FIN3403 FSU Exam 1

Capital Budgeting

- The process of planning and managing a firm's long-term investments.
- Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting.

Capital Structure

The specific mixture of long-term debt and equity the firm uses to finance its operations.

Working Capital Management

A firm's short-term assets and liabilities.

What are the three legal forms of business organization?

1. Sole Proprietorship
2. Partnership
3. Corporation

Sole Proprietorship Definition

A business owned by a single individual.

Partnership Definition

A business formed by two or more individuals.

Corporation definition

- A business created as a distinct legal entity composed of one or more individuals or entities.
- Most important form of business organization in the United States.
- Stockholders elect board of directors, who then select managers.
- Limited Liability Company (LLC): a hybrid of partnership and corporation.

What is the most important form of business organization?

The corporation.

General Partnership

All the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share.

Limited Partnership

A limited partner's libaility for business debts is limited to the amount that partner contributes to the business.

Partnership Agreement

The way partnership gains and losses are divided is described in this document.

Forming a corporation involves...

Preparing articles of incorporation(or a charter) and a set of bylaws.

Bylaws

Are rules describing how the corporation regulates its existence.

The articles of incorporation must contain:

- The corporation's name
- The corporation's intended life, which can be forever
- The corporation's business purpose
- The number of shares that can be issued.

Double Taxation

Corporate profits are taxed twice: at the corporated level that they are earned and again at the personal level when they are paid out.

Stakeholder

Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

Corporate Finance is the study of following questions:

- What long-term investments should you take on?
- Where to get long-term financing to pay for your investment?
- How to manage your everyday financial activities?

Are owners of a corporation directly invovled in business making decisions?

No. Corporations employ managers to represent the owner's interests and makedecisions on their behalf.

What are some advantages of a sole proprietorship?

- Easiest to start
- Least regulated
- Single owner keeps all the profits
- Taxed once as personal income

What are some disadvantages of a sole proprietorship?

- Limited to life of owner
- Equity capital limited to owner's personal wealth
- Unlimited liability
- Difficult to sell ownership interest

What are some advantages of a partnership?

- Two or more owners
- More capital available
- Relatively easy to start
- Income taxed once as personal income

What are some disadvantages of a partnership?

- Unlimited liability
- General partnership
- Limited partnership
- Partnership dissolves when one partner dies or wishes to sell
- Difficult to transfer ownership

What are some advantages of a corporation?

- Limited liability
- Unlimited life
- Separation of ownership and management
- Transfer of ownership is easy
- Easier to raise capital

What are some disadvantages of a corporation?

Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)

What are the goals of financial management?

- To maximize the current value per share of the existing stock.
Stockholders are residual owners. If stockholders are winning, everyone else is winning, too.
Redefine corporate finance: The study of the relationship between business decisions and the value of the stock in the business.
More generally, Maximize the market value of the existing owners' equity.

Agency Relationship

The relationship between stockholders and management, the relationship between the principal and the agent who is hired to represent principal's interests.

Agency Problem

The conflict of interest between the principal and the agent.

Agency Costs

- The cost of the conflict of interest between stockholders and management:
- Indirect agency cost: a lost opportunity.
- Direct agency cost
A corporate expenditure that benefits management but costs stockholders.
An expense that arises from the need to monitor management actions.

Whether managers act in the best interests of stockholders depends on 2 factors:

- How closely are management goals aligned with stockholder goals?
- Can Managers be replaced if they don't purse stockholder goals?

How to solve agency problem: Compensation

Compensation is tied to financial performance and share value.
Better performers within the firm tend to get promoted.

How to solve agency problem: Control of the firm

- Proxy fight: unhappy stockholders can replace existing management.
- Takeover: avoiding a takeover by another firm gives managers incentive to act in stockholder's interest.

Primary Markets

Original sale of securities by governments and corporations.
-public offerings and private placements.

Secondary Markets

- Buying and selling securities after the original sale, providing means for transferring ownership of corporate securities.
The equity shares of most of the large firms in U.S. trade in organized markets.
NYSE, NASDAQ, TSE, LSE
OTC

Balance Sheet Equation

Assets = Liability + Equity

What are the two types of liabilities?

Current or long-term.

Current Liabilities

Like current assets, have a life of less than one year and are listed before long-term liabilities.

Long-term liabilities

A debt that is not due in the coming year.

Net Working Capital

Current assets minus current liabilities.

Liquidity

Refers to the speed and ease with which an asset can be converted to cash. I.e. gold and cash.

Generally Accepted Accounting Principles(GAAP)

The common set of standards and procedures by which audited financial statements are prepared.

Balance Sheet

Financial statement showing a firm's accounting value on a particular date.

Income Statement

Financial statement summarizing a firm's performance over a period of time.

Statement of Cash Flows

Financial statement summarizing its source and uses of cash over a specified period.

Current Asset

has a life of less than one year. It will convert to cash within 12 months.

Fixed Asset

Can not be easily converted to cash.

Current Liability

Has a life of less than one year. It must be paid within the year.

Financial Leverage

The use of debt in a firm's capital structure. The more debt a firm has as a percentage of assets, the greater is its degree of financial leverage.

Market value vs. Book value

- Values on balance sheet are book values, not market values.
- Which value is more important to financial managers?

Income Statement Equation

Revenues - Expenses = Income

Accounting Rule

Revenue is recognized at the time of sale. Match those revenues with the costs associated with producing them.

Income Statement: noncash items - depreciation

Suppose the firm bought equipment for $5,000. Instead of deducting $5,000 as an expense, we depreciate the asset over a 5-year period, $1,000 per year as an expense.

Average Tax Rate

Tax bill / taxable income

Marginal Tax Rate

Rate of the extra tax we would pay if you earned one more dollar.

Cash Flow

The difference between the number of dollars that came in and the number that went out.

Examples of cash flow from assets

- Operating cash flow (OCF)
- Capital Expenditure (CAPEX)
- Change in net working capital (∆NWC)

Operating Cash Flow (OCF):

Cash flow that results from firm's day-to-day activities of producing and selling.

OCF equation

= EBIT + Depreciation - Taxes

Capital Spending(CAPEX):

Net spending on fixed assets. It's the money spent on fixed assets less money received from the sale of fixed assets.

CAPEX equation:

= Ending net fixed assets - Beginning net fixed assets + Depreciation

Change in net working capital:

Net change in current assets relative to current liabilities for the period being examined.

A dollar today vs. A dollar one year from now. Which is worth more?

A dollar in hand today is worth more than a dollar promised in the future. You could have earned interest with the dollar today rather than waiting to receive it in the future.

Future Value

- The amount of money an investment will grow to over some period of time at some given interest rate.
- If you invest for one period at an interest rate of r, your investment will grow to (1 +r) per dollar invested.

Compounding Interest

The process of accumulating interest on an investment over time to earn more interest.

For a given length of time...

...the higher the discount rate is, the lower the present value

Annuities

A finite series of equal payments that occur at regular intervals. I.e. $1,000 per year for 10 years

Perpetuities

An annuity in which the cash flows continue forever. It's a special case of annuity.

PV for a perpetuity

PMT / r

Example of Perpetuities

Preferred stock. When a corporation sells preferred stock, the buyer is promised a fixed cash flow dividend every quarter forever.

What are the three types of financial statements?

- Balance Sheet
- Income Statement
- Statement of Cash Flows

What is capital structure?

The mixture of a firm's debt and equity financing.

What is a capital budgeting decision?

Determining which one of two projects to accept. Has to do with long term projects.

What questions are addressed by financial managers?

- Should customers be given 30 or 45 days to pay for their credit purchases?
- Should the firm borrow more money?
- Should the firm acquire new equipment?

What is the goal of financial management?

To increase the market value per share.

Using the present value formula, for a given discount rate and FV, an increase in the number of periods leads to what effect on present value?

Decreases present value.

A _______ asset can be quickly sold without a significant loss in value.

Liquid

Shareholders equity:

Represents the residual value of a firm.

The Sarbanes-Oxley Act of 2012 was enacted to do what?

Protect investors from corporate abuses, such as in the Enron scandal.

What are some examples of current assets?

Cash, accounts receivable, inventory.

What are some examples of current liabilities?

Accounts payable, notes payable

A loan where the borrower receives money today and repays a single lump sum on a future date is called a:

Pure discount loan

What kind of decision belongs to capital budgeting?

Whether to spend money on a new project or a new machine

What is the difference between general partner and limited partner in a partnership?

General partner has unlimited liability and is responsible for running business. Limited partner has limited liability.

What is an income statement?

The financial statement that summarizes performance of a firm (revenue and expenses).

Perpetuity equation"

PV = payment amount per period / rate

What is an interest only loan?

Periodic interest payment + lump sum principal payment in the end