Fundamentals of Finance Lecture Review

Comprehensive flashcards covering introductory finance concepts, business organizations, principles, financial statements, time value of money, investment criteria, and risk/return according to the provided lecture transcript.

What is the definition of Finance provided in the text?

The study of how people/businesses evaluate investments and raise capital to fund them.

What are the three basic questions addressed by the study of finance?

1. What long-term investments should the firm undertake (Capital budgeting decision)? 2. How should the firm raise money to fund investments (Capital structure decision)? 3. How can the firm manage cash flows as they arise in its day-to-day operations (Working capital management)?

What is a key disadvantage of a Sole Proprietorship?

The owner is personally liable for the business debts, known as unlimited liability.

How is a corporation legally different from its owners?

It functions separately from owners (shareholders); it can sue, be sued, and own property.

What is the concept of 'double taxation' in a corporation?

Earnings are taxed at the corporate level, and dividends are taxed at the personal level.

What is a Limited Liability Company (LLC)?

A business form that combines the tax benefits of a partnership (no double taxation) with the limited liability benefit of a corporation.

What is the primary goal of the Financial Manager?

To maximize shareholder's wealth.

What is the purpose of the Sarbanes-Oxley Act (SOX) passed in 2002?

To protect investors by improving the accuracy and reliability of corporate disclosures and mandating senior executives take responsibility for financial reports.

Define Principle 1 of Finance: Money Has a Time Value.

A dollar received today is worth more than a dollar received in the future because it can be invested to earn interest.

Define Principle 2 of Finance: There is a Risk-Return Trade-off.

Investors are risk-averse and prefer certain returns; they only hold risky investments if compensated with additional expected return ($Higher\,risk = higher\,expected\,return$).

What is the difference between 'incremental cash flow' and accounting profit?

Profit is an accounting concept measuring performance, whereas incremental cash flow is the difference between cash flows with a potential investment versus without it.

What are the four types of financial statements?

1. Income Statement 2. Balance Sheet 3. Cash Flow Statement 4. Statement of Shareholder's Equity.

What are the three fundamental accounting principles used to prepare financial statements?

1. The revenue recognition principle 2. The matching principle 3. The historical cost principle.

What is the formula for Earnings Per Share (EPS)?

$$EPS = \frac{\text{Net Income}}{\text{Number of common shares outstanding}}$$

What are the definitions of Gross, Operating, and Net profit margins?

$Gross\,Profit\,Margin = \frac{\text{Gross\,Profits}}{\text{Sales}} \times 100$; $Operating\,Profit\,Margin = \frac{\text{Net\,Operating\,Income\,(EBIT)}}{\text{Sales}} \times 100$; $Net\,Profit\,Margin = \frac{\text{Net\,Profits}}{\text{Sales}} \times 100$

Define Marginal Tax Rate.

The tax rate the company will pay on its next dollar of taxable income; it is the most important for financial decisions.

What is the basic Balance Sheet equation?

$$\text{Total Assets} = \text{Total Liabilities} + \text{Total Shareholders Equity}$$

How is Net Working Capital calculated?

$$\text{Net Working Capital} = \text{Current Assets} - \text{Current Liabilities}$$

What is the quality of earnings ratio?

$$\text{Quality of Earnings} = \frac{\text{Cash Flow from Operations}}{\text{Net Income}}$$

What is the basic formula for Future Value (FVn) in year n?

$$FV_n = PV \times (1 + i)^n$$

What is the Rule of 72 formula?

$$N = \frac{72}{\text{interest rate}}$$

How do you calculate the Effective Annual Rate (EAR)?

$$EAR = (1 + \frac{APR}{m})^m - 1$$

How do you calculate Continuous Compounding EAR?

$$EAR = (e^{APR}) - 1$$

What is the difference between an Ordinary Annuity and an Annuity Due?

In an ordinary annuity, payments occur at the end of each period; in an annuity due, payments occur at the beginning of each period.

What is the formula for the Present Value of a Level Perpetuity?

$$PV = \frac{PMT}{i}$$

What is the Net Present Value (NPV) decision criteria?

Accept investment projects if the NPV is positive ($> 0$) and reject if the NPV is negative ($< 0$).

What is the Profitability Index (PI) formula?

$$PI = \frac{\text{PV of the annual after tax cash flows}}{\text{cost of the project}}$$

Define Internal Rate of Return (IRR).

The discount rate that results in a zero Net Present Value (NPV) for a project.

What are the limitations of the Payback Period method?

It ignores the time value of money, ignores cash flows beyond the payback period, and utilizes an arbitrary cutoff criterion.

How is the total Rate of Return calculated for a stock?

$$Rate\,of\,return = \frac{\text{Ending Price} + \text{Cash Dividend} - \text{Beginning Price}}{\text{Beginning Price}}$$

What are the three forms of the Efficient Market Hypothesis (EMH)?

1. Weak-form: all past market information is reflected. 2. Semi-strong form: all public information is reflected. 3. Strong-form: all information (public and private) is reflected.

Define Systematic vs. Unsystematic Risk.

Systematic risk (market risk) consists of uncontrollable changes in the economy like inflation or interest rates. Unsystematic risk (firm-specific) is risk that can be eliminated through diversification, such as a strike or a failed project.