COB 300 Finance Exam #1

Finance

the system that includes the circulation of money, the granting of credit, the making of investments and the provision of banking facilities

What are the 3 parts finance is divided into?

-financial management

-capital markets

-investments

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate.

Proprietorship

an unincorporated business owned by a single person who is responsible for its liabilities and entitled to its profits

Partnership

An unincorporated business owned by two or more persons.

Corporation

A business owned by stockholders who share in its profits but are not personally responsible for its debts

Advantages of Sole Proprietorship

Easiest to start

Least regulated

Single owner keeps all the profits

Taxed once as personal income (no corporate income tax)

Disadvantages of Sole Proprietorship

Limited to life of owner

Equity capital limited to owner's personal wealth

Unlimited liability

Difficult to sell ownership interest

Advantages of Partnership

Two or more owners

More capital available

Relatively easy and cheap to start

Income taxed once as personal income

Disadvantages of Partnership

Unlimited liability

Management disagreements

Lack of continuity

Frozen investment

Difficulty transferring ownership

Difficulty raising capital

Advantages of a corporation

Limited liability

Unlimited life

Separation of ownership and management

Transfer of ownership is easy

Easier to raise capital

Access to capital markets

Disadvantages of a corporation

double taxation

complex and time consuming to set up

Advantages of Limited Liability Company

Members are liable for the debts and obligations of the business only up to the amount of their investment

The number of shareholders is unlimited.

An LLC can elect to be taxed as a sole proprietor, partnership, S corporation, or corporation

Taxed as a partnership

Disadvantages of LLC

difficulty raising capital

complex set up

legal protector varies by state

complicated business structure

Advantages of LLPs

*essentially same as LLC but LLPs are used for professional firms in fields like accounting, law etc.

Disadvantages of LLPs

difficulty raising capital

complex set up

legal protector varies by state

complicated business structure

S corporation

corporation taxed as though it were a partnership with only 100 stockholders allowed and they are exempt from corporate taxes

C Corporation

The most common type of corporation, which is a legal business entity that offers limited liability to all of its stockholders, deals with double taxation, and can easily get large amounts of capital

What are the three reasons any business would be maximized if it were a corporation?

1. limited liability reduces the risk borne by investors

2. A firm's value is dependent on its growth opportunities

3. a corporation has great liquidity

Marginal Investor

an investor whose views determine the actual stock price

Corporate Raider

investor conducting a type of hostile corporate takeover against the wishes of the company because the company is undervalued

Debtholders

a company's banker and bondholders (generally receive fixed payments regardless of how well the company does)

Stockholders

people or entities that own stock in a corporation and therefore are its owners (do better and receive bigger payments when the company does better)

Intrinsic Value

An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely.

What is the primary financial goal of management?

shareholder wealth maximization, which translates to maximizing stock price

market equilibrium

Intrinsic Value = Stock Price

Stockholder-Debtholder Conflicts

Stockholders are more likely to prefer riskier projects because they receive more if the project succeeds.

Bondholders receive fixed payments and are more interested in limiting risk.

Bondholders are particularly concerned about the use of additional debt.

Stocholder's are not always worried about risk bc they're protect by limited liability and can only loose what they put in

Stockholder-bondholder Conflicts

Stockholders are more likely to prefer riskier projects because they receive more if the project succeeds.

Bondholders receive fixed payments and are more interested in limiting risk.

Bondholders are particularly concerned about the use of additional debt.

Stockholder's are not always worried about risk bc they're protected by limited liability and can only lose what they put in

annual report

a yearly statement of the financial condition, progress, and expectations of an organization

verbalsection: letter describing past year and future plans

report section: contains all 4 financial statements

annual report

a yearly statement of the financial condition, progress, and expectations of an organization

verbalsection: letter describing past year and future plans

report section: contains all 4 financial statements

Net Working Capital

current assets - current liabilities

Net Operating Working Capital (NOWC)

current assets - non-interest-bearing current liabilities

hybrid securities

financial instruments that have both debt and equity characteristics

consist of: preferred stock, convertible bonds and long-term leases

Preferred stock

Hybrid between debt and equity;

Typically have fixed periodic payments to investors;

Usually don't have voting rights;

Have a stated par value and dividend is a percentage of that par

convertible bonds

Bonds that can be converted into common stock at the bondholder's option

When do you use accerlerated or straight-line depreciation?

Accelerated for tax purposes

Straight-line for stockholder reporting

Earnings Per Share (EPS)

net income/shares outstanding

Operating Income

sales rev -operating costs

Amoritization

a non-cash charge similar to depreciation except that it represents a decline in value of intangible assets

after tax operating income

EBIT(1-tax rate)

Free Cash Flow

(EBIT(1-T)+ Depreciation) -(capital expenditures + change in NOWC)

the amount of cash that could be withdrawn without harming a firm's ability to operate and produce future cash flows

**when it is negative(usually happens when starting): the company has insufficent funds to finance investments in FA and WC so it will have to raise new money in capital markets

Market Value Added (MVA)

(Po x # of shares) - Book Value

The difference between market value and the book value of a firm's common equity

Economic Value Added (EVA)

EBIT(1-T) - (total invested capital x cost of capital)

Companies create value with this if the benefits of their investments exceed the cost of raising the necessary capital

EVA differs from accounting Net Income because

EVA takes into account the total dollar cost of all capital (includes cost of debt and equity capital)

Progressive Taxes

the higher one's income, the higher the tax rate

marginal tax rate

the tax rate applicable to the last unit of a person's income

Traditional IRA

Individual Retirement Account in which qualified contributions are tax deductible and income and capital gains on investments within the account are not taxed until the money is withdrawn after the age of 59 1/2

Roth IRA

Individual retirement arrangements in which contributions are NOT tax deductible but the future income and capital gains within these accounts are not taxed if the money is withdrawn after age 59 1/2

alternative minimum tax

Created by Congress to make it more difficult for wealthy individuals to avoid paying taxes through the use of various deductions.

Corporate taxes

70 % of dividends received are excluded from taxable income whereas the remaining 30% are taxed at the ordinary tax rate

Triple Taxation on Dividends

1. original corporation is taxed

2. 2nd corporation is taxed on dividends in receives

3. individuals who receive the final dividends are taxed

Triple Taxation on Dividends

1. the original corporation is taxed

2. 2nd corporation is taxed on dividends it receives

3. individuals who receive the final dividends are taxed

The Tax Cuts and Jobs Act (TCJA)

reduced federal corporate income tax rate to one flat rate at 21%

Current Ratio

current assets divided by current liabilities

measures liquidity

Quick Ratio

(Current Assets - Inventory) / Current Liabilities

measure liquidity

Inventory Turnover

cost of goods sold/average inventory

want it to be nigher because that means you're moving your inventory quickly

Inventory Turnover

cost of goods sold/average inventory

want it to be higher because that means you're moving your inventory quickly

Reasons why managers will act in favor of stockholders

1. reasonable compensation packages

2. firing managers

3. the threat of hostile takeover

Financial Management

focuses on decisions about aquiring assets, raising capital, and running the firm so as to maximize its value

Capital markets

relate to the markets where interest rates, along with stock and bond prices, are determined

Investments

involve the sale or marketing of securities, the analysis of securities, and the management of investment risk through portfolio diversification

What do liquidity ratios explain?

the firm's ability to pay off debts that are maturing within a year

what do asset management ratios explain?

how effectively the firm is using its assets

what do debt management ratios explain?

how the firm financed its assets as well as the firms ability to repay its long-term debt

what do profitability ratios explain?

how profitably the firm is operating and utilizing its assets

what do market value ratios explain?

they give an idea of what investors think about a firm and its future prospects

Liquid Asset

an asset that can quickly be converted into cash with little risk of loss

what are some current assets?

cash, marketable securities, accounts receivable and inventories

what are some current liabilities?

accounts payable, accrued wages and taxes, short-term notes payable to its bank

what does it mean when your current ratio is too high?

it means that you are in a very strong and safe liquidity position, but may also mean you have too much old inventory that will be written odd and too many old accounts receivable that will become bad debt

what does it mean when your current ratio is too high?

it means that you are in a very strong and safe liquidity position, but may also mean you have too much old inventory that will be written off and too many old accounts receivable that will become bad debt

Fixed Assets Turnover Ratio

Sales/Net Fixed Assets

*keep in mind the age of the fixed asset because depreciation can change an asset value drastically

Total Assets Turnover Ratio

Sales/Total Assets

when the number is lower than industry average it means that the firm isn't generating enough sales given its assets

Total Debt to Total Capital Ratio

Total Debt / Total Invested Capital

Total Invested Capital

Notes Payable + Long-Term Debt + Total common equity

times interest earned ratio

EBIT/Interest Charges

when the number is below industry average it may mean the company is having difficulty borrowing money

Operating Margin Ratio

EBIT/Sales

when the number is below the average it means that the operating costs are too high

Profit Margin Ratio

net income/net sales

when it's below the average it;s b/c operating margin was below average and profit margin is negatively impacted by the firm;s heavy use of debt

Profit Margin Ratio

net income/net sales

when it's below the average it's b/c operating margin was below average and profit margin is negatively impacted by the firm's heavy use of debt

Return on Total Assets (ROA)

Net Income/Total Assets

lower value than average is NOT good, it is the result of using large sums of debt

Return on Common Equity (ROE)

Net Income/Common Equity

when the average is not drastically lower but the other ratios are that is b/c of the company's greater use of debt

Return on Invested Capital (ROIC)

EBIT(1-T)/total invested capital

Basic Earning Power (BEP) Ratio

EBIT/Total Assets

lower value of this when you have high inventory

this will be lower if your turnover ratios are low and you have a poor profit margin

What three ways are market value ratios used

1. by investors when deciding to buy or sell stock

2. by investment bankers when setting the share price for a new stock issue

3. by firms when they are deciding how much to offer for another firm in a potential merger

Price/Earnings (P/E) Ratio

market price per share/earnings per share

relatively high values for firms with strong growth prospects and little risk, but low for slowly growing and risky firms

*will fall as the company becomes more stable

book value per share

common equity / shares outstanding

market/book (M/B) ratio

market price per share/book value per share

companies that are well regarded by investors have high market book ratios

DuPont Equation

ROE = Profit Margin x Asset Turnover x Equity Multiplier

OR

ROE= (net income/sales) x (sales/total assets) x (total assets/total common equity)

Profit Margin

tells us how much the firm earns on its sales

if the firm can command a premium price and hold down its costs then this will be high which helps ROE

when it is below average it means costs ate not being controlled well

Profit Margin

tells us how much the firm earns on its sales

if the firm can command a premium price and hold down its costs then this will be high which helps ROE

when it is BELOW average it means costs are not being controlled well

Equity Multiplier

directly tied to the use of debt

(more debt used = higher equity)

Equity Multiplier

directly tied to the use of debt

Benchmarking

a process by which a company compares its performance with that of high-performing organizations

trend analysis

An analysis of a firm's financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition.

Uses of ratios by 3 main groups

1. Managers: to help analyze, control and improve firm's operations

2. credit analysts: to help judge a company's ability to repay its debts

3. stock analysts: interested in a company's efficiency, risk and growth prospects

Limitations to analyzing ratios

1. ratios are better/more useful for narrowly focused firms rather than multidivisional ones

2. most firms want to be better than just the average

3. inflations has distorted many firm's balance sheets so their book value isn't their market value

4. seasonal trends distort ratios

5. firms employ "window dressing" to improve financial statements

6. different accounting practices can distort comparisons

7. it is difficult wether to generalize if a ratio is good or bad

8. firms often have some ratios that look good and others bad making it hard to tell if the company is balanced or not

Things to consider: What would happen if the company's revenues were tied to one key customer?

the company could decline drastically if they were to lose that customer, but if there's no alternative sales with stablize

Things to consider: To what extent are the company's revenues tied to one key product?

focusing on one thing is efficient but no diversification increases risk because having variety stabilizes profits and cash flow

Things to consider: To what extent does the company rely on a single supplier?

one supplier could lead to an unanticipated shortage and a hit to profits/sales

Future Value (FV)

the amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate