Chapter 10: Financial Management

What is the risk-return trade-off?

Higher risk generally requires the possibility of a higher return.

What is the time value of money?

Money today is worth more than the same amount in the future because it can earn a return; Individuals usually prefer to have good things sooner and prefer to put off bad things until later.

Why is cash flow more important than profits for paying bills?

A business needs actual cash to pay expenses, even when it reports a profit.

What is valuation of assets?

Determining an asset's value based on its expected future cash flows.

• Assets that generate positive cash flows sooner are valued higher.

• The value of an asset in an organization is its ability to generate positive cash flow over time

What is diversification?

Spreading investments across different assets to reduce overall risk.

What are forecasts?

Predictions of an organization's future financial needs and activities.

What is a cash flow forecast?

A prediction of expected cash inflows and outflows.

What is the difference between short-term and long-term cash flow forecasts?

Short-term forecasts cover the next 12 months; long-term forecasts cover one year or more.

What are the three steps of the financial planning process?

Forecast, budget, and control.

What are budgets?

Financial plans showing how an organization intends to allocate its resources.

What is the difference between the four types of budgets?

Operating = normal business activities; capital = major long-term investments; cash flow = expected cash surpluses and shortfalls; master = combines all budgets.

What are controls?

Financial managers establish and administer financial controls to measure actual performance against the budget plan, identify variances, and take corrective action

What is working capital?

Funds used to support daily business operations. Net working capital equals current assets minus current liabilities.

What are accounts receivable and accounts payable?

Receivable = money customers owe the business. Payable = money the business owes suppliers.

What is trade credit?

Receiving goods or services now and paying for them later.

What does 2/10, net 30 mean?

A 2% discount for paying within 10 days; otherwise, the full amount is due within 30 days.

What is collateral?

An asset pledged to secure a loan.

What is the difference between secured and unsecured loans?

Secured loans are backed by collateral; unsecured loans do not require pledged assets.

What is factoring?

Selling accounts receivable at a discount to receive cash sooner; Selling accounts receivables to a specialized lender that is then responsible for collecting on those accounts.

What is commercial paper?

Short-term, unsecured promissory notes that are issued in denominations in excess of $100,000.

What is a letter of credit?

A bank's commitment to pay a beneficiary if specified conditions are met.

What is debt financing?

Borrowing money that must be repaid with principal and interest.

Advantage: business interest payments can generally be deducted as an expense, which lowers the firm's overall taxable income and tax liability

Forms: bank loans, commercial paper, corporate bonds, factoring

What is equity financing?

Raising money by giving investors an ownership interest in the business.

• issuing stock

• selling a share of ownership

• using retained earnings

What is the difference between debt and equity financing?

Debt requires repayment and interest but does not automatically give lenders ownership. Equity does not require repayment of the investment but gives investors ownership.

What are principal and interest?

Principal is the original amount borrowed; interest is the cost of borrowing.

What are corporate bonds?

Debt securities issued by companies to borrow money.

Corporate bonds may be secured or unsecured

Issuers of corporate bonds pay interest to those who purchase the bonds (investors)

Corporate bonds are a form of debt financing

What is stock?

An ownership interest in a corporation.

What are dividends?

Payments a corporation may distribute to its shareholders.

What are retained earnings?

Profits kept in the business instead of being distributed to owners.

What is venture capital?

Funding provided to start-ups or growing businesses in exchange for ownership.

How does the tax treatment of debt differ from equity?

Interest on debt is generally tax-deductible; dividends are not tax-deductible.