FINA 4200 Exam 1 Review Notes

Capital (funds)

equity and debt capital

Equity capital

private equity, public equity

Private equity (non-tradeable)

family & friends, angel investors, venture capital firms, private equity funds

Public equity (tradeable)

stocks (Initial public offerings & seasoned equity offerings)

Debt capital

private debt, public debt

Private debt

Bank debt, rule 144A debt

Public debt

bonds

Value of a company

FCF1/(1+WACC)^1 +... FCFn/(1+WACC)^n

Free Cash Flow

Revenue - Operating costs & taxes - required investments in operating capital

Capital budgeting decision

what long-term investments should the firm choose, assets, FCF

Capital structure decision

how should the firm raise funds for the selected investments?, liabilities, WACC

Other decisions of firms

Payout decisions, merger & acquisitions, IPOs

Types of businesses

proprietorship, partnership, corporation(unlisted vs listed)

Proprietorship

many firms begin as this, unincorporate business owned by one individual, easy to form/very few regulations, limited life/unlimited liability

Partnership

similar to proprietorships, but more than one owner, General partners (unlimited liability/decision makers) and Limited partners (limited liability/no decision authority)

Corporations

legal entity separate from its owners and managers, unlimited life/limited liability/ease of raising capital, double taxation/subject to a lot of regulations

Private corporations

shares are owned only by a small number of entities, and these shares are not traded on stock exchanges, LLCs,S-corps, B-corps

LLC

limited liability corporations, all the partners are limited partners

S-corps

no double taxation, all shareholders are US citizens

B-corps

main goal is to maximize social welfare, not financial welfare

De-equitization of US capital markets

# of firms and # of shares down

Why the decline in publicly held companies

increase in bankruptcies, growth in private equity, debt capital has been very attractive over the past 20+ years, increase in mergers

Primary objective of financial management

shareholder wealth maximization (maximizing firm value and the intrinsic stock price)

Shareholder's investments

stock price * # of shares = market capitalization

3 important factors in a Balance sheet

asset liquidity, debt/equity ratio, historical cost vs market values

Liquidity

the ease and quickness with which assets can be converted to cash without a significant loss in value, current assets are the most liquid

Higher liquidity represents

a lower probability of running into financial difficulties and provides more flexibility to firms, but also produces a lower rate of returns

Why are companies hoarding cash?

buffer against uncertainty in future profitability (e.g., pandemic, crisis), buffer against drops in lending (2008 mortgage crisis), take advantage of "fire sales" (buy rivals assets cheap, or buy their own stocks at a low price), cheap debt (low interest rates, eg. Issuing a 30-year bond), repatriation of foreign earnings is taxed heavily

Debt

a contractual claim that entities the investor(banks, bondholders) to receive a fixed payment(interest plus principal) from the borrower(firm) within a specified period

Equity

a residual claim, whatever leftover after all other claimants are paid goes to the firm, a portion of which is paid to shareholders as dividends

Debt's effect on shareholders

debt magnifies profits to equityholders, but also magnifies losses (debt increases risk for equityholders)

Income statement

sales - costs = profits

EBITDA

Earnings before interest, taxes, depreciation, and amortization

EBIT

Earnings before interest and taxes

Net Income

EBIT - interest - taxes - preferred dividends

Net cash flow

net income + depreciation and amortization

CFO

NI before preferred dividends + Depreciation - ΔA/R - ΔInv + ΔA/P + ΔAccruals

Working capital = current assets (st. inv., A/R, inventory) - current liabilities (A/P, W/P, Accruals)

NOPAT

Net operating profit after taxes, How much the firm could generate from its operations, (EBIT * (1-Tax Rate))

NIOC

Net investment in operating capital, how much firm spent to support its operations, ΔTNOC from the year prior

FCF

(How much the firm could generate from its operations - how much firm spent to support its operations), financial/free cash flows are used to value firms(DCFs) and to evaluate project profitability

DCF

discounted cash flow method

Operating current assets

includes cash, inventory, receivables, excludes short-term investments(if an asset is generating a financial return, it cannot be an operating asset)

Operating current liabilities

accounts payable and accruals, excludes notes payable(these are the result of a discretionary decision made by the firm, meaning it's not an operating current liability, also, if a liability is charging interest, it cannot be an operating liability)

Net operating working capital

Operating CA(cash+A/R+inventories) - Operating CL(A/P + accruals)

Net fixed assets

operating Long-term assets

TNOC

total net operating capital, Net Operating Working Capital + LT Operating assets

Five uses of FCF

pay interest on debt, pay back principal on debt(LT debt & notes payable), pay dividends, buy back stock, buy non-operating assets (e.g., marketable securities, investments in other companies, etc.)

FCF usage to pay debtholders

interest payments and paying back debt

FCF usage to pay shareholders

dividends, share buybacks

FCF usage for acquiring non-operating assets

payments to acquire ST investments and assets

Is negative FCF a bad thing?

If negative FCF's is due to negative NOPAT(NOT GOOD), If negative FCF's is due to large NIOC (OK if large NIOC stems from large amount of Net fixed assets because they are a long-term asset, NOT GOOD if large NIOC stems from large amount of NOWC because they are a current asset)

ROIC

return on invested capital, NOPAT / operating capital

EVA

economic value added, NOPAT - (WACC x Operating Capital)

MVA

market value added, market value of stock(# of shares of stock * price per share) - Book value of the stock(total common equity)

Methods for evaluating the financial health of a firm

trend analysis, peer group analysis, or both

Trend analysis

same firm over time

Peer group analysis

same year across the firm's peers (same industry/similar size and products)

Liquidity financial ratios

ability to pay bills in the short-run, cash ratio/current ratio/tie ratio

Leverage financial ratios

ability to meet long-term obligations; the best mix of debt and equity, debt asset ratio/debt equity ratio

Asset management (turnover) financial ratios

efficiency of asset use, how effectively a firm uses its fixed assets and sells it products and collects money, total asset turnover

Profitability financial ratios

efficiency of operations and overall business activity, profit margin/return on assets/return on equity

Price-based ratios

investors' view of the firm valuation and performance

ROA

profit margin x Total assets turnover

ROE

ROA * equity multiplier

Equity multiplier

total assets / common equity

Firm valuation methods

discounted cash flow, multiples, dividend growth

Multiples valuation

pick a firm to value, pick a group of firms that is the most comparable(same industry, most similar in size/age/etc.), calculate various price-based ratios(like P/E ratio), average these ratios across comparable firms, compare the firm to its per-share ratios to determine its true price

Bond

financial instrument where a borrowing firm receives a certain amount of money in return for making periodic interest payments and then returning the principal to the lender

Bondholders

have no voting rights within a corporation, but can indirectly influence them by threatening not to renew/refinance the debt

Bond markets

goal is to raise long-term debt capital

Short term debt vs long term debt

short term debt is often cheaper than long term debt, but if rates skyrocket or investor demand may vanish; refinancing risk(long term bonds lock-in fixed payments)

Simple, straight bonds

fixed coupon payments for the life of the bond, plus the principal payment at the maturity

Convertible bonds

bondholders can convert the debt into shares of the firm at a predetermined ratio at their discretion, lower rates than straight bonds

Callable bonds

firms can withdraw the bond sale, higher rates than straight bonds

Variable rate bonds

interest rate is based on Prime rate or LIBOR

Euro bonds

bonds issued in a foreign country in USD

Covered (secured) bonds

collateral is pledged in case of non-payment

Zero coupon bonds

no coupon payments, and the principal plus the interest is paid at maturity

Yield to maturity

the interest rate that equates the present value of coupon payments and principal to the bond's current price

Bond prices(YTM) components

YTM, inflation expectations, default risk, liquidity

TVM(bond prices)

determined by the fed funds rate(floor), higher fed funds rate leads to higher yields and lower prices

Inflation expectations

if expectations of inflation go up, YTM increases and bond prices drop

Liquidity

how quickly we can sell the bond and how close to the bond's true value we can sell, corporate bonds are rated by their default risk (S&P, Moody's, Fitch)

Default risk

the chance of non-payment of principal or interest

Investment grade bonds

BBB or higher rating

Junk/high yield bonds

rating below BBB

Credit default swap (CDS)

CDS spreads pay the bondholders in full in case of default, derivative security

Default risk premium

yield on AAA corporate bond - yield on 10-year treasury bond

Interest rate risk

the sensitivity of bond prices to changes in interest rates

When does a bond have higher interest rate risks

when it has a longer time to maturity(as interest rates change, longer maturity bond prices will change more) or a smaller coupon rate (the smaller the coupons, the less the total PV depends on these intermediate payments & more on the one big cash flow at the very end)

2 types of stock

Common stock, preferred stock

Preferred stock

voting rights and a fixed dividend(like coupon payments)

Board of directors

they are the shareholder's agents in the firm, can fire and hire CEO'S

2 types of cash flows for shareholders

dividends and capital gains(when stockholder sells shares)

If dividends don't grow

Po=D1/R

If dividends grow at a constant rate

Po=D1(R-g)

If dividends grow at a differential rate

growing annuity for first few years (find pv of dividend cash flow) + growing perpetuity for rest of years (dividend / r-g, then discounted to present)

When retention ratio increases

1. dividends go down/stock price goes down, 2. Then, dividend growth rate goes up and stock price goes up, depends on whether R is higher or lower than ROE(if R is higher price goes down, If R is lower, price goes up)

Dividend growth rate formula using retention ratio

g = (retained earnings/total earnings) * ROE