, timing, risk |
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Term
| How will the firm finance these long term investments? |
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Definition
CAPITAL STRUCTURE
How much? How to get it? (debt or equity) |
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Term
| How is the firm managing their short term, day-to-day activity? |
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Definition
WORKING CAPITAL MANAGEMENT
Managing short term cash inflows and outflows, (A/R, Inventory, A/P, etc.) |
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Term
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Definition
Long term-sell bonds or take out a loan
Debt is cheaper than equity
Not ownership
Interest is Tax Deductable |
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Term
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Definition
| LONG TERM- T-Bills, Fed funds, money market funds, Treasury Notes/Bonds DEBT- Muni bonds, Term loans, Mortgages, Corporate bonds EQUITY- Preferred/common stock DERIVATIVES- Options/Futures |
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Term
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Definition
Not have to be paid back
Can't force into bankruptcy
Can only be sold by corporations
All equity is long term
PUBLIC EQUITY- Issue Stock
PRIVATE EQUITY- Venture and Non-Venture |
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Term
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Definition
Financial assets whose value is derived from the value of other assets
CONVERTIBLES- derived from underlying stock
FUTURES- Obligation to buy or sell, currency or commodity. Mark to Market (trued up) |
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Term
| Agency Relationship- Aligning Interests |
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Definition
1)Managerial Compensation- Incentives can be used to align management and stockholder interests.
2) Corporate Control- Unhappy stockholders can elect a new board of directors. |
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Term
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Definition
1) Monitoring costs of shareholders- cost of an audit of financial statements
2) Costs of implementing incentives- Profit sharing, bonus, etc.
3) Opportunity Cost- loss of profit due to forgone opportunity |
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Term
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Definition
| Snapshot of assets/liabilities at a given point in time |
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Term
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Definition
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Term
| CALCULATE FUTURES/FORWARDS |
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Definition
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Term
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Definition
| Converted to cash quickly without significant loss of value |
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Term
Current Assets
Fixed Assets |
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Definition
CA- can be converted to cash within 1 year
FA- have a life longer than 1 year |
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Term
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Definition
Obligations of the firm that require payout of cash within stipulated time period.
"Liabilities" and "Debt" used interchangably |
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Term
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Definition
Claim against firm's assets that is residual and not fixed
Made up of stock and retained earnings |
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Term
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Definition
Also called "Net Assets"
It is Assets minus Liabilities
AKA: Total Equity |
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Term
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Definition
| #shares outstanding multiplied by the current price |
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Term
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Definition
For individual items e.g. A/R, A/P, etc.
DONT confuse Line values with Firm values |
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Term
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Definition
"Video" of Firm's operations for a period of time
AKA: P&L |
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Term
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Definition
Cash flow from day-to-day activities
Does NOT include: Interest, or investments or financing |
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Term
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Definition
Subtract taxes
Adjust for Non-cash items |
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Term
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Definition
*Could be a loss*
Depreciation and Interest are included because they are not cash expenses |
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Term
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Definition
Non-cash item, will ALWAYS be positive
Entire purchase amount doesn't go through as an expense in just 1 year.
Allows companies to take a smaller hit to P&L each year instead of 1 big hit |
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Term
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Definition
Big items that will last more than a year e.g. PP&E.
On balance sheet under NFA.
Ex: END NFA
-BEG NFA
+Depreciation
If we do not add back depreciation, we will understate CAPEX |
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Term
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Definition
Current (short-term) Assets and Liability.
END(CA-CL)-BEG(CA-CL)=Change in NWC.
CA: A/R and Inventory
If A/R increases, NOPAT is overstated
If A/R decreases, cash is NOT in NOPAT and is captured by FCF.
CL: A/P, Accruals, short-term debt
**Good for CL to increase b/c it means you have not paid for items that you bought, this will offset any purchases of inventory made on credit. |
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Term
| CALCULATE FREE CASH FLOWS |
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Definition
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Term
| Financial Statements-Internal uses |
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Definition
Performance Evaluation- compensation and comparison between divisions
Planning For the Future- guide in estimating future cash flows, building budgets, and financial modeling |
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Term
| Financial Statements- External Uses |
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Definition
Anyone doing business with a firm is going to use ratios to get a feel for the financial health of the firm
-Quick and Dirty |
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Term
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Definition
| Comparing a firm's financials with another company |
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Term
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Definition
Compare current company datawith data from the past to see a trend.
*Watch out for Fiscal year, quarters vs. full year P&L's, Are the companies even comparable? |
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Term
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Definition
Good "starting point"
Ask yourself what each ratio is TRYING to measure and why that information is IMPORTANT. |
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Term
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Definition
CURRENT RATIO, QUICK RATIO, CASH RATIO.
Indication of firm's ability to meet short-term financial obligations.
Short-term Creditors are interested in these.
A good Current Ratio is at least 1.
Consider how quickly the cash is needed: If needed quickly calculate quick or cash ratios. If most CA of firm are in Inventory, the firm cannot sell them quickly and collect A/R. |
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Term
| Asset Management/Turnover Ratios |
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Definition
Inventories, Receivables, Total Asset Turnover.
Describe how efficiently a firm uses its assets to generate sales.
Inventory- (How fast firm sells products) Too high indicates carrying too much inventory or having some that is not moving. Too low may run out of product and lose revenue.
Receivables- (How fast firm collects on sales) 30-60 days are reasonable.
Total Asset Turnover- (How efficiently a firm is using its Assets) Amount of sales generating from total Assets. If number is too low, may want to see if sales are too low or assets are too high. |
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Term
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Definition
Total Debt Ratio, Debt to Equity Ratio, Equity Multiplier.
Measure firm's ability to meet Long-Run obligations.
How much debt a firm has (how they are financing their investments).
TOTAL DEBT RATIO-(looks at all debt, short and long term)
Tells what % debt is of total assets (1-TDR is the amount in equity).
DEBT/EQUITY RATIO- important to investors. (shows how many dollars of debt a firm has for every dollar of equity.
EQUITY MULTIPLIER- 1 + D/E ratio |
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Term
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Definition
Profit Margin, Return on Assets, Return on Equity
Focus is on Net Income.
PROFIT MARGIN- (Indicates how effective the firm is in generating profits. How well it controls costs). Not always accurate because lower price means higher volume in sales.
RETURN ON ASSETS-(Indicates how effectively a firm is using its assets to generate income, deifferent from TAT because it uses Net Income). Used as a performance measure for management incentives.
RETURN ON EQUITY- Measure of the efficiency with which the firm employs owners' capital. Very important to shareholders. |
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Term
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Definition
ROE= PM x TAT x EM.
Tells us ROE is affected by 3 things.
1)Operating efficiency (PM)
2)Asset use efficiency (TAT)
3)Financial leverage (EM)
*A firm could leverage up its ROE by increasing its amount of debt. |
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Term
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Definition
Earnings per Share (EPS), Price-Earnings Ratio.
PRICE-EARNINGS- (Measures how much investors are willing to pay per dollar of current earnings. *Warning: If a firm had little or almost no earnings its PE would probably be quite large.
Means of standardizing stock prices for comparison. |
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Term
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Definition
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Term
| How does an increase in time impact the Present Value of an investment? |
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Definition
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Term
| How does an increase in Rate impact the Present Value? |
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Definition
| To get more money you will pay less now |
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Term
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Definition
1) You are presented an investment opportunity that you need to figure out return for.
2) You know the beginning and ending amounts, and the time. You need to figure out what rate will get you from beginning to end money in the certain time period. |
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Term
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Definition
FV: Compound forward each individual cash flow then add together. PV: Discount back each cash flow then add together.
*Multiply by answer by (1+r) |
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Term
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Definition
Infinite series of constant payments (can be same amount, OR same Rate).
Perpetuity calculation brings the value back 1 time period.
PERPETUITY= Cf/(r-g) |
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Term
| CALCULATE MULTIPLE CASH FLOWS (PV and FV) |
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Definition
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Term
| CALCULATE ANNUITIES (Including annuities due and annuities past time 1) |
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Definition
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Term
| CALCULATE PERPETUITIES (Constant and Non-Constant Growth) |
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Definition
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Term
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Definition
If first payment is at beginning of time period, it is annuity DUE.
You know it is an annuity of payments are involved. |
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Term
| Special Case Annuities (Annuity Due) |
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Definition
*If first cash flows occurs today, it is annuity DUE. ("first payment is today" "starting today" "payments are at the beginning of each year or month")
*Annuity Due Value= Ordinary Annuity Value*(1+r). |
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Term
| Special Case Annuities (Past Time 1) |
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Definition
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Term
| Annual Percentage Rate (APR) |
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Definition
Stated interest rate per period times the number of periods in a year.
APR= Stated interest rate per period x # of periods in a year.
*Monthly compounding |
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Term
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Definition
*ONLY USED WHEN WE COMPARE INVESTMENTS
The actual rate paid after accounting for compounding that occurs during the year.
Used to compare two alternative investments with different compounding periods. Compute EAR and use as comparison. |
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Term
| What are some examples of Decisions a Financial Manager will make? |
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Definition
-Acquisitions
-Divestitures
-Launch new product line?
*(Mutually Exclusive)
*Lease vs Buy?
*Which piece of equipment to buy?
*Make or Buy?
*Expansion Projects |
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Term
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Definition
1) Does the decision rule adjust for the TVM?
2) Does the decision rule adjust for risk? |
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Term
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Definition
Tells us the difference between the cash flows the project generates and the cost of the project in today's dollars.
1)Estimate the expected future cash flows.
2) Estimate the required return for a project of this risk level.
3) Find the PV of the cash flows and subtract the initial investment.
*DECISION RULE: Accept investments with positive NPV's and reject ones with negative NPV's.
PROS:
NPV takes into account tvm and risk.
ALWAYS leads to the right decision (cash is king).
CONS:
CF difficult to estimate.
r can be difficult to estimate.
Mgmt may want to use IRR because it is easier to understand.
***Use NPV when you have Unconventional Cash Flows AND Mutually Exclusive Projects. |
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Term
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Definition
IRR is the discount rate that makes NPV=0.
DECISION RULE: Accept the project if the IRR is greater than the required return.
PROS:
Often leads you to make same decision as NPV.
Takes into account tvm and risk.
"Return" is intuitively appealing to non-financial managers and easier to communicate.
CONS:
Project can get multiple IRR's leading to an incorrect decision.
If you are using it on Mutually Exclusive Projects or Unconventional Cash Flows it can lead to wrong decision.
*When the CF signs change more than once, you have more than one IRR. |
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Term
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Definition
DECISION RULE: Accept if the payback period is less than some preset limit.
PROS:
-Easy to understand
-Adjusts for uncertainty of later cash flows
CONS:
-Ignores TVM and risk
-Requires arbitrary cutoff point.
-Biased against long term projects. |
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Term
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Definition
Can use Discounted Payback to overcome tvm problems and can place risk on CF.
Will lead to longer payback period.
*Payback is something people like to know.
*It should NOT be a go or no-go tool. |
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Term
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Definition
The PV of an investment's future cash flows divided by its initial cost (positive amount).
DECISION RULE: Accept if PI is greater than 1.
*This measure can be useful in situations where we have limited capital.
PROS:
-Closely related to NPV
-Easy to communicate
-Useful when available investment funds are limited
CONS:
-May lead to incorrect decisions in comparisons of mutually exclusive investments |
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Term
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Definition
| Cash flows that will occur ONLY if a project is accepted. |
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Term
| Project Cash Flows: What do you include and NOT include? |
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Definition
INCLUDE:
-Sales and Costs
-Opportunity Costs
-Side Effects (Synergies/Cannibalism)
-Working Capital
-CapEx and Depreciation
-Taxes and Tax Benefits
DO NOT INCLUDE:
-Sunk Costs
-Financing Costs |
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Term
| CALCULATE PROJECT CASH FLOWS |
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Definition
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Term
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Definition
DEBT:
-Not ownership in a firm
-Payments on interest (coupon pmts) are tax deductible
-Unpaid debt is a liability and can force firm into bankruptcy.
EQUITY:
-Ownership
-Pay taxes on Dividends
-Equity cannot force a firm into bankruptcy |
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Term
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Definition
| The current interest rate required in the market on a bond. i.e. if the same bond were issued today, what the coupon rate would be). |
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Term
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Definition
The coupon rate is less than the YTM.
You would pay less for the bond than the amount you are getting at maturity to make-up for the difference in return between the coupon rate and the YTM.
Discount Bonds sell for less than par value. |
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Term
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Definition
The coupon rate is greater than the YTM.
You would pay more for the bond than the amount you are getting at maturity to close the gap between YTM and the coupon rate.
Premium Bonds sell for more than par value. |
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Term
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Definition
No matter what the COUPON RATE is at the date of issue, the price you pay will still be $1000 (or w/e par value is). It is the EXPECTED RETURN that varies.
As we approach maturity, the value of the bond transfers from the coupon payments to the principal. |
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Term
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Definition
| 1) If a buyer is offering to buy your bond, the YTM you solve for is the return (YTM) the buyer expects. THIS NEEDS TO BE COMPARED WITH THE ACTUAL MARKET YTM. 2) If you are given market information, like a price, the YTM that you solve for is the actual market YTM. |
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Term
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Definition
1) Federal Government
2) State and local government
3) Corporations |
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Term
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Definition
The biggest borrowers.
T-Bills typically don't pay coupons.
No risk of default.
Coupons are exempt from STATE income taxes.
T-Bills < 1yr.
T-Notes 1-10yrs
T-Bonds 10+ years |
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Term
| State and local government Bonds |
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Definition
Municipal Bond- Issued to pay for things like streets.
Have varying levels of default risk.
Coupon payments are exempt from FEDERAL income taxes. This offers a larger benefit than the state tax break. |
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Term
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Definition
Bonds issued by corporations to raise capital to fund capital budgeting projects.
Varying degrees of default risk.
Coupons are NOT tax exempt. Will pay a taxability premium over bonds issued by gov. |
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Term
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Definition
-Pays no coupons
-T-Bills are good example
-The return is the spread between the purchase price and par value. |
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Term
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Definition
-Coupon rates are adjustable
-Less price risk because it floats and is not likely to be substantially different than the YTM.
-Coupons have a "collar"
-Ex: Adjustable Rate Mortgage, Inflation -linked Treasuries. |
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Term
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Definition
| -Coupon payments are tied to company income. Will only be paid if company income is sufficient. |
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Term
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Definition
-Bond can be swapped for a predetermined number of shares of stock before its maturity date.
-Helps on balance sheet because it removes debt. |
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Term
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Definition
*High Risk, makes them have high return for investors and expensive for corporations.
- Issuers have bad credit quality |
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Term
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Definition
1)Inflation
2)Interest Rate Risk
3)Default Risk
4)Taxability
5)Liquidity |
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Term
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Definition
| Compensation investors demand for inflation risk |
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Term
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Definition
-Arises from fluctuating interest rates over time.
-All things being equal
1)The longer the time to maturity, the greater the Interest Rate Risk.
2) The lower the interest rate when the bond was issued, the greater the Interest Rate Risk.
*With more time you are exposed to more fluctuations. |
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Term
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Definition
| Corporate Bonds and Municipal Bonds must pay a default premium because Fed Gov Bonds have no default risk. |
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Term
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Definition
-Treasuries are exempt from state but not federal taxes
-Bonds w/o a tax exemption will require a premium over those which have tax exemption. |
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Term
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Definition
-Bonds are usually not traded frequently, making them not very liquid. Treasuries are traded on a regular basis.
-Less liquid bonds will require a premium over bonds with more liquidity. |
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Term
| 3 Reasons Common Stock is more difficult to value than a Bond |
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Definition
1) Cash flows are unknown
2) no maturity date
3) No easy way to observe rate of return in the market. |
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Term
| Must know 3 things to value a stock |
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Definition
1) The market rate
2) The projected growth of dividends
3) The projected dividend for the next period. |
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Term
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Definition
Can only be used if:
-Dividends are expected to grow at a constant rate
-Dividends are being paid
*Be aware of the price you are asked for (today or some day in the future). |
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Term
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Definition
Can only be used if:
-Dividends are expected to grow at a constant rate
-Dividends are being paid
*Be aware of the price you are asked for (today or some day in the future). |
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Term
| Stock Price in the Future |
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Definition
2 METHODS:
1) Take PV on the next dividend to infinity.
2) Take the value today and calculate its future value using the growth rate. |
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Term
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Definition
1)Dividend Yield- A stock's expected cash dividend divided by its current price. (How much was made in dividends over the year divided by the purchase price).
2) Capital Gains Yield- The dividend growth rate, or the rate at which the value of an investment grows. (How much was made on the buy-sell spread divided by the purchase price). |
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Term
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Definition
| Total return in dollars that an investor earns on a stock = Amount received in Dividends + Amount made on buy-sell spread |
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Term
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Definition
Dividends are not a liability of the firm until declared by the Board.
Not considered a business expense so they are NOT tax deductible. |
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Term
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Definition
Ownership is exercised through voting.
*Proxy- Shareholder allowing another individual to vote their share. |
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Term
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Definition
| Common Stockholder's right to first shot at new stock issue to maintain proportional ownership if desired. |
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Term
| Preferred Stock- Dividends |
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Definition
Constant, pre-stated amount.
Cumulative Dividends- If any dividends were missed, they are paid first in next period. |
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Term
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Definition
Voting- Holders do not typically have voting rights.
Preference- holders must be paid dividends before holders of common stock.
Stated Value- Shares have a stated liquidated value and dividend. |
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Term
| Transfer Income through time |
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Definition
-Borrowing Sacrifices future income to increase current income.
-Saving, or Investing, sacrifices current income in exchange for greater expected income in the future. |
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Term
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Definition
The extra return earned for taking on risk.
The Risk Premium is the return over and above the risk-free rate. |
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Term
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Definition
-Prices reflect all information
-If market is strong form efficient, investors could not earn abnormal returns.
-Our market is NOT strong form efficient because insider trading can occur. |
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Term
| Semistrong Form Efficient |
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Definition
-Prices reflect all PUBLICLY available information.
-Investors cannot earn abnormal returns by trading on public information. |
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Term
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Definition
| -Prices reflect all PAST market information. |
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Term
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Definition
Information revealed after you pruchased an aasset.
1) Systematic Risk
2) Unsystematic Risk |
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Term
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Definition
Market Risk. Affects many assets. Investors only rewarded for bearing systematic risk.
Ex: changes in GDP, inflation, interest rates, consumer spending. |
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Term
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Definition
Affects a limited number of assets. Asset specific risk.
Ex: Labor striked, earnings announcements, sales. |
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Term
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Definition
| 1) Is it Risk at all? If it is expected it is NOT risk. |
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Term
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Definition
Assets in different industries.
Diversification can reduce the variability of return without an equivalent reduction in expected returns.
Worse than expected returns are offset by better than expected returns.
Systematic risk cannot be eliminated. |
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Term
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Definition
| Used to measure systematic risk present in a particular asset. |
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Term
| Beta and Standard Deviation |
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Definition
Standard Deviation measures total risk.
An asset can have a lot of total risk, but the majority of the risk could be diversified out, leaving it with a low Beta. |
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Term
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Definition
Says that for every risk level (Beta) there is only one appropriate return.
Origin is at T-Bill rate.
If an asset does not plot on this line it is over or under priced.
The slope is a measure of an assets risk-reward ratio.
Market or Asset risk premium/Risk
*Price reacts first.
-If plot is above line, Expected return is too high and the asset is underpriced.
-As people try to buy it, the price will increase and the Return will decrease. |
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Term
| Capital Asset Pricing Method |
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Definition
CAPM will give you the Return the asset SHOULD be earning, given its Beta.
Made up of 3 things:
1)Pure TVM (Rf)
2)Market risk premium (E(Rm)-Rf)
3)An asset's systematic risk (Bi)
*when multiplying Beta by the Risk Premium the return is being adjusted up or down depending on the risk level. Higher risk equals higher return. |
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Term
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Definition
| Firms need to know the expected return when issuing debt or equity. This minimum return is the cost of capital. |
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Term
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Definition
1)The discount rate used to evaluate capital budgeting investment decisions (ex: NPV, IRR, etc.)
2)Made up of the cost of debt and cost of equity. |
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Term
| Weighted Average Cost of Capital |
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Definition
Important b/c a company needs to know how much it costs to borrow money so they can invest at a higher rate.
Can ONLY use WACC for projects representative of current operations/core competencies.
Actual "r" (cost of capital) for individual projects will often differ from WACC. |
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Term
| 3 possibilities for Cost of Capital |
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Definition
1)It is the same risk level as the existing operations. USE WACC.
2)It is a project with a higher or lower risk level than existing operationsand the firm does not have a lot of projects similar to it. Start with WACC then adjust rate up or down.
3)It is a project with a higher or lower risk level than existing operations and the firm has several projects similar to this project. Create a DIVISIONAL cost of capital, may be higher or lower than WACC. |
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Term
| Using WACC for all Projects |
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Definition
-Must adjust the WACC up or down if have a project that has a different risk level than existing operations.
-Not adjusting will result in accepting unprofitable projects or not accepting profitable projects. |
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Term
| Divisional Cost of Capital |
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Definition
-In order to get most accurate Divisional Cost of Capital, a firm should ask a bank what rate they would charge them if they borrowed money for that division.
-For divisional cost of equity, a firm should find a stock with a similar risk level and see what it's required return is. |
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Term
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Definition
-PRIMARILY depends on the USE of funds, not the SOURCE.
-The use of funds reflect the riskiness of a project, the higher the risk, the higher banks will charge them for borrowing money.
-Interest expense on debt reduces tax liability Rd(1-Tc)
-Equity not tax deductible so no tax impact on cost of equity. |
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Term
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Definition
The return that investors require on their investment in the firm.
When investors give money to the firm they expect more money back in return, the amount they expect back is the cost of equity.
Two methods to determine COE:
1)DGM
2)CAPM |
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Term
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Definition
The return that lenders require on new borrowing.
*r x (1-t)
Cost of debt can be:
1)Bank loans
-COD=Interest rate
-After tax=Interest rate x (1-t)
2)Bonds
-COD=YTM of bond
-After tax=YTM x (1-t) |
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Term
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Definition
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