Fin 300 Midterm Masterset

Role of Financial Manager

Make decisions on behalf of the firm's investors

For good decisions, the benefits exceed the costs

Stakeholder Theory

A theory that holds that social responsibility is paying attention to the interest of every affected stakeholder in every aspect of a firm's operation

Capital Budgeting

the process of analyzing the needs of the business and selecting the assets that will maximize its value

Financing decision/Capital structure decision

How will the company obtain investment capital to obtain its productive assets?

Financing Decision

How a firm builds the liability and equity side of the balance sheet to finance its investments. Whether the firm chooses to finance (pay) for its assets through using debt, or issuing equity.

equity

ownership of assets that may have debts or other liabilities attached to them

Agency Conflict

the possibility of conflict of interest between the stockholders and management of a firm

Agency Relationship

relationship between stockholders and management

Sarbanes-Oxley Act (SOX)

Regulations passed by Congress to reduce unethical corporate behavior.

FED

the Federal Reserve System (the nation's central banking organization)

FED goals

1) Maximum Employment

2) Price Stability

3) Financial Market Stability

FED tools

open market operations, discount rate, reserve requirement

open market operations

the buying and selling of government securities to change the supply of money

discount rate

rate the Federal Reserve charges for loans to commercial banks

Reserve Requirements (RR)

- affect how much money banks can create by making loans

- the fraction of deposits banks must hold in the vault or on deposit at the FED

Financial Markets

markets where financial securities, such as stocks and bonds, are bought and sold

Primary markets versus secondary markets

-Primary markets are the markets in which corporations raise new capital. The corporation selling a newly created stock receives the proceeds from the sale in a primary market transaction (Business/Gov to Investor)

-Secondary markets are markets in which existing, previously issued securities are traded among investors. (investor to investor)

EMH (efficient market hypothesis)

Theory describing the behavior of an assumed "perfect" market in which (1) securities are in equilibrium, (2) security prices fully reflect all available information and react swiftly to new information, and (3), because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities.

Securities

stocks and bonds

real versus nominal interest rates

- a nominal interest rate makes no allowance for inflation

- the real interest rate is the amount of extra purchasing power a lender must be paid for the rental of his/her money

--- the ex ante real interest rate is adjusted for expected changes in the price level

---the ex post real interest rate is adjusted for actual changes in the price level

Fisher Equation

states that the real interest rate equals the nominal interest rate minus the inflation rate

real interest rate = nominal interest rate - inflation rate

nominal interest rate = real interest rate + inflation rate

real interest rate formula

= nominal interest rate - inflation rate

nominal interest rate formula

= real interest rate + inflation rate

Annual report

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

annual report includes

1. Financial statements.

2. Management discussion and analysis.

3. Notes to the financial statements.

4. Auditor's report.

balance sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

income statement

A financial statement showing the revenue and expenses for a fiscal period.

RE statement

• The revision and publication of one or more of a company's previous financial statements

• Necessary when it is determined that a previous statement contains a material inaccuracy

• Company must file a form 8-K within four days to notify investors of non-reliance on previously issued financial statements

Beg RE

+ NI

-Dividends

End RE

Statement of Cash Flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.

Statement of Cash Flows Equation

Cash flows from operating activities + cash flows from investing activities + cash flows from financing activities = change in cash

CFO +/- CFI +/- CFF = Change in Cash

current assets

cash and other assets expected to be exchanged for cash or consumed within a year

current liabilities

debts of the business that must be paid within the next accounting period

Current Ratio Definition

measures a company's ability to repay debt in the short term

Treasury Stock

A corporation's own stock that has been reacquired by the corporation and is being held for future use (later reaquired)

Market Value vs. Book Value

The balance sheet provides the book value of the assets, liabilities, and equity.

Market value is the price at which the assets, liabilities, or equity can actually be bought or sold.

Taxes of a Corporation

A corporation is a taxable entity; it must pay income taxes on its profits and also file a tax return, dollar is taxed twice before it is deposited by shareholder

corporate income tax (CIT)

The United States imposes a tax on the profits of US resident corporations up to a maximum rate of 35 percent. The corporate income tax is the third largest source of federal revenue

Financial Ratios

relationships determined from a firm's financial information and used for comparison purposes

financial ratio analysis

a technique for measuring the performance of a firm according to its balance sheet, income statement, and market valuation

financial performance

how successful or not a company is in a financial way

revenue recognition, cash flow, payment guarantees, credit rating, stock price

Quick Ratio Definition

The Quick Ratio is a measure of a business' ability to pay its short term obligations that is a more strict test than the current ratio.

inventory turnover definition

Number of times inventory is sold and replaced

total asset turnover definition

measures how efficiently a company's assets are being used to generate sales

Equity Multiplier definition

indicates the portion of a company's assets that are funded by equity

profit margin definition

measure of the firm's operating efficiency - how well it controls costs

(measures the income earned on each dollar of sales)

ROA definition

indicator of how profitable a company is relative to its total assets

EPS definition

the portion of a company's profit allocated to each outstanding share of common stock

PE (Price Earnings)

the price of a share divided by the company's earnings in the past year

Enterprise Value (EV)

A measure of a company's total market value from which the value of cash and short-term investments have been subtracted.

minority interest

a subsidiary company's equity that is held by stockholders other than the parent company

trend analysis

an analysis that focuses on aggregate sales data over a period of many years to determine general trends in annual sales

peer analysis

•using other firms in same period as benchmark

TVM (Time Value of Money)

Addresses the concept that a dollar today is better than a dollar tomorrow due to inflation

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

Present Value (PV)

the current value of future cash flows discounted at the appropriate discount rate

compounding

the process of accumulating interest on an investment over time to earn more interest

(the process in which interest is earned on both the principal and on any previously earned interest)

Continuous Compounding

Compounding interest literally all the time. Equivalent to compounding interest an infinite number of times per year.

discounting

- the process of finding present value; the inverse of compounding to find future value

- The process of finding the present value of a cash flow or a series of cash flows; discounting is the reverse of compounding.

Cash flows over a project's life should include _____.

depreciation and amortization expenses

Depreciation Expense

The portion of the cost of a fixed asset that is recorded as an expense each year of its useful life.

Amortization

the reduction of a loan balance through payments made over a period of time

Amortization Expense

Operating Expense, Income Statement, Debit

Annuities

annual payments from the government

perpetuities

an annuity that continues to pay forever

annuities with infinite lives

PV perpetuities = PMT/(discount rate)

Preferred Stock Dividends

Fixed. Have priority over common stock dividends.

stock dividend

Corporation's distribution of its own stock to its stockholders without the receipt of any payment.

APR (Annual Percentage Rate)

The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

Another name for the yearly interest rate charged on the balance of a credit card.

Capital: What are the two basic sources of funds for all businesses?

The two basic sources of funds for all businesses are debt and equity.

Management role: What is net working capital?

It measures a company's short-term liquidity and operational efficiency.

Cash flows: Explain the difference between profitable and unprofitable firms.

A profitable firm is able to generate enough cash flows from productive assets to cover its operating expenses, taxes, and payments to creditors. Unprofitable firms fail to do this, and therefore, may be forced to declare bankruptcy, or close the business.

Management role: What three major decisions are of most concern to financial managers?

1. Capital Budgeting – Deciding which long-term projects to invest in

2. Capital Structure – Determining the best mix of debt and equity financing

3. Working Capital Management – Managing short-term assets and liabilities for liquidity

Cash flows: What is the appropriate decision rule for a firm considering undertaking a capital project? Give a real-life example.

A firm should undertake a capital project only if the value of its future cash flows exceeds the cost of the project. For example, a financial manager would not invest $10,000,000 in a new production line if the net present value of future cash flows from that line are expected to be only $9,000,000. That would be like throwing $1,000,000 away.

Management role: What is a firm’s capital structure, and why is it important?

Capital Structure is the mix of a firm’s debt and equity used to finance its operations.

Importance:

• Affects risk and return balance

• Influences cost of capital

• Impacts financial flexibility and control

Management role: What are some of the working capital decisions that a financial manager faces?

The financial manager must make working capital decisions regarding the level of inventory to hold, the terms of granting credit (accounts receivable), and decide the firm’s policy on paying accounts payable.

Finance function: All public companies must hire a certified public accounting firm to perform an independent audit of their financial statements. What exactly does the term audit mean?

An independent examination of a company’s financial statements to ensure accuracy, fairness, and compliance with accounting standards.

Firm’s goal: What are some of the drawbacks to setting profit maximization as the main goal of a company?

Drawbacks include: It is difficult to determine what is meant by “profit”; It does not address the size and timing of cash flows—it does not account for the time value of money; It ignores the uncertainty or risk of cash flows.

Firm’s goal: What is the appropriate goal of financial managers? How do managers’ decisions affect how successful the firm is in achieving this goal?

Goal: Maximize shareholder wealth (increase stock price).

Managers’ decisions impact profitability, risk, and growth, which determine the firm’s success in reaching this goal.

Firm’s goal: What is stakeholder value maximization?

The idea that corporate management should focus on the value or wealth of the company’s stakeholders including managers, other employees, suppliers, creditors, and the government as all of these groups contribute to the value that managers can produce for stockholders.

Firm’s goal: What is stockholder welfare maximization?

means making decisions that increase the overall well-being and long-term value for shareholders, not just short-term profits.

Firm’s goal: What are the major factors that affect a firm’s stock price?

1. Earnings and growth prospects

2. Risk level

3. Dividend policy

4. Market conditions

5. Investor perception and sentiment

Environmental, Social, and Governance: What is the goal of ESG disclosure standards?

To provide transparent, consistent, and comparable information on a company’s environmental, social, and governance practices for investors and stakeholders.

ESG: Why might different ESG ratings agencies assign very different ESG scores to the same company?

Different ratings agencies focus on different aspects of ESG, they measure those aspects of ESG in a variety of ways, and use diverse processes when developing an overall ESG rating.

ESG: Stockholders who submit environmental shareholder proposals to companies would most likely want managers to pursue which corporate goal? Explain your answer.

Stockholders submitting environmental proposals want managers to pursue sustainable, long-term value creation by integrating environmental responsibility into corporate goals.

This aligns profit with protecting the environment, reducing risks, and enhancing reputation.

Agency conflicts: What is an agency relationship, and what is an agency conflict? How can agency conflicts be reduced in a corporation?

• Agency Relationship: When managers (agents) are hired to act on behalf of shareholders (principals).

• Agency Conflict: When managers’ interests differ from shareholders’, leading to decisions that may not maximize shareholder value.

• Reduction Methods:

  • Align incentives (e.g., stock options)

  • Strong corporate governance

Firm’s goal: What can happen if a firm is poorly managed and its stock price falls substantially below its potential price if the firm was better managed?

• Loss of investor confidence

• Higher cost of capital

• Vulnerability to takeovers

• Difficulty raising funds

• Lower employee morale and retention

Agency conflicts: What are some of the regulations that pertain to boards of directors that were put in place to reduce agency conflicts?

Some of the regulations include: The majority of board members must be outsiders; A separation of the CEO and chairman of the board positions is recommended; Firm is required to have a code of ethics approved by the board

Agency conflicts: What are some of the regulations that pertain to executive compensation that were put in place to reduce agency conflicts?

• Sarbanes-Oxley Act (SOX): Increased transparency and accountability in executive pay

• Dodd-Frank Act: Requires shareholder votes on executive compensation ("say on pay")

• SEC rules: Mandate detailed disclosure of executive compensation packages

• Clawback policies: Allow recovery of bonuses for misconduct or restated earnings

Agency conflicts: How does stockholder voting act as a corporate governance mechanism?

Managers have to consider whether or not the issue to be voted on is in stockholders’ interests before it goes to a vote—if it is likely to fail managers may not even raise the issue as having a proposal voted down makes them look bad. Second, if an issue does go to a vote shareholders have the final say and can vote it down if it is not in their best interest.

Agency conflicts: What are the advantages and disadvantages of dual class stock?

Advantages:

• Allows founders to retain control

• Protects long-term vision from short-term market pressures

Disadvantages:

• Reduces shareholder voting power

• Can lead to governance risks and less accountability

Business ethics: How can a lack of business ethics negatively affect the performance of an economy?

A lack of business ethics can lead to corruption, which, in turn, creates inefficiencies in an economy, inhibits the growth of capital markets, and slows the rate of overall economic growth. For example, the Russian economy has had a relatively difficult time attracting foreign investment since the fall of the Soviet Union due, in part, to weak ethics and corruption in the business community and local and national governments. Lower foreign investment has led to slower overall economic growth than the country might otherwise have enjoyed

Business ethics: What ethical conflict does insider trading present?

It creates unfair advantage by using non-public information, violating fairness and trust in the markets

Financial system: What is the role of the financial system, and what are the two major components of the financial system?

The role of the financial system is to gather money from households, businesses, and governments with surplus funds and channel these funds to those who need them. The financial system consists of financial markets and financial institutions.

Financial system: What does a competitive financial system imply about interest rates?

A competitive financial system implies interest rates reflect true risk and supply-demand, leading to efficient allocation of capital and fair borrowing costs.

Financial system: What is the difference between saver-lenders and borrower-spenders, and who are the major representatives of each group

Saver-lenders are those who have more money than they currently need. The principal saver-lenders in the economy are households. Borrower-spenders are those who need the money saver-lenders are offering. The main borrower-spenders in the economy are businesses, vbbnm, followed by the federal government, although households are important mortgage borrowers.

Financial markets: List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two?

1. Direct Transfer: Funds move straight from savers to borrowers without intermediaries.

2. Indirect Transfer: Funds flow through financial intermediaries (e.g., banks).

Main difference: Whether intermediaries are involved.

Financial markets: Suppose you own a security that you know can be easily sold in the secondary market, but the security will sell at a lower price than you paid for it. What does this imply for the security’s marketability and liquidity?

As the price of the security is lower than what you paid for it, it has a lower degree of liquidity to you, the owner. That is because the security cannot now be sold without a loss in value to the owner. Marketability refers to the ease with which a security can be sold or converted to cash. The information in the problem mentions that the security could be easily sold in secondary market, which implies it has high degree of marketability to you.

Financial markets: Why are direct financial markets also called wholesale markets?

Because they involve large transactions directly between big investors or institutions, not small retail investors.

Financial markets: Trader Inc. is a $300 million company, as measured by asset value, and Horst Corp. is a $35 million company. Both are privately held corporations. Explain which firm is more likely to go public and register with the SEC, and why.

Trader Inc. is more likely to go public because of its larger size. Since the cost of SEC registration and compliance is very high, larger firms can offset these costs with the lower funding cost in public markets. Smaller companies find the cost prohibitive for the dollar amount of securities they sell.

Primary markets: What is a primary market? What does IPO stand for?

• Primary Market: Where new securities are issued and sold for the first time.

• IPO: Initial Public Offering — a company's first sale of stock to the public.

Primary markets: Identify whether the following transactions are primary market or secondary market transactions.

Jim Hendry bought 300 shares of IBM through his brokerage account.

Peggy Jones bought $5,000 of General Motors bonds from another investor.

Hathaway Insurance Company bought 500,000 shares of Trigen Corporation when the company issued stock.

Secondary market transactions.

Secondary market transactions.

Primary market transactions.