Corporate Finance Exam 1

long-term investments, raise funds, short-term assets

Corporate Finance addresses the following three questions:
• What ____________ should the firm choose?
• How should the firm _______ for the selected investments?
• How should _________ be managed and financed?

Cash flow is important in the overall financial health of a business. When you are out of cash, you are in trouble.

Why is cash flow so important in financial management?

Maximize shareholder wealth

What is the goal of financial management?

When managers place personal goals ahead of the goals of shareholders.

What is the agency problem?

Monitoring/regulation and incentives/threats

How can you mitigate agency problem?

Balance Sheet

a summary of a firm's financial position at a given point in time.

Income statement

a financial summary of a company's operating results during a specified period.

Statement of Cash Flows

Official accounting statement showing cash flow movements

Cash Flow Management

Total cash flow is more objective, but the underlying components may also be “managed”

Being misled by cash flow management

Moving cash flow from the investing section to the operating section may make the firm’s business appear more stable.

Standardized financial statements

balance sheet and income statement

Compare financial information, compare different companies

using financial statements

liquidity ratios

current ratio, quick ratio, cash ratio

current ratio

Measures the ability for the firm to meet short-term obligations

quick ratio

like current ratio but excludes inventory, which is generally the least current asset

cash ratio

counts only cash - good for short-term analysis

leverage (debt) ratios

total debt ratio, debt to equity ratio, equity multiplier, times interest earned, cash coverage

total debt ratio

measures the proportion of total assets financed by the firm's creditors

debt to equity ratio

measures the relative proportion of total liabilities and common stock equity used to finance the firm's total assets.

times interest earned ratio

the firm’s ability to make contractural interest payments, sometimes called the interest coverage ratio.

cash coverage ratio

firm’s ability to make contractual interest payments with cash.

asset management or turnover ratios

inventory turnover, days’ sales inventory, receivables turnover, days’ sales in receivables, total asset turnover

inventory turnover

measures the activity, or liquidity, of a firm's inventory.

days’ sales in inventory

How quickly does the inventory turn over on average?

receivables turnover

measures how fast a firm collects on those (credit) sales

days’ sales in receivables

average amount of time needed to collect accounts receivable

total asset turnover

indicates the efficiency with which the firm uses its assets to generate sales.

Profitability Measures

profit margin, EBITDA margin, ROA, ROE

Profit Margin

measures how much in profit a firm generates for every 1 dollar in sales

EBITDA Margin

measures how much EBITDA a firm earns for every 1 dollar in sales

ROA

measures the overall effectiveness of management in generating profits with its available assets

ROE

measures the return earned on common stockholders' investment in the firm

market value measures

Earnings per share, PE ratio, market-to-book ratio, enterprise value

market-to-book ratio

provides an assessment of how investors view the firm's performance

enterprise value

indicates the estimated market value of the company’s operating assets

earnings per share

the number of dollars earned during the period on behalf of each outstanding share of common stock

PE ratio

measures the amount that investors are willing to pay for each dollar of a firm’s earnings, which indicates the degree of confidence that investors have in the firm’s future performance.

Proforma financial statement

setting up the plan as projected financial statements allows for consistency and ease of interpretation

percent of sales approach

What ways can you prepare a proforma financial statement?

things you should do if you have a positive EFN

• Borrow more short-term debts (Notes payable, etc.)

• Borrow more long-term debts (Bonds, etc.)

  • Issue more common stock

things you should do if you have a negative EFN

• Buy more assets

• Retire debt obligations

• Buy back stocks

internal growth rate

tells us how much the firm can grow assets using retained earnings as the only source of financing.

sustainable growth rate

tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

risk premium

the benefit of taking on extra risk

components of risk premium

default risk, maturity risk, contractural provision risk

default risk

The possibility that the issuer of debt will not pay the contractual interest or principal as scheduled.

Maturity Risk

That the longer the maturity, the more the value of a security will change in response to a given change in interest rates.

Contractual Provision Risk

Conditions that are often included in a debt agreement or a stock issue. Some of these reduce risk, whereas others may increase risk

higher

In general, the longer the bond's maturity, the ____ the interest rate (or cost) to the firm

lower

the larger the size of the offering, the ____ will be the cost (in % terms) of the bond

higher

the greater the default risk of the issuing firm, the _____ the cost of the issue

coupon interest rate

Finally, the cost of money in the capital market is the basis form determining a bond's _________

restrictive covenants

provisions in a bond indenture that place
operating and financial constraints on the borrower. This help bondholder against increases in borrower risk

conversion feature

allows bondholders to change each bond into a stated number of shares of common stock.

call feature

gives the issuer the opportunity to repurchase bonds at a stated call price prior to maturity

stock purchase warrants

instruments that give their holders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time.

expected future cash flows

The value of any asset is the present value of its ____________________

free cash flow model

determines the value of an entire company as the present value of its expected free cash flows discounted at the firm’s weighted average cost of capital, which is its average expected future costs of funds over the long run.

price/earnings multiple approach

calculated by multiplying the firm's expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry.

Limitation of the P/E approach

when using this approach to estimate stock values, the estimate will depend more on whether stock market valuations are high or low rather than on whether the particular company is doing well or not.

Payback Period Disadvantages

Disadvantages:
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive NPV

Payback Period Advantages

Advantages:
• Easy to understand – often used in lower level decisions
• Biased toward liquidity

Advantages of Discounted Payback Period

Advantages
• Includes time value of money
• Easy to understand
• Does not accept negative estimated NPV investments when all future cash flows are positive
• Biased towards liquidity

Disadvantages of Discounted Payback Period

Disadvantages
• May reject positive NPV investments
• Requires an arbitrary cutoff point
• Ignores cash flows beyond the cutoff point
• Biased against long-term projects, such as R&D and new products

Problems with IRR

you can get multiple rates of return, timing