finance exam 1

what is finance?

can be defined as the art of money management, a field that is concerned with the allocation (investment) of assets and liabilities over space and time, with risk and uncertainty

what 3 divisions is finance divided into?

1. corporate financial management

2. capital markets

3. investments

corporate financial management

• what types of assets to acquire?

• how to raise capital? (equity/borrow)

• how to maximize the firm’s value?

• how to plan for the future?

capital markets

• financial intermediaries - banks, investment banks, stockbrokers, mutual funds (groups of stocks)

• governmental organizations (SEC, federal reserve system)

investments

• valuation of stocks and bonds

• structuring of portfolios

most common type of business by number

proprietorships

most common type of business by sales

corporations (which conduct more than 80% by dollar value)

proprietorship

an unincorporated business owned by one individual; easy to form, inexpensive, few regulations, lower income taxes, but unlimited personal liability, limited life, and difficulty raising large capital

advantages of proprietorship

easy and inexpensive to form, subject to few government regulations, lower income taxes than corporations

limitations of proprietorship

unlimited personal liability, limited business life, difficulty obtaining large capital

partnership

legal arrangement between two or more people; income taxed individually, easy to establish, but partners have unlimited personal liability, making large capital difficult to raise

corporation

a legal entity from owners/managers; limited liability for stockholders, unlimited life, easy to transfer ownership, easier to raise capital, but subject to double taxation

s corporation

taxed like a proprietorship/partnership, exempt from corporate income tax, limited to 100 stockholders; generally for small, privately owned firms

c corporation

standard corporation subject to DOUBLE taxation; larger firms

limited liability company (LLC)

hybrid between a partnership and a corporation; limited liability, taxed as a partnership, popular for non-professional businesses

limited liability partnership (LLP) 

similar to LLC, but used mainly for professional firms (accounting, law, architecture); provides limited liability protection and partnership taxation

trade-off in choosing business form

firms must weigh advantages of incorporation (limited liability, capital access, liquidity) against double taxation

how is stockholder wealth determined

by the present value of the stream of cash flows the asset provides to its owners over time

stock price determination

stock prices are based on expected future cash flows, not just current year earnings

long-run view in stock price maximization

managers must consider the long term impact of their decisions, as actions affecting company value may not immediately show in stock prices

3 basic factors of maximizing shareholder wealth

1. assets must generate cash flows

2. optimize the timing of the cash flows

3. find the optimal tradeoff between risk and return

decisions which affect the stock price:

1. what products or services should be produced?

2. how should these products or services be produced/delivered?

3. what mix of debt and equity should be used?

4. what percentage of earnings should be paid out in dividends rather than retained and reinvested?

stock price is also affected by EXTERNAL factors:

1. legal constraints (laws)

2. health of the economy

3. tax laws

4. interest rates

5. conditions in the stock market

does maximizing profits always maximize shareholder wealth?

NO; shareholder weath depends on the long term, risk adjusted cash flows, not just short term accounting profits

true cash flows and risk

based on all available information

perceived cash flows and risk

based on the limited information investors actually have

instrinsic value vs market price

instrinsic value is the estimated “true” value of a stock by a competent analyst market price is the price set by the marginal investor based on PERCEIVED information

stock price equilibrium

occurs when a stock’s market price equals its intrinsic value; no pressure exists to change the price

difference between actual stock price and instrinsic value

actual stock prices are observable daily, while instrinsic values are estimates based on analysis and future expectations

who has the best information about instrinsic value?

managers, because they know the firm’s prospects, though they can be wrong

management’s goal regarding instrinsic value

take actions to maximize the firm’s long run instrinsic value, not necessarily the current stock price

should managers maximize current market price or instrinsic value?

stockholders would want managers to maximize intrinsic value, because it reflects long term wealth and sustainable returns, rather than short term price fluctuations

globalization of business

• improved transporation and communication

• trade barriers have been lowered

• development costs of new products have risen due to the sophistication of such products

• survival requires that most manufacturers produce and sell globally

information technology

• need for stronger computer and quantitative skills

• reduces costs and expand markets, thus increasing competition

• need for intermediaries reduced by electronic commerce

corporate governance

• stockholders are more proactive in replacing managers

• SEC has made it easier forinvestors to make changes

• SEC requires more transparent information on CEO compensation

business ethics

a company’s standards of conduct or moral behavior; affects the firm’s conduct toward its employees, customers, community, and stockholders

positive correlation between ethics and LT profitability

• avoids fines and legal expenses

• builds public trust

• attracts business from customers who appreciates its policies

what is an agency relationship?

someone who owns an asset, and allows someone to handle the contracts of that asset 

stockholders/managers versus creditors

managers have a duty to protect existing creditors from detrimental changes in:

• the riskiness of the firm’s existing assets (lower the price of the bond)

• expectations concerning the riskiness of future asset additions

• the amount of debt used

• expectations concerning future capital structure decisions

how do you motive managers to act in the stockholders’ best interests?

• managerial compensation

• direct intervention by shareholders

• threat of firing

• threat of takeovers

retained earnings

the cumulative accounting profits a company has kept over time instead of paying out as dividends, they appear on the balance sheet as part of SHE — but does not tell you how much cash the company actually has

source of cash

• decrease in an asset account

• increase in a liability or equity account

use of cash

• increase in an asset account

• decrease in a liability or equity account

operating income (EBIT)

earnings before interest and taxes; derived from the firm’s core operations, excluding non operating items like interest and taxes

earnings per share (EPS)

often called “the bottom line” because it summarizes the net income available to common shareholders and is the key figure stockholders focus on 

EBITDA

earnigns before interest, taxes, depreciation, and amortization; reflects cash generated by operations without non-cash charges

depreciation and amortization

non-cash expenses that allocate the cost of tangible (depreciation) and intangible (amortization) assets over their useful lives

operating activities

cash flows from normal business operations, including net income adjustments, depreciation/amortization, changes in inventories, receivables, payables, and accruals

investing activities

cash flows related to long-term assets, including purchases and sales of property, plant, equipment, and other investments

limitations of financial statements

managers have discretion in reporting; two firms in the same situation may report differently due to legitimate accounting choices or attempts to present higher/stable earnings

why might companies account for similar transactions differently?

differences can stem from 1) legitimate choices in interpreting GAAP, 2) management decisions to smooth earnings or highlight stability, and 3) differences in business circumstances

sarbanes oxley act (SOX)

passed in 2002 to improve internal auditing, require CEO/CFO certification of financial statements, and strengthen oversight of external auditors

free cash flow (FCF)

the cash a firm generates that can be withdrawn without harming its operations or future growth (add back depreciation), it is the cash flow actually available for distribution to all the investors (stockholders and debtholders) after the company has made all the investments in fixed assets, new products, and working capital necessary to sustain operations

positive free cash flow

cash generated exceeds what’s needed for investments in assets and working capital — the excess can go to investors

negative free cash flow

cash generated is insufficient, the firm must raise external funds, often seen in rapidly growing companies or during major capital investments

free cash flow in decision making

• measures true cash available to investors

• used by managers to evaluate capital projects, mergers, or expansion

• used by analysts to estimate firm value and stock price

why is free cash flow an important determinant of firm value?

it reflects the actual cash available to investors, which determines the instrinsic value of the firm and supports capital budgeting decisions

what is MVA?

the difference between the market value of a firm’s equity and the book value of equity; measures the value management has added for shareholders

high MVA indicates..

management is creating significant value for shareholders

can MVA be influenced by market trends?

yes; not all of MVA is due to managerial performance; stock market movements also affect it

what is EVA?

a measure of a company’s true economic profit in a given year, accounting for the total cost of capital (debt + equity)

positive EVA means..

company’s investments generate more than the cost of the capital; value is being created

what does negative EVA indicate?

investments do not cover the cost of capital; value is being destroyed

why is EVA useful for managers?

it helps evaluate managerial performance, divisional performance, and guides incentive compensation

how are MVA and EVA related?

positive EVA over time tends to result in a positive MVA, showing long-term shareholder value creation

how is EVA useful?

• good measure of addition to shareholder value

• can be used for divisons as well as for the entire company

• provides useful basis for determing managerial compensation

• very strong correlation between EVA and firm’s stock price

• if EVA is positive, then ROE exceeds cost of equity

tax cuts and jobs act (TCJA) key provisions

the bill lowered the maximum tax rate from 39.6% to 37%

tax cuts and jobs act (TCJA) key provisions

the bill eliminated the personal exemption for taxpayers and their dependents

tax cuts and jobs act (TCJA) key provisions

the bill sharply raised the standard deduction for all individuals and married couples

tax cuts and jobs act (TCJA) key provisions

the bill limited mortgage interest deductions

tax cuts and jobs act (TCJA) key provisions

• the individual alternative minimum tax (AMT) was kept; although the AMT exemption amounts were increase and continued to be indexed for inflation

• the bill doubles the estate tax exclusion amount of $10M

implications of TC&J act

most households received a tax cut, either due to increase in the standard deduction and/or drop in marginal tax rates

implications of TC&J act

the increase in the standard deduction will likely cause many taxpayers to stop itemixing their deductions, which would simplify the filing of taxes

implications of TC&J act

could potentially lead to higher taxes for itemizing households living in high tax rate states

major changes to the corporate tax code

the TCJA established a flat 21% corporate tax rate

major changes to the corporate tax code

the TCJA permits an immediate 100% expensing of certain new and used business assets

major changes to the corporate tax code

the TCJA repealed the corporate alternative minimum tax (AMT)

major changes to the corporate tax code

the TCJA will provide a one-time repatriation tax holiday for firms with money parked overseas

major changes to the corporate tax code

the TCJA changed the corporate dividend exclusion from 70% to 50% for less than 20%-owned subsidiaries and from 80% to 65% for less than 80%-owned subsidiaries.

what type of tax system does the U.S use?

progressive tax system - as the income increases, both the tax rate and percentage of income paid in taxes increase

what is taxable income?

gross income minus deductions and exemptions - personal exemptions were eliminated by the TCJA (2018)

what is the standard deduction for 2024?

$14,600 for single taxpayers, $29,200 for married filling jointly - if itemized deductions are lower than this, taxpayers take the standard deduction

what are marginal rates?

tax on the last dollar of income (2024: 10-37%)

what are average rates?

total tax / total income

how are capital gains taxed?

short term: taxed as ordinary income

long term: generally 15%; 20% for a single income

what is the alternative minimum tax (AMT)?

ensures high income taxpayers pay a minimum tax by adding back deductions (like depreciation or municipal bond interest) and taxing at a special rate

liquidity ratios

which give an idea of the firm’s abbility to pay off debts that are maturing within a year

asset management ratios

which give an idea of how efficiently the firm is using its assets

debt management ratios

which give an idea of how the firm has financed its assets as well as the firm’s ability to repay its long term debt

profitabilty ratios

which give an idea of how the firm has financed its assets as well as the firm’s ability to repay its long term debr

market value ratios

which give an idea of what investors think about the firm and its future prospects

satisfactory liquidity ratios are necessary

if the firm is to continue operating

good asset management ratios are necessary for..

the firm to keep its costs low, and net income high

debt management ratios indicate how..

risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders

profitability ratios combine..

the asset and debt management categories and show their effects on ROE

market value ratios tell us..

what investors think about the company and its prospects

managers have the most control over..

their firm’s ROE; ROE tends to be the main focal point

liquidity ratios help answer the questions:

will the firm be able to pay off its debts as they come due and thus remain a viable organization?

liquid asset

one that trades in an active market and thus can be quicly converted to cash at the going market price

besides strong liquidity, what might a high current ratio suggest about a firm’s asset management?

it could indicate too much old inventory, accounts receivable that may become bad debts, or overall inefficient management of cash, and inventory relative to sales