Combined Flash Cards for Review

Finance for Managers

What is Finance?

The study of managing and allocating funds at the personal or business level.

What are the subspecialties of finance?

• Business/ Corporate Finance

• Investments

• Institutions

Business/ Corporate Finance

Focuses on sources of funding and how firms manage their finances to achieve optimal results.

Investments

Involves managing other people's money to obtain the best return for clients.

Institutions

Deal with banks, pension funds, insurance funds, etc.

What is the difference between finance and accounting?

The difference between finance and accounting is that finance focuses on the future and accounting focuses on the past – what has already happened.

Accounting is -

the system of recording, reporting, and summarizing past financial information and transactions.

Finance uses -

accounting information to manage and allocate capital.

Capital

A financial asset that can be used by a firm or individual.

What is the main goal of Personal Finance?

To maximize individual utility and assesses if benefits outweigh costs.

What is the main goal of Organizational Finance?

To maximize shareholder wealth (public) or owner wealth (private).

What is the main question being asked in both personal and organizational finance?

Do the benefits outweigh the cost?

What are the main roles of finance?

• Making Investment Decisions.

• Making Financing Decisions.

• Managing Working Capital.

Investment Decisions

Involve determining what assets to buy to grow the firm and add value. This is the most important role.

Financing Decisions

Are concerned with selecting what financing capital to use for new assets/projects (loan, cash, etc.?).

Working Capital Management

Involves day-to-day operations like inventory and supplier payments.

What role does finance play in personal finance?

Budgeting, assessing financial goals, financing goals, and investing in achieving goals.

Financial Markets

Include the Money Market and Capital Market, with primary and secondary markets. Both markets exist to manage liquidity and risks for the government, corporations, and individuals.

Money Market

Used by the government and corporate entities to borrow/ lend money short-term (<1yr).

Capital Market

Used for long-term assets that are held (>1yr)

Primary Market

Where securities (stocks/bonds) are first sold with the help of temporary syndicate groups/ underwriters via initial public offerings (IPO).

Syndicate Groups

Are made up of large investment banks and sometimes underwriters that help with initial issuances and are usually temporary.

What is the role of underwriters in the Primary Market?

To buy all the securities from the issuer and then re-sell them at a higher cost to investors.

What are the two ways bonds are issued with a syndicate group?

Via Competitive Sales or Negotiated Sales.

In both competitive and negotiated sales the syndicates —

place bids on different bonds and the underwriter with the highest bond and lowest interest rate will be accepted.

What is the difference between the competitive and negotiated sales?

Negotiated sales involves a more thorough interview process, and firms will carefully select the management team placing these bonds.

Secondary Market

Known as the stock market and is where securities are traded after the IPO. Prices in the stock market are determined by supply and demand.

What are the two types of stock markets?

The Auction and Dealer Market.

Auction Market

Has a physical location, and prices are determined by the highest price an investor is willing to pay (i.e. New York Stock Exchange/ NYSE).

Dealer Market

Doesn’t have a physical location and securities are bought and sold through a network of dealers who trade for themselves, also involves bidding (i.e. NASDAQ). Stocks listed on NASDAQ have multiple dealers for each, this is to provide liquidity.

Financial Institutions

Include depository institutions (savings & loans association), non-depository institutions (securities and investment firms and contractual savings institutions).

Depository Institutions (AKA Thrift Institution)

Accept monetary deposits and provide loans. Includes: Savings and Commercial Banks, Savings and Loan Associations, and Credit Unions.

Savings and Loan Associations

Type of depository institution that places significant focus on providing loans for residential mortgages and real estate.

Non-Depository Institutions

Not allowed to accept monetary deposits but may perform functions such as lending money or acting as an intermediary between saver and lenders. Includes: Brokerage Firms, Investment Firms, Mutual and Hedge Funds, Securities firm, and contractual savings institutions.

Securities Firm

Facilitates the investment and purchase of securities in financial markets.

Investment Firm

Invests the capital of investors in financial securities (i.e. Mutual Funds & Investment Trusts).

Contractual Savings Institution:

Raise capital for long-term contractual agreements (i.e. insurance company or a private pension fund).

Pension Funds

Uses the contributions to a company’s retirement accounts to buy securities to provide retirement funds to those contributors.

Private Equity Funds

Investment companies funded by wealthy individuals that invest in private companies or purchase entire companies with the purpose of achieving a financial return through the eventual sale of the company.

Central Banks

Financial institutions that oversee/ manage all other banks. They ensure that a nation’s economy remains healthy by controlling the amount of money circulating in the economy.

Banks and Credit Unions

Offer products/ services to individual consumers and businesses. They receive deposits and extend loans to individuals and businesses.

Insurance Companies

Offer products to help individuals transfer risk of loss. They charge premiums to invest in bonds/ stocks to pay claims.

Mutual Funds

Offer investments and buy financial securities and instruments on behalf of investors.

Pension Funds

Retirement funds contributed through companies to invest and provide retirement.

Investment Banks

Offer various services such as underwriting, facilitating mergers, and trading financial securities on behalf of large institutions and companies.

Private Equities

Receive money from institutional investors and wealthy individuals to buy high-potential companies or troubled companies to improve and earn returns by selling them or going public.

Economic Indicators

Leading, lagging, and coincident indicators used to assess the state of the macroeconomy. #L8

Leading Indicators

Have the potential to forecast where the economy is headed so they usually change before the economy changes as a whole. Governments/ Policymakers use them to implement/ alter policies/ programs to avoid economic downturn. #L8

Lagging Indicators

Change after the economy changes. They don’t predict the future of the economy, but they do indicate changes and patterns over time and can help identify trends in the long run. #L8

Coincident Indicators

Collected, used, and analyzed as shifts in the economy occur. They provide information on the current state of the economy and are used jointly with leading and lagging indicators to see the big picture of past changes leading to future trends. #L8

Ethics

Accepted standards of conduct guiding behaviors for the best outcome for stakeholders. #L9

Morals

Reflect beliefs about right and wrong, good and bad, or just and unjust. #L9

Legal

Acting in accordance with laws and rules set by an authority. #L9

Ethical Dilemma

an issue in the process of deciding between multiple options where no option is completely acceptable from an ethical standpoint. #L10

Profit vs. Shareholder Wealth

When a company is primarily motivated by profit, it can lead to unethical behavior. Attempting to maximize shareholder wealth unethically does not maximize shareholder wealth (i.e. ENRON). #L10

Low-Cost vs. Ethical Manufacturing

Businesses often face the dilemma of reducing costs without risking unethical practices such as unfair wages and forced labor. However, businesses can reduce costs while still remaining ethical in their decision making (i.e. TOMS). #L10

Customer Demand vs. Good Due Diligence

Prioritizing due diligence over short-term gains can prevent long-term financial and ethical consequences such as those faced during the Financial Crisis of 2008. #L10

What are some differing demands that can lead to ethical conflicts?

1. Competing Interests

2. Agency Problems

3. Conflicts between Shareholders and Bondholders

4. Client Demand vs. Professional Responsibilities

5. Personal Interest vs. Professional Duties #L11

What are financial managers interested in, in a corporation?

Safe but successful projects. #L11

Shareholders in a corporation prefer…

Riskier projects for higher returns. #L11

Bondholders want…

Stable projects to ensure repayment. #L11

A company pursuing riskier projects for higher shareholder returns that could jeopardize job security and bondholder repayments is an example of what?

Ethical conflicts within financial decision-making. #L11

When management doesn’t act in the interest of the shareholders and misuses company funds or pursues their own interests, this is an example of what?

An agency problem in the context of ethical conflicts. #L11

When company goals conflict with client interest this might cause financial advisors to have?

An ethical dilemma, where they feel pressured to push riskier investment on clients to meet company goals, even when it’s not in the client’s best interests. #L11

When decisions are influenced by personal interests, such as favoring family in contracts or hiring based on perks, what is this an example of?

Potential conflicts between personal interests and professional roles. This can compromise the ethical and objective business practices of a corporation. #L11

What steps should be taken to resolve ethical conflicts?

Identify the problem, evaluate alternative actions based on ethical guidelines, consider stakeholders' impacts, and choose the most ethical course of action. #L11

When clients demand unethical actions, this is an example of what?

A conflict between professional responsibility and client loyalty (Individual Responsibility vs. Client Demand) #L11

Return

The gain or loss on an investment over time, expressed as an annualized percentage.

Risk

The uncertainty in the distribution of possible outcomes, measured by standard deviation of returns.

Ratios in Finance

Used to analyze and compare companies' performances, focusing on maximizing shareholder wealth.

Trend Analysis

Comparing a firm's financial ratios over time to assess management performance and improvement trends.

Cross-sectional Analysis

Comparing a firm's financial ratios to a peer group to determine benchmark standards and equity valuation.

Progress Measurement

Using ratios to measure progress and achieve goals for competitiveness in global markets.

Liquidity Ratios

Measure a firm's ability to meet short-term obligations without external capital, including cash availability and asset conversion ease.

Activity Ratios

Assess a firm's efficiency in generating sales/cash from assets, analyzing inventories, fixed assets, and accounts receivable.

Leverage Ratios

Describe how a firm is financed, considering equity and debt proportions for long-term financial health.

Profitability Ratios

Evaluate a firm's profitability based on sales or asset investments, indicating management effectiveness and wealth maximization.

Market Ratios

Used to evaluate a firm's stock price, helping investors decide on buying or selling decisions based on perceived value.

DuPont Framework Components

Include profitability ratios like Return on Assets (ROA) and Return on Equity (ROE) to assess company performance comprehensively.

What is Net Present Value (NPV)

The sum (or net) of present values of a project’s expected cash inflows/ outflows.

How is Net Present Value (NPV) calculated?

Add the present values of all expected cash inflows and then subtract the present value of cash outflows (i.e. initial outlay).

What are the advantages of Net Present Value (NPV)?

1. Considers time value of money

2. Calculates value added to the firm

3. Considers risk and required return

What are the disadvantages of Net Present Value (NPV)?

1. Requires calculation of appropriate cost of capital

2. Is not useful to compare projects of varying sizes

What is Internal Rate of Return (IRR)?

The rate of return that a firm earns on its capital projects.

Using the Internal Rate of Return (IRR), when should a project be accepted?

If the IRR exceeds the cost of capital.

(IRR > Discount Rate = Accept; IRR < Discount Rate = Reject).

What are the advantages of Internal Rate of Return (IRR)?

1. Easy to interpret,

2. Considers time value of money

3. Doesn’t require use of the required rate of return.

What are the disadvantages of Internal Rate of Return (IRR)?

1. Not a good indicator of the amount of value created.

2. Ignores mutually exclusive projects.

3. Assumes reinvestment at the IRR rate.

4. Can’t be used to compare projects with different durations.

5. Requires conventional cash flows.

Why is the IRR a poor valuation method for a project with unconventional cash flows?

There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.

Projects with unconventional cash flows must be valued using NPV.

You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project?

The cost of capital was underestimated, so you adjust the cost of capital to be higher.

Increasing the cost of capital decreases the PI. Therefore, the new PI will be less than 1, and you should reject the project.

What area of finance deals with sources of funding and the capital structure of corporations?

Business Finance.

What is the primary difference between finance and accounting?

Finance focuses on the future, while accounting is backward-looking.

Which sub-specialty of finance involves deciding which assets create more wealth?

Investments.

What is the primary goal of the financial manager of a firm?

To maximize owner wealth.

What should a firm consider when making investment decisions?

Do the benefits of this investment outweigh the costs?

What is the primary aim of personal finance goals?

To maximize one's utility.

What task does a financial manager perform when obtaining a loan for a new project?

Making financing decisions.

Which financial career focuses on investing in privately held firms?

Private Equity.

What task does a financial manager perform when assessing potential project costs and benefits?

Making investment decisions.

What tool helps you understand your overall personal cash flows?

Budgeting.

What is a reasonable alternative to keeping an emergency stash of cash?

Investing in a savings account.