FIN3403 - Exam 1

Goal of the Firm

Shareholder wealth maximization

• Firm should make decisions that maximize firm value or stock price.

The Role of Finance

• Selecting the firm’s long-term investments (CAPITAL BUDGETING)

• = How to fund these investments (CAPITAL STRUCTURE)

• How to manage cash flow from operations (WORKING CAPITAL MANAGEMENT)

All Legal Forms of Business Operations

• Sole Proprietorship

• General Partnership

• Limited Partnership

• Corporation

• S-Coporation

• Limited Liability Company (LLC)

Sole Proprietorship

A business owned and operated by a single individual, who is personally liable for all debts and obligations of the company. (ENTITLED TO ALL PROFITS AND ALL LOSES) (NO LIMITS ON LIABILITY)

General Partnership

A business structure where two or more individuals share ownership and management responsibilities, with each partner personally liable for the debts and obligations of the partnership.

Limited Partnership

Partnership in which one or more partners have limited liability (they can lose up to the amount of capital management they invested in the business) (THERE MUST ALSO BE A GENERAL PARTNER WHO HAS UNLIMITED LIABILITY FOR DEBTS AND OBLIGATIONS)

Corporation

A business that functions separately and apart from its owners (shareholders). ALL OWNERS HAVE LIMITED LIABILITY - not personally responsible for beyond their investment in their company.

S-Coporation

Provided limited liability, but taxed like a partnership. (In an S-corporation, the company itself doesn’t pay taxes on its profits. Instead, the owners report the company’s profits (or losses) on their own personal tax returns. This means the company only gets taxed once, not twice like with other types of businesses.)

Limited Liability Company (LLC)

provides limited liability, but taxed like a partnership. (MORE FLEXIBLE THAN S-CORPORATION)

Stakeholders

anyone impacted by companies decisions (owners employees, customers)

Shareholders

buys shared from a company and invests money in buying those shares

Stockholders

Purchase stocks within a company and receive dividends

Securities

financial assets that companies sell to raise capital. Investors purchase these in the hope of earning a high rate of return. (ex. selling stocks or bonds)

Selling stock =

equity for the company and assets for buyer

Selling bonds =

liability/debt for company vs asset for buyer

Types of securities

1) Treasury bills and bonds

2) Municipal bonds

3) Corporate bonds

4) Preferred Stock

5) Common stock

Treasury Bills and Bonds

• Issued by the federal government

• RISK FREE

Treasury Bills are

short term

Treasury bonds are

long term

Default risk

risk that the borrower would be unable to repay that money

Municipal bonds

• issued by state governments and local governments

• NOT RISK FREE

• Exempt from federal income taxes

Corporate Bonds

• issued by corporation

• NOT RISK FREE

Bond

an asser, that a firm can issue in order to raise money

Preferred stock

• Seen on the balance sheet as equity

• Has a HIGHER priority relative to common stock

• Pays HIGH dividends

Order of payouts if a firm were to liquidate

1) Bondholders

2) Preferred stockholders

3) Common stockholders

Relationship between risk and return

the higher the risk the higher the return

Public offering

securities are made available to all individual and institutional investors

Private placement

securities are offered and sold directly to a limited number of investors

Primary market

corporation receives money by selling new securities, often to an investment bank

Secondary Market

investors buy and sell existing securities

Money market

short-term debt in instruments (ex. treasury bills, negotiable CDs, commercial paper)

Capital market

long-term financial instruments (ex. loans, stocks, bonds)

Spot market

market where something sells today (also known as cash market)

Futures Market

market where you can buy or sell something at some future date (price, quantity, and date are set)

Organized exchange

formal organization for buying or selling securities (ex. NYSE, AMEX, regional exchanges)

Over-the-counter market

all security markets except organized security exchanges. A network of brokers and dealers linked by computer (ex. NASDAQ)

Nominal Interest Rate

interest rates that have no been adjusted for inflation

Fisher effect formula

(1+ nominal IR) = (1+ real IR) (1+IRP)

Real risk-free interest rates

interest rate of treasury securities have inflation taken in equation

NASDAQ

Global electronic market place for buying and selling securities

Real rate interest

interest rate adjusted for inflation

Yield rate

metric that measures the efficiency of a process or the return on an investment

Why might a yield rate be inverted

interest rates are expected to fall / recession

Unbiased expectation theory

expectations of future rates determine the term structure (expectations can shape behaviour)

Liquidity preference theory

investors require maturity premiums to invest in long term securities

Market segmentation

there are separate markets for long and short term investments

Income Statement Expanded

Sales

(COGS)

= Gross profit

(Operating Expenses)

= Operating Income/EBIT/Operating Profit

(Interest Expense)

= Earnings before taxes/EBT/ Taxable income

(Income taxes)

= Net income

(Preferred stock dividends)

= Net income available to distribute to commo stockholders

Form 10k

yearly report that publicly traded companies in the US filed with the securities and exchange commission (summarizes their financial performance)

Balance sheet

total assets = outstanding debt + stockholders equity

Marketable securities

any short-term securities

Current assets in the balance sheet

• cash

• marketable securities

• accounts receivable

• inventories

• prepaid expense

Fixed assets on balance sheet

• machinery and equipment

• buildings and land

Other assets on balance sheet

• investments and patents

Current liabilities on balance sheet

• accounts payable

• accrued expenses (ex. you work today but wont get paid until two weeks)

• short-term notes

Long term liabilities on balance sheet

• long term notes

• mortgages

Equity on balance sheet

• preferred stock

• common stock (par value)

• paid in capital

• retained earnings

Dividend income

50% is exempt from federal taxation (dividends)

Net operating income

may be carried indefinitely and applied against future income

Net capital gains

taxed as ordinary income at 21%

Net capital loses

may be carried back 3 years or forward up to 5 years and applied against net capital gains

Taxes are not paid on

EBIT loss

Dividends paid have no effect on

firms taxable income or tax liability

Tax liability formula

taxable income x 21%

Dividends paid by the firm ________.

are paid out of net income

Trend analysis

comparing a company’s financial ratios with its ratios in previous years

Ratios can also be used to

compare a company’s financial ratios with those of its industry

Financial ratios help us determine

if we have enough liquid assets to meet approaching obligations

Liquid

how easy it is to covert an asset to cash quickly without much loss of value example (a 50% sale is now liquid since you’re losing a lot of value)

What is the least liquid current asset

inventories

Days in receivables is

how long it takes the customer to pay / average collection period

How to get daily sales

sales/365

The higher the accounts receivable the

less time its taking a company to collect receivables

Days in inventories determines

how long it stakes to sell an item

Inventory turnover means

how many times a company restocks

Why is low inventory turnover expensive

• items can become obsolete or expire

• storage takes up space and rent

Operating probability ratios means

how efficiently the firm’s assets generate operating profits

Operating profit is also known as

EBIT

Leverage is also known as

debt

By taking on more debt a firm can

increase its return on equity

Time interest earned means

are customers able to make the interest payments

Common stock/retained earnings

common stock + paid in capital + retained earnings

Which of the following are tax deductible expenses for a corporation?

interest paid on debt

Net operating losses may be _______.

carried forward forever

Stockholders and shareholders are the same thing

true

Suppose your firm selects an investment banking firm to assist with your firm's $10 million stock issue. The investment banker will act as a broker and will attempt to sell each new share of stock for a commission for each share sold. This distribution method is referred to as:

Best efforts

A goal of the firm is never maximizing

profit

The law that established the SEC is:

the Securities Exchange Act of 1934

Suppose your firm selects an investment banking firm to assist with your firm's $50 million bond issue. The investment bank will buy the entire issue and sell each new bond to investors. This distribution method is referred to as

best efforts

When a new issue of securities is marketed to a definite and select group of investors, such as the firm's employees or current stockholders, the issue is called a(n)

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